Credit Spreads Rally on Jobs Report
But market rebound isn't enough to offset losses experienced earlier in the week.
Markets rebounded sharply Friday in response to a surging payroll report; however, the rise was not enough to offset many of the losses experienced earlier in the week. The average spread in the Morningstar Corporate Bond Index tightened 2 basis points Friday, but even including that gain, credit spreads widened to +118 from +115 on a week-over-week basis. The S&P also surged higher Friday but ended down 0.75% on a weekly basis. While the high-yield market weakened at the beginning of the week, it was one of the few asset classes that improved on a weekly basis. The average spread in the Bank of America High Yield Master II Index tightened 13 basis points Friday and ended the week at +429. Even though our weekly fund flows calculation showed that more than $1.6 billion of assets were redeemed from high-yield mutual funds and exchange-traded funds through Wednesday night, we suspect that the combination of strong employment growth and wide credit spreads will prompt investors to return to this asset class and inflows will resume this week.
Economic releases at the beginning of last week were modestly weaker than expected and prompted many investors to reassess their expectations for continued economic growth. For example, while manufacturing reports continued to indicate economic expansion, the levels declined from prior reports. In addition, pending homes sales edged down and auto sales were lackluster. All of these reports were quickly forgotten Friday morning when the payroll report surged higher, prior payroll reports were revised higher, and the unemployment rate fell to its lowest postrecession level. However, Robert Johnson, Morningstar's director of economic analysis, cautioned that he thought the markets were reading too much into this one jobs report. While he acknowledged the report was good, he did not think it was as great as the headline figure indicated. For instance, the report benefited from seasonal factors and the inclusion of 20,000 workers who had been on strike returning to their jobs. In addition, hourly wages inched down. Johnson also thinks the falling unemployment rate, low level of initial unemployment claims, and wage growth in select professions may lead to spot labor shortages in 2015. In this scenario, wages in these professions may increase and pressure corporate earnings, especially for companies that have a high labor component in their cost base. The increase in jobs and the declining unemployment rate will also probably pressure the Federal Reserve to begin raising its federal funds rate sooner than later. The increase in wages, along with our expectation for rising interest rates and the recent increase in the foreign exchange value of the U.S. dollar, could begin to pressure corporate margins next year.
Recent Changes to Best Ideas and Recommendations
We have made several changes to our investment-grade Best Ideas list, including the addition of Celgene (rating: A, narrow moat) and Eaton Vance (rating: A, wide moat) and the removal of eBay (EBAY) (rating: A+/UR-, wide moat). Celgene's bonds widened approximately 20 basis points in September, although there has not been any significant news for creditors to account for the widening. At the current credit spread, we think there is 20 basis points of upside potential for investors if the bonds trade to our fair value estimate. Similarly, Eaton Vance's notes have widened over the past few weeks more than we'd expect. Despite some recent spread widening in the sector as a whole, Eaton Vance's solid earnings, moderate financial leverage, and wide moat make the credit attractive relative to the risk.
We removed eBay's bonds from our Best Ideas and placed the company's issuer credit rating under review based on the intended spin-off of the PayPal business into a separate publicly traded company. Initially, after a shareholder activist had advocated for the company to split up, management had rejected that suggestion and stated that eBay would be stronger with PayPal. However, with the company reversing course and now acceding to the split, we think credit spreads on the bonds may widen further until eBay issues greater clarity as to the proposed capital structure of the remaining entity.
We changed our recommendation on EMC (rating: A+, narrow moat) to overweight from market weight and on NetApp (NTAP) (rating: A+, narrow moat) to market weight from overweight. Based on speculation that EMC may be considering a spin-off of its majority stake in VMware, credit spreads on the company's bonds widened over the past two weeks. EMC's credit currently benefits from its position as a market leader in enterprise storage solutions as well as the embedded value from its 80% ownership of software-defined solutions provider VMware. We would view a spin-off as an incremental reduction in credit support, although, we believe EMC could remain positioned in the A+ category, even if we assume a modestly negative sales growth environment over the next few years. We view the recent widening in EMC as excessive, given our view of the risks, and peg fair value for EMC at 25 bps tight versus NetApp levels. Since we originally recommended an overweight on NetApp's bonds, the credit spread has tightened to our fair value estimate.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.