Heightened Volatility Results in Sloppy Corporate Bond Trading
While marriages are increasing in the health-care sector, conscious uncoupling increases in the technology sector.
The trading activity in the corporate bond market was described as "sloppy" by one trader last week because of the heightened daily volatility in the stock market. Even after accounting for the snapback rally Wednesday, the path of least resistance over the course of the week was downward. However, while the market softened over the course of the week, portfolio managers were not panicking or indiscriminately hitting any bids that appeared. There were plenty of bid wanted lists, but if investors were not getting the prices they thought were reasonable, then the bonds did not trade and were held back until the tone improved on another day. The sell-off in the equity market is leaving many investors feeling queasy; nevertheless, to put the pullback in the equity market into perspective, the S&P 500 has fallen only 5.6% from its high and year to date has risen 3.13%.
In the investment-grade sector, the damage was relatively contained as the average spread in the Morningstar Corporate Bond Index widened out only 2 basis points to +120. Last week we speculated that the combination of strong employment growth and wide credit spreads would prompt investors to reallocate assets into high yield and inflows would resume. We were correct that fund flows into high-yield mutual funds and exchange-traded funds through Wednesday rose $1.2 billion; however, since the high-yield sector is highly correlated to the stock market, the average spread in the Bank of America Merrill Lynch High Yield Master II Index widened 37 basis points to +466 despite the fund flows. This is the widest spread this index has registered since October last year.
The sloppiness in the investment-grade bond market has been exacerbated by the record-breaking amount of new issuance that was brought to market in September. Much of this new issuance is still sloshing around the secondary market looking for a permanent home. However, many issuers are in their quiet periods ahead of third-quarter earnings releases, which should allow some more time for the market to settle down before the pace of new issuance resumes in the second half of October and beginning of November. As we progress into the reporting season for third-quarter earnings, if earnings are weak or fourth-quarter guidance is lowered, then we could continue to see general market weakness. In this case, we expect new issue concessions will need to widen out significantly in order to generate much market interest. For investors with cash to put to work, this could lead to some attractive opportunities in the new issue market.
The heightened volatility has been caused by the tug of war between concerns that global growth may be slowing versus easy monetary policy. Economic metrics in the eurozone (such as weaker German industrial production and declining exports) and China (slowing purchasing managers' index reports) are suggesting that global economic growth is rapidly dwindling. As the markets are switching into defensive positions, the dollar has been strengthening and the dollar index has risen to its highest level against foreign currencies since mid-2010. Commodity prices have also been dropping precipitously, supporting the notion that global economic growth is slowing. The rate of strengthening of the U.S. dollar has been so robust and rapid that the Fed in its most recent meeting minutes indicated it is concerned that this could weaken the current economic rebound in the United States. Reading between the lines, investors took that comment to mean that the Fed would continue its easy monetary policy longer than was currently thought and will not begin to raise the fed funds rate anytime soon, as that would further bolster the dollar.
Since the beginning of the month, the basic materials sector has widened out by 6 basis points--triple the amount of widening in the general market index. The basic materials sector has been hit by the decline in commodity prices as China's voracious appetite for raw materials has slowed along with its economic growth. As such, we recently reduced our forecast for iron ore and metallurgical coal prices. We now expect real prices for iron ore to average $70 per ton in 2018, a $20 decrease from our prior forecast of $90. The impetus for this reduction is that we expect Chinese steel production will peak at 800 million tons in 2014 and drop to 730 million tons in 2018 (a 9% decline). As steel production declines, we have also reduced our long-term metallurgical coal price forecast to $130 per ton from $160. The energy sector has similarly weakened. The average spread in that sector has widened out by 6 basis points as oil prices have fallen by about $10 per barrel since the end of September and are at their lowest level since the end of 2012.
While Marriages Are Increasing in the Health-Care Sector...
The recent market turmoil has yet to put a dent on strategic mergers and acquisitions in the health-care sector. In a surprising development, Becton Dickinson (BDX) (rating: AA-/UR-, narrow moat) announced plans to acquire CareFusion (rating: A-/UR, narrow moat). As such, we have placed our credit ratings for both firms under review. To finance the deal, Becton plans on increasing its net debt leverage to 3.2 times EBITDA on a pro forma basis from about 0.7 times at the end of June. The company's management team said it intends to maintain a solid investment-grade rating throughout this process and will suspend the share-repurchase program to enable significant deleveraging. However, we anticipate downgrading Becton's credit rating. At first glance, we believe our rating for the combined entity will wind up in the weak A to strong BBB category from its current AA-.
Endo International (ENDP) (rating: BB, narrow moat) announced that it plans to acquire Auxilium (not rated) by mid-2015. This transaction may increase Endo's net debt leverage to the mid- to high 3 times range on a pro forma basis (including planned cost synergies) from 3.1 times at the end of June. Management anticipates that it will be able to deleverage to the low to mid-3 times range within 12-18 months of the transaction's closing. We had expected Endo to remain quite active on the M&A front, and its financial plans remain in line with our view that it will operate with net debt leverage of 3-4 times in the long run. Therefore, at first glance, we do not anticipate changing our credit rating on Endo. Given our view that Endo's credit profile isn't going to change significantly, we maintained our overweight recommendation on the bonds, and Endo still remains a high-yield Best Idea.
After publicizing its initial bid in May, Kindred Healthcare (rating: B-, no moat) finalized its merger agreement with Gentiva Health Services (not rated) on Oct. 9. By using a combination of equity and debt financing and by generating revenue and cost synergies, Kindred's management team has outlined a strategy that could allow the combined entity to deleverage modestly to debt/EBITDAR in the mid-5s by the deal's closing in early 2015 from about 6 times by our estimates at the end of June. While we appreciate Kindred's deleveraging goals, which contribute to our market weight recommendation on its bonds, we do not anticipate changing our credit rating until the firm makes meaningful progress toward those goals.
...Conscious Uncoupling Increases in the Technology Sector
While the strategic M&A in the health-care sector continues unabated, the technology sector is moving in the other direction. Following eBay's announcement to split itself up, several other firms in the tech sector are following suit. We placed Hewlett-Packard's (HPQ) (rating: BBB+/UR, narrow moat) issuer credit rating under review following the announcement of the firm's intention to separate its technology infrastructure, software, and services businesses (enterprise) from its personal systems and printing businesses in a tax-free spin-off to shareholders. We believe Hewlett-Packard has flexibility to structure the new companies with higher leverage without necessarily jeopardizing an investment-grade rating. On the investor call, management stated its expectation that both companies would be structured to merit investment-grade ratings without disclosing specific leverage targets. We look forward to hearing more details in the months ahead on the relative financial structure of the proposed entities and the implications to bondholders. In the interim, we expect that HP Inc. will bear the bulk of HP's existing operating debt, while HP Enterprise will continue to support the financial services business and its related debt.
We placed Symantec's (SYMC) (rating: A+/UR, narrow moat) issuer credit rating under review following the announcement of the firm's intention to separate its core personal and enterprise security businesses from its data backup and storage (information management) businesses in a tax-free spin-off to shareholders. We are also lowered Symantec's senior notes to market weight from overweight until we can rule out some of the more negative outcomes for bondholders. While we do not see a catalyst for near-term upside in the bonds, we would not yet be sellers, given the potential for early redemption of some of the notes. Symantec's 3.95% notes due 2022 are about 40 bps wider relative to where notes were indicated before the breakup news. Without identifying specific capitalization targets for the new entities, management indicated its expectation that the security firm would retain an investment-grade rating and that both entities would be "well capitalized" with "strong balance sheets." In the interim, we view the separation as increasing credit risk for the existing bondholders through a reduction in business diversity and less cash flow support for the outstanding notes.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.