Investors Ignore Greece, Risk Assets Rally On
More strategic M&A: Expedia to acquire Orbitz.
For the most part, corporate bond market participants have continued to ignore the headlines surrounding the turmoil in Ukraine and Greece's attempt to renegotiate, swap, or write down its outstanding sovereign debt. While the global capital markets could be extremely volatile in the near term if Greece were to default on its debt and exit the European Union, we think the situation is substantially different now than it was in 2010. At that time, Greek debt was widely held throughout the European banking system, yet no one knew exactly who held how much. Banks were concerned that even if they did not hold Greek debt themselves, a Greek default could weaken the solvency of other banks to which they had counterparty risk. After restructuring most of the debt and drawing down on the loans from official creditors, almost 80% of Greece's debt is now held by organizations such as the International Monetary Fund, European Financial Stability Facility, and European Central Bank. As such, the credit counterparty risk is no longer borne by the banking system and would not instigate the same systemic concerns that rippled through the financial markets before.
Instead of focusing in Ukraine and Greece, corporate bond investors in the United States last week focused on the expected positive impact to risk assets from global easy monetary policies and were busy putting new money from inflows to work. As such, the demand for corporate bonds sent the average spread of the Morningstar Corporate Bond Index tighter by 3 basis points to +139, and the average spread of the Bank of America Merrill Lynch High Yield Index tightened 7 basis points to +471. In addition, investors were comforted that oil prices have halted their slide. Oil prices appeared to bottom out in the mid- to high $40s a few weeks ago and subsequently have rebounded into the low $50s. Corporate bonds in the energy sector have similarly rebounded. The average credit spread in the energy sector of our investment-grade index tightened 10 basis points to +232 and in the high-yield index tightened 19 basis points to +717. As risk assets continued to climb, the demand for safe-haven Treasury bonds diminished, sending yields higher. The yield on 10-year Treasury bonds rose 6 basis points and ended the week at 2.02%, and the 30-year Treasury rose 11 basis points to 2.63%.
Investors continued to pour more money into the high-yield asset class as fund flows into junk bonds remained exceptionally robust. Another $3.1 billion of new funds was invested in high-yield mutual funds and exchange-traded funds last week, bringing the cumulative amount of money flowing into the sector over the past three weeks to a little over $9 billion. This is the second-greatest amount of inflows over any three-week span since October 2011, when more than $9.2 billion of cash flowed into the asset class. Over this most recent three-week period, the average spread of the Bank of America Merrill Lynch High Yield Master Index tightened 59 basis points to its current level of +471.
More Strategic M&A: Expedia to Acquire Orbitz
Last week, we highlighted the plethora of recent strategic mergers and acquisitions and contrasted this with the dearth of leveraged buyouts. That trend continued last week as Expedia (EXPE) (rating: BBB/UR-, narrow moat) announced its intention to acquire competitor Orbitz. We were a bit surprised by the announcement as Expedia management had said in December that Orbitz was "doing as well as they can, but they are simply subscale," and that "we don't think we could make a deal happen because of antitrust." We agreed with those thoughts in December, and we question the effectiveness this deal will have on Expedia's network advantage over the long term. The Orbitz acquisition increases Expedia's exposure to the U.S. and to air travel, both of which are slower-growing and lower-margin markets than foreign and hotel markets. While the $1.6 billion purchase price representing 10.3 times Orbitz's 2014 EBITDA appears reasonable, we would have preferred that capital be allocated to markets that offer more growth and diversification for Expedia.
Expedia had $1.4 billion in cash on its balance sheet at the end of the year, but we estimate it will fund the acquisition with at least $900 million in debt. Pro forma (excluding synergies), we forecast leverage will increase to 2.2 times from 1.7 times. As such, we placed Expedia's issuer credit rating under review with negative implications as we await further details on the planned financing for the transaction.
Credit Rating Downgrades Outpaced Upgrades Last Week
The number of downgrades outpaced the upgrades last week. We downgraded AT&T's (T) (rating: BBB, narrow moat) credit rating by two notches in response to the firm's announcement of an $11.2 billion term loan financing to fund its acquisition pipeline. In our review, we evaluated the impact on its credit metrics and financial flexibility of its growing pipeline of announced acquisition commitments, including its wireless auction participation. We also reviewed management's capital-allocation strategy in the context of our five-year outlook for the company's operating performance. Over the past year, AT&T has announced acquisitions totaling $36 billion, including $18 billion of commitments for wireless spectrum purchases as well as last year's announcement of its intent to merge with DirecTV (DTV) (rating: BBB/UR, narrow moat). Following our two-notch downgrade of AT&T, we left our credit rating on DirecTV under review but removed our positive bias as both credits are now equally rated.
After the company raised an additional $1.5 billion of debt, we downgraded our rating on Netflix (NFLX) (rating: BB-, narrow moat) by two notches to BB-. Netflix's cash flow generation is poor because of its heavy investments in content and international growth, which require material up-front costs long before the revenue is realized. Because of the competitive environment, we see content investment as a continual portion of Netflix's expenses. Netflix has a material amount of programming commitments, which pressures its leverage and liquidity profile. We also downgraded our credit rating for BioMarin (BMRN) (rating: BBB-, narrow moat) two notches to BBB- after reviewing the firm's credit fundamentals following the recent Prosensa acquisition. In addition to the downgrades, we placed our credit rating for Bombardier (BBD.B) (rating: BB-/UR-, narrow moat) under review for downgrade following its announcement of weak fourth-quarter results, poor cash flow performance and outlook, various charge-offs, additional debt, and new management. We expect at least a one-notch downgrade when we conclude our review within a couple of weeks.
The lone upgrade last week was for Hospira (HSP) (rating: AA-, narrow moat), which we upgraded to AA- from BBB reflecting its agreement to be acquired by Pfizer (PFE) (rating: AA-, wide moat). Since we expect the acquisition to close as scheduled in the second half of 2015, our credit rating for Hospira is now connected to our Pfizer rating. Based on our estimates, the combined entity's debt/EBITDA will remain stagnant around 2 times and Pfizer's currently large net cash position will probably dwindle to a roughly net neutral position.
Pfizer, on the other hand, is grappling with a negative credit trajectory, in our opinion. Given its weak growth prospects, Pfizer may have incentive to make more capital-allocation decisions that are not friendly to debtholders. Its failed attempt to acquire AstraZeneca in 2014 shows that Pfizer is open to large acquisitions, which could significantly change its financial health.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.