Corporate Bond Market Rebounding
Tech investors burned by earnings disappointments and recapitalization.
The corporate bond market stabilized and credit spreads recaptured some of the widening they suffered in the first half of October. As the stock market bounded some 4.1% higher last week, lower-rated bonds outperformed the broader market. While the Morningstar Corporate Bond Index tightened only 1 basis point to +125, the BBB- tranche of the index tightened 5 basis points. Even further down the quality spectrum, in the high-yield space, the Bank of America Merrill Lynch High Yield Master II index tightened 30 basis points to end the week at +438.
Even though corporate bonds made some headway in recovering their losses over the past month, this recent rally has lagged the rebound in the equity market. Part of the reason that corporate credit spreads have not yet rebounded to the same degree as the stock market is investors' expectations that there will be plenty of new issue volume over the next few weeks. As portfolio managers are digesting the earnings reports, they are also deciding how they want to position their portfolios for year-end. They assume that they will be able to use such a sizable new issue calendar to readjust their sector and issuer weightings.
Among the asset flows into and out of the bond market, the volatile week-to-week swings in high-yield fund flows continued. For the week ended last Wednesday, high-yield mutual funds and exchange-traded funds saw a net inflow of $1.6 billion. The cumulative amount of fund flows over the past two months is essentially zero.
The next Federal Open Market Committee meetings are Tuesday and Wednesday, with the FOMC's statement to be released after the meeting Wednesday. There will not be a press conference after the meeting, nor will the FOMC release updated economic projections. We expect the Fed will wind down its asset-purchase program and halt any further purchases. While some recent global economic metrics have been softer than expected, we think it would send the wrong signal to the market if the Fed did not end its bond-buying program. Changing the current course would indicate to the markets that the Fed is worried that the economy and job creation are no longer on as sound a footing as they have been over the past few months. In our view, the key to this meeting's statement will be that the FOMC may revise its communication regarding how long it plans on keeping the federal funds rate near zero.
Assuming that the FOMC will vote to conclude its asset-purchase program this week, Monday will be the final permanent open market operation. While the European Central Bank and Bank of Japan are continuing their respective quantitative easing programs, the markets will have to learn to survive without the regular injections of newly created money looking to find a home.
While the average spread of the indexes tightened over the course of the week, there were several issuers whose bonds widened out meaningfully. The technology sector was disproportionately hit as earnings misses and idiosyncratic risk drove spreads wider. For example, International Business Machines' (IBM) (rating: AA-, wide moat) bonds were under pressure after the firm's disappointing earnings release. IBM's 10-year notes widened out about 10 basis points and appear to be poised to widen further. As one trader bemoaned, "There was nothing but sellers out there of IBM paper." Similarly, Amazon's (AMZN) (rating: A-, wide moat) 2022 bonds widened 15-20 basis points after its earnings release disappointed investors. Finally, KLA-Tencor's (KLAC) (rating: A+/UR-, wide moat) 2018 notes were indicated over 20 basis points wider after the firm announced it would pursue a leveraged recapitalization of its balance sheet via a debt-financed special dividend and stock-buyback program. KLAC intends to pay a $2.75 billion special cash dividend equal to $16.50 per common share in November, subject to debt financing. It also announced it will add $250 million of share repurchases to its existing $1 billion share-repurchase plan, to be executed over the next 12-18 months. At the outset, we estimate the new financing will increase gross leverage above 3.5 times trailing EBITDA from its current level of 1.0 times.
Notable Earnings Takeaways
Edwards Lifesciences (EW) (rating: BBB+, narrow moat) reported stellar third-quarter operating results, and we placed its credit rating under review with positive implications due to durable improving operating trends and higher expected cash flow. At first glance, our potential upgrade would be limited to one notch. Our issue credit rating is currently two notches higher than Moody's and S&P, which rate the firm Baa3 and BBB+, respectively.
We placed our AA credit rating for Pfizer (PFE) (rating: AA/UR-, wide moat) under review with negative implications after its board increased the share-repurchase program by $11 billion. Combining this expected increase in returns to shareholders with ongoing weakness in Pfizer's fundamentals relative to peers, we believe our credit rating may deserve a downgrade. At first glance, if we make a change we think that potential downgrade would be limited to one notch. Of note, our bond recommendation for Pfizer has been underweight for some time because of the firm's weak fundamental outlook. It has been our long-held belief that Pfizer needs to consider debt-funded acquisitions to boost growth or increase returns to shareholders who may be disappointed by its weak internal growth prospects.
Among those issuers on our Best Ideas list, Celgene (CELG) (rating: A, narrow moat) reported third-quarter results that highlighted continued expansion of its top and bottom lines. In our opinion, Celgene's notes remain attractively valued. For example, Celgene's 2024s were recently indicated at +124 basis points over the nearest Treasury, 30 basis points wider than the Morningstar A Industrials Index at +94 bps. Quest Diagnostics (DGX) (rating: BBB+, narrow moat) released third-quarter results that were consistent with our expectations, and we would continue to overweight its bonds. Quest issued $600 million in new debt in the first quarter to fund the Solstas and other recent acquisitions, which temporarily inflated debt leverage. Management intends to repay a majority of the incremental debt issued within 18 months of the Solstas transaction, which should push debt/EBITDA toward the mid-2s by the end of 2015 from about 2.9 times by our estimates at the end of September (down from 3.1 times at the end of June). Quest's 2024s are indicated around +178 basis points over the nearest Treasury, compared with the Morningstar BBB+ Industrials Index, which is +126, and peer LabCorp (LH) (rating: BBB+, narrow moat), whose 2023s are indicated around +138 basis points over the nearest Treasury.
Omnicom (OMC) (rating: BBB+, narrow moat) issued $750 million in new 10-year bonds last week at +145 basis points over the nearest Treasury. We view this level as attractive, given the stable leverage level historically and solid operating results. The company posted third-quarter results that were slightly above expectations and is well on pace to meet our full-year revenue and profit outlook. As such, we updated our recommendation to overweight from market weight.
Still Not Fully Reflected in China's Headline GDP,
Real Estate Woes Will Have Big Impact in 2015 (Dan Rohr, CFA)
China reported third-quarter GDP growth of 7.3% on Tuesday (7.4% year to date), beating market expectations. Many regarded the performance as particularly impressive given the troubles in China's real estate market. This is a misinterpretation that provides a dangerously false sense of comfort.
Despite faltering fundamentals, real estate continues to add meaningfully to China's GDP growth. We estimate that real estate added about 0.65 percentage point to GDP growth year to date, based on the contribution of gross capital formation to GDP growth (41.5%) and the contribution of real estate to fixed-asset investment growth (roughly 21%).
Real estate drove more growth than any infrastructure-oriented "ministimulus" from Beijing. Transportation fixed-asset investment contributed 0.29 percentage point to the GDP print. Utilities fixed-asset investment added 0.15 percentage point.
Real estate's contribution to GDP contrasts with the sector's weak coincident and leading indicators. Through September, starts have fallen 9.3% in floor space terms and sales are down 8.3%--both worse than the summer numbers.
As we noted after the release of second-quarter figures, the apparent disconnect is a consequence of how GDP is calculated. GDP number crunchers are mainly focused on changes in floor space under construction. As long as starts (inflow) exceed completions (outflow), floor space under construction rises and so, too, will real estate fixed-asset investment.
While starts and sales have declined this year, floor space under construction continues to rise. Through September, floor space under construction was up 11.5%. Private real estate fixed-asset investment grew a nominal 12.5% in the first nine months of the year. Including public investment (social housing), we estimate total real estate fixed-asset investment growth at about 13.0%. With faltering starts and sales, floor space under construction growth is likely to weaken in the next several quarters. With it, so will real estate fixed-asset investment and GDP.
To better gauge future floor space under construction and real estate's contribution to GDP, we need to consider future completions (outflow) and future starts (inflow).
Completions have been fairly modest in 2014, up 7.2% through September. This is partly a consequence of the comparably soft period for starts in 2009. The average construction period has been about five years recently, so the bulk of those 2009 starts are probably reaching completion in 2014.
The situation should change in 2015 with the arrival of the 2010 "starts vintage." Starts rose a staggering 42% in 2010. We expect completions to rise accordingly in 2015. This would subtract meaningfully from floor space under construction. In doing so, the stage would be set for a diminished GDP contribution from real estate in 2015, provided that starts remain weak.
As discussed in our July report, a 10% decline in floor space under construction roughly translates to a 1.3-percentage-point drop in GDP growth. Taking the year-to-date GDP growth figure as our starting point, a 10% drop in floor space under construction would result in GDP growth of 5.4%-5.5%, all else equal.
The outlook for starts depends heavily on housing prices, but not in the usual way. Rather than boost buyer appetite, falling prices seem to have done the opposite lately. Price weakness has spread in recent months. Prices declined in 68 of China's 70 largest cities surveyed in August compared with declines in 64 cities in July, 55 in June, and 35 in May. Each month, sales declines have worsened.
Falling sales despite better affordability reflects the real estate market's increasing reliance on investment buyers to drive incremental demand. According to a recent study by the China Household Finance Survey, first-time homebuyers accounted for only 19.7% of home sales this year, sharply lower than the 70%-plus share this cohort accounted for in most of the past decade. Buyers who already own a home accounted for a 55.4% share of purchases, while those with multiple homes accounted for 24.9%.
This matters because sentiment plays a critical role in decision-making among investment buyers. In contrast to owner-occupier buyers, for whom falling prices represent an opportunity, investment buyers take falling prices as a sign of weakness. Falling prices beget falling prices. It doesn't help matters that heavily indebted developers need to move inventory to meet onerous repayment requirements.
Falling prices do more than scare away investors: They make investors poorer, too. This is one reason for the weakness in retail sales growth. September retail sales rose 11.6% in nominal terms, the weakest growth since the financial crisis. While 11.6% might sound far from worrisome, readers should note that statistical anomalies mean China's retail sales growth rates aren't directly translatable to GDP-ready figures. Urban consumption spending, a better proxy for the household consumption component of GDP, rose 6.0% over the same interval, weaker than GDP growth.
This negative wealth effect is a big reason we doubt household consumption is likely to accelerate as China rebalances from investment-led to consumption-led growth. Those expecting a smooth handoff from investment and a consumption growth trajectory greater than the 7.5% of the past decade are likely to be disappointed. As a result, so too will those expecting GDP to muster anything better than 5% over the medium term.
New Issue Market Momentum Picking Up
As we expected, the new issue market began to pick back up last week as the credit market stabilized and issuers exited their quiet periods following their earnings releases. While most of the deals performed reasonably well in the secondary market, it was no surprise to us that Verizon's (VZ) (rating: BBB, narrow moat) new issue struggled at the break. Verizon issued $6.5 billion in a three-part deal consisting of 7-year notes priced at +115, 10-year notes at +135, and 20-year notes at +135. We thought the initial whisper talk on the 10-year was reasonably attractive in the mid-150s; however, the official price talk was tightened to +140 (which is where we opined was fair value for the notes), yet the notes were priced 5 basis points inside talk. Several large orders reportedly dropped out of the book, the notes traded wide of the new issue price on the break, and flippers (investors who intend to quickly resell the bonds after issuance to capture the small gain from a new issue concession) immediately sought to hit bids at the new issue spread. Fortunately for investors who participated in Verizon's new issue, a rising market led to tightening credit spreads across the market and the notes finished the week at just inside their new issue spread. We expect the new issue market will be robust over the next few weeks as more issuers exit their quiet periods and the combination of low interest rates with relatively tight credit spreads tempts CFOs to hit the market sooner rather than later.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.