Weak Oil and Falling Industrial Metal Prices, Along With New Buyout Rumors, Weaken Credit Markets
New issue market subdued; JPMorgan's issue attractive whereas Ecolab looked expensive.
Corporate credit spreads continued to widen last week as the average spread of the Morningstar Corporate Index rose another 8 basis point to +151, its widest level since mid-2013. While the energy sector widened another 11 basis points to +264, helping to pull the index wider, the basic industries sector was the worst-performing sector last week. Basic industries widened 15 basis points, and within the sector, the metals and mining subsector caused most of the damage, widening 23 basis points. Last week, we had opined that oil prices had found a near-term bottom, and subsequently, oil held in the mid- to upper $40s range, which helped to rein in the decline in the energy sector. Among the commodities markets, it was industrial metals that sank last week. For example, copper opened the week at $2.72 per pound, and in one of its worst one-day losses, fell as low as $2.42 before rebounding higher on Friday and ending the week at $2.62.
Typically, in an environment where credit risk is rising, a defensive sector such as consumer products will hold its value better than more cyclical sectors. However, consumer products widened 9 basis points last week as a result of several buyout rumors. Kraft Foods' (KRFT) (rating: BBB+, narrow moat) bonds reportedly widened 30-50 points on speculation that it could be the next target of 3G Capital. 3G Capital and Berkshire Hathaway teamed up in 2013 to purchase Heinz in a debt-funded transaction and have been rumored to be on the hunt for additional acquisitions. We think 3G was attracted to Heinz because of the combination of the company's strong brands and high proportion of international and emerging-market sales. The rationale behind this recent rumor is that 3G could integrate Kraft's strong brands, which are mainly domestically sold, into Heinz's international distribution chain and use Heinz's strength to negotiate for shelf space in international markets. ConAgra CAG (rating: BBB-, narrow moat) was also subject to rumors that it may also be the target of either private equity buyers or shareholder activists. It appears that the rumors for both of these companies began to surface after both had publicly confirmed that they would not present at the Consumer Analyst Group of New York annual conference in mid-February.
In the high-yield sector, the average spread of the Bank of America Merrill Lynch High Yield Master II Index widened 19 basis points to +823. Within the high-yield index, the energy sector widened +40 basis points to +823 and the metals and mining sector widened 39 basis points to +894. Investors, however, appear to be warming up to the higher credit spreads that below-investment-grade bonds offer. Last week, inflows into high-yield mutual funds and exchange-traded funds totaled $0.9 billion, the first week of inflows over the past two months.
New Issue Market Subdued; JPMorgan's Issue Attractive
Whereas Ecolab Looked Expensive
The new issue market remained relatively subdued as we approach earnings season and many companies are in their quiet period. We have heard that the shadow calendar is building and expect that as more issuers report earnings, many will look to tap the capital markets. Among those companies that reported results last week, JPMorgan (JPM) (rating: A-, narrow moat) sold a multitranche offering consisting of 5-year fixed- and floating-rate notes and 10-year bonds. In our view, the spread offered on the fixed-rate notes were attractive. The 5-year was sold at +110 over Treasuries compared with our fair value estimate of +90, and the 10-year was sold at +145 compared with our fair value estimate of +135. Interestingly, after pricing the new issues, JPMorgan subsequently reduced the size of its offering. The total amount of the transaction was reduced to $6.15 billion from the initially priced $7.15 billion offering. While we have seen issuers resize offerings to adjust between maturities or the split between different security classifications (that is, secured versus unsecured), it's a rare event to see the total size of an offering reduced after pricing.
Ecolab (ECL) (rating: BBB+, narrow moat) sold $600 million of debt, consisting of $300 million 3-year notes offered at a spread of +68 basis points over Treasuries and 5-year notes at +88. We had been expecting Ecolab to tab the market and included it on our Potential New Supply list published Dec. 18. We thought the offering was expensive, as our fair value estimates on the notes were +75 and +100, respectively.
Outright Monetary Transaction Program Deemed Legal;
Market Is Pricing ECB Quantitative Easing as a Foregone Conclusion
In the developed markets, long-term interest rates are either near or hitting historic lows. In Europe, as of Jan. 14, 10-year German Bunds are yielding 0.45%, French OATs are 0.63%, Swiss 10-year bonds are reportedly trading at a negative yield of 0.03%, U.K. gilts are at 1.53%, Spanish 10-years are 1.50%, and the Italian 10-year is 1.66%. In other large developed markets, the 10-year U.S. Treasury is yielding 1.81% and the Japanese government bond is 0.25%. On the shorter end of the yield curve, investors are paying up to shelter their assets from the impacts of deflation in the eurozone as the interest rate on German bonds has been driven to a negative yield out to the 5-year point on the yield curve.
These low yields are a reflection of economic weakness and deflationary forces at work in the eurozone, along with the speculation that purchases from a European Central Bank quantitative easing program would spur bond prices higher. Demand from global investors who have diversified away from sovereign European debt has pushed interest rates lower in other countries. These investors have been attracted to the yield pickup and foreign exchange gains from purchasing non-euro-denominated bonds.
With long-term interest rates hitting their historic lows across the globe, it appears that the fixed-income markets have fully priced in a new quantitative easing program by the ECB. Besides figuring out just how to structure and implement a QE program in an economic zone where members each have their own sovereign debt outstanding, the ECB was awaiting a decision on a lawsuit that sought to declare outright monetary transactions as unconstitutional. The OMT program was created in August 2012, backing up ECB President Mario Draghi's statement in July that he would do whatever it took to preserve the euro. This statement and financial assistance program are credited with halting the contagion in the eurozone as Italian and Spanish government bonds were plummeting. If the OMT was ruled unconstitutional, the ECB may not have had the political wherewithal to institute a QE program.
Last week, the advocate general of the Court of Justice of the European Union opined that the OMT program is legal so long that it is used to stabilize the economy and is not used to directly finance governments. While this opinion requires the ECB to justify why it is implementing such a program, the requirement is a low hurdle to preclude the ECB from acting. While the opinion isn't binding, the court has historically ruled using the AG's legal reasoning.
With this legal challenge resolved, only the opposition from Germany stands in the way of the ECB's launching a new QE program. The opposition stems from a cultural aversion to inflation as well as the belief that QE would reduce the motivation for peripheral governments to push through structural economic reforms, as well as place taxpayers at risk of suffering losses if a sovereign government defaults or restructures its debt.
Even though Germany is the single-largest economy in the EU, Draghi has stated previously that he does not need unanimous approval in order to implement an expanded asset-purchase program. The intent of the asset-purchase program will be to rouse inflation in the eurozone; the ECB expects this will help to stimulate the moribund eurozone economy, which has been mired in high inflation and low economic growth.
Several media articles have speculated that a EUR 500 billion program will be announced after the next monetary policy meeting of ECB's governing council on Jan. 22.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.