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Credit Insights

Unusual Activity in 10-Year Treasury Hits Markets

Only best-known issuers with strong balance sheets dared tap the new issue market.

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The corporate credit market suffered another week of widening spreads as investors fretted that global economic growth is slowing and that developed markets' central banks have exhausted their ammunition. In the investment-grade sector, the Morningstar Corporate Bond widened out 6 basis points and ended the week at +162. In the high-yield sector, the average spread in the Bank of America Merrill Lynch High Yield Master II Index had widened as much as 40 basis points by midweek, but recovered almost all of its widening on Thursday and Friday and ended the week at +468, only 2 basis points wider than the prior week. Through the week ended Wednesday, high-yield funds and exchange-traded funds experienced an outflow of $0.7 billion.

Wednesday was the worst day of the week, with traders hiding under their desks to keep from being hit by falling bids. It was not uncommon to see throwaway bids that were 10 basis points below pricing levels being hit. It seems that the market action was at least partially instigated by unusual market movement in the 10-year Treasury bond. As the bond market opened early in the morning, the yield on the 10-year began to steadily decline to a little over 2% from 2.15% as investors bid up the price of bonds as they looked to the safety of Treasuries. However, once the equity market opened, the yield on the 10-year immediately began to gap downward to as low as 1.87% within minutes.

Simultaneously, the S&P 500 fell as much as 2.1%. Within the span of 10 minutes, the yield on the 10-year Treasury had dropped and immediately recovered over 12 basis points, an almost unheard-of movement in what is termed the largest, most liquid market in the world. The S&P 500 also quickly rebounded, recapturing a significant amount of its opening loss, but the damage to market sentiment was already done.

The S&P 500 continued to decline throughout the rest of the morning until it hit the level that was a 10% correction from the top of the market. Hitting the 10% correction level brought out the buyers, and the markets began to generally head back up for the rest of the week. Reportedly, the unusual trading activity in both the bond and equity markets was brought about by an investor who made a large portfolio asset reallocation by selling equities and purchasing bonds all at once, without regard as to market dynamics or price sensitivity.

Two weeks ago when the sell-off began in earnest, we noted that while the market softened, portfolio managers were not panicking or indiscriminately hitting down bids. While full-fledged panic mode has still not set in, one trader described the market as starting to feel a little "panicky" Wednesday and said trading activity had the worst tone in the corporate bond market since the 2011 budget showdown.

Equity market volatility was boosted by recent losses at many hedge funds. There are several stocks that are known as "hedge fund hotels" because of the high concentration of those companies' equities being owned by these alternative asset managers. Those equities were disproportionately hurt as those hedge funds had to sell down positions in order to cover margin calls. For example, in the merger arbitrage space, those investors in Shire (SHPG) (rating: A-/UR, narrow moat) suffered up to 30% losses (and significantly more if their positions were leveraged) after AbbVie's (ABBV) (rating A-/UR, narrow moat) board withdrew its recommendation to merge with Shire. AbbVie's board now recommends that shareholders vote against the proposed transaction in light of new U.S. tax rules on tax inversion deals that make the valuation offered for Shire too rich without previously expected tax benefits.

While it is still nowhere near significant enough to have an impact on the economy, the spread of Ebola was never far from investors' minds. Several portfolio managers mentioned that it is currently a big unknown as to if and how quickly it could spread and that there is no playbook on how a pandemic could affect the economy and markets. If several more cases emerge, especially if those cases were spread from existing victims who were traveling on public flights, then we could see a big leg down in the markets as traders sell first and ask questions later.

The Federal Open Market Committee meets next on Oct. 28-29, with its statement to be released after the second day of meeting. There will not be a press conference after the meeting, nor will the FOMC release updated economic projections. We expect the Fed will continue its path of reducing its asset-purchase program and will halt further purchases. While some of the economic metrics such as the retail sales report have been softer than expected, it would send the wrong signal to the market if the Fed did not wrap up its bond-buying program. By changing course from tapering its purchases, it would indicate to the markets that the Fed is worried that the economy is no longer on as sound a footing as it has been over the past few months.

Downgrades Dominate Rating Actions
Downgrades were the predominant theme in our coverage universe last week as a result of idiosyncratic risks as well as changes to our sector outlooks. We downgraded Becton Dickinson's (BDX) (rating: BBB+, narrow moat) credit rating to BBB+ from AA-, which reflects its higher expected debt leverage pro forma for the acquisition of CareFusion (CFN) (rating BBB+, narrow moat). To finance the deal, Becton plans to increase its net debt leverage to 3.2 times EBITDA on a pro forma basis from about 0.7 times at the end of June. In conjunction with downgrading Becton, we downgraded CareFusion's credit rating to BBB+ from A-.

Similarly, we downgraded Merck KGaA's (MKGAY) (rating: BBB+, narrow moat) credit rating to BBB+ from A, reflecting the increase in leverage planned to fund the acquisition of Sigma-Aldrich (SIAL) (rating: NR, narrow moat). Merck KGaA will fund most of this planned transaction with debt, which we estimate will push net leverage up by about 3 turns to the mid-3s on a pro forma basis.

Rounding out the downgrades in the health-care sector, we downgraded Medtronic's (MDT) (rating: A, wide moat) credit rating to A from AA after the firm revealed plans to increase total debt leverage to fund the Covidien (COV) (rating: A, wide moat) merger. Instead of using its substantial overseas cash stores as it initially anticipated, Medtronic now plans to fund the entire cash portion of the deal with new debt proceeds. We estimate this will push total debt leverage up to about 4 times from our previous expectation in the mid-2 range. Concurrently, we downgraded Covidien's credit rating to A from AA-.

In the basic materials sector, we downgraded our issuer credit ratings for Vale (VALE) (rating BBB, narrow moat) and Anglo American (AAL) (rating: BBB-, no moat) by one notch each as the downward revisions to our iron ore and metallurgical coal price forecast will weaken the company's respective credit metrics. We had recently reduced our forecast for iron ore and metallurgical coal prices and 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 decline 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.

Only Best-Known Issuers With Strong Balance Sheets Dared Tap the New Issue Market
The new issue market was almost nonexistent last week. As we swing into earnings season, many companies are still in their quiet period before releasing earnings. Of those firms that have reported or are not in a quiet period, only well-known issuers with strong balance sheets dared to tap the market despite the ongoing volatility. PepsiCo (PEP) (rating: AA-, wide moat) issued $500 million of 30-year bonds at +130, which was about a 10-basis-point concession to where its existing long-dated bonds were trading. Considering our issuer credit rating is one to two notches higher than the rating agencies', we think the bonds are trading at attractive levels. However, we caution investors that there could be downside if shareholder activists advocating for the company to split up are successful. While we expect Pepsi will remain as a single entity for the foreseeable future, if it were broken up, we expect this would probably result in a multinotch downgrade. Assuming the markets stabilize or recover from this near-term correction, we expect the new issue market will begin to recover this week and then surge for the two weeks thereafter.

David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.