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Credit Insights

U.S. Corporate Bonds Strengthening as Demand From Foreign Investors Picks Up

Corporations benefit in new issue market as demand drives cheaper financing.

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Strong demand for U.S. corporate bonds drove credit spreads tighter across both investment-grade and high-yield markets. In the investment-grade space, the average spread of the Morningstar Corporate Bond Index tightened 6 basis points to +133. Demand was especially strong for 5-year duration bonds of on-the-run issuers. This demand was attributed to a significant amount of assets being reallocated by Japanese investors into U.S. dollar-denominated fixed-income assets. Reportedly, several investment managers were operating under the same mandate and were bidding against one another for the same limited supply of bonds. This demand drove spreads tighter.

In addition to the investments from Japanese buyers, we expect that additional demand will come from European buyers as the European Central Bank begins its quantitative easing program next month. As the ECB purchases sovereign debt and asset-backed securities, the proceeds will need to be reinvested somewhere, and the path of least resistance will be the corporate bond market. This demand is likely to drive corporate credit spreads tighter in Europe. As corporate credit spreads in Europe contract, this will naturally pull credit spreads tighter in the United States. Investors who can purchase debt in either euros or U.S. dollars will gravitate toward the debt that offers both greater spread and a higher all-in yield, which is currently U.S. dollar-denominated debt. In addition, as the ECB prints new euros with the intention of pushing down exchange rates, European investors in U.S. dollar-denominated debt will benefit from the appreciation of the dollar. According to several sources, global investors are already beginning to reallocate funds from the European fixed-income markets into the U.S. markets.

As global investors reach for yield, new funds continue to pour into the high-yield asset class. Another $1.5 billion of new funds was invested in high-yield mutual funds and exchange-traded funds last week. This brings the cumulative amount of money flowing into the sector over the past four weeks to almost $10.6 billion. Since the 2008-09 credit crisis, the only other four-week period that came close to this record amount of inflows into high yield was in November 2011, when $10.3 billion of funds were directed into high-yield assets. Over this most recent four-week period, the average spread of the Bank of America Merrill Lynch High Yield Master Index has tightened by 84 basis points to its current level of +453.

In addition, investors were comforted that oil prices have halted their eight-month slide. A number of weeks ago, we noted that oil prices had appeared to bottom out in the mid- to high $40s. Subsequently, prices 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 8 basis points to +224, and in the high-yield index, the energy sector tightened 32 basis points to +688. 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 11 basis points and ended the week at 2.13%, and the 30-year Treasury rose 11 basis points to 2.74%.

The corporate bond market continued to ignore (correctly, in our opinion) the headlines surrounding the turmoil in Ukraine and Greece's attempt to renegotiate, swap, or write down its outstanding sovereign debt. While a Greek default in 2010 had the potential to initiate systemic risk in the financial system, the situation is substantially different now. Back then, 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. Now, after restructuring most of the debt and drawing down upon the loans from official creditors, almost 80% of Greece's debt is 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.

Individually, Some Fed Officials Lean Toward Raising Rates,
but as a Group, FOMC Sees Lower for Longer

On Feb. 16, The Wall Street Journal detailed comments from 6 of the 17 top Federal Reserve officials of the board of governors. Since the beginning of the year, the comments indicate that these officials are inclined to begin raising the federal funds rate in the middle of this year. However, institutionally, it appears that the Federal Open Market Committee may still be hesitant to raise rates in the near term. Specifically, according to the minutes released for the FOMC's Jan. 27-28 meeting, "Many participants indicated that their assessment of the balance of risks associated with the timing of the beginning of policy normalization had inclined them toward keeping the federal funds rate at its effective lower bound for a longer time." This means keeping short-term rates at essentially zero, the level at which the Fed had dropped short-term rates as part of what was supposed to be a temporary emergency policy when the economy and financial system was crashing in 2008. In addition, "Many participants regarded dropping the 'patient' language in the statement, whenever that may occur, as risking a shift in market expectations for the beginning of policy firming toward an unduly narrow range of dates. As a result, some expressed the concern that the financial markets might overreact, resulting in undesirably tight financial conditions."

Yet the remainder of the minutes consistently highlighted that economic activity expanded at a solid pace in the second half of 2014. For example, industrial production rose at a robust pace in the fourth quarter, and surveys point to moderate gains early this year. Real personal consumption expenditures have risen at a robust pace over the second half of 2014. Additionally, factors that influence household spending support additional gains early this year, and declining energy prices will raise household purchasing power. Finally, the FOMC pointed out that the unemployment rate has fallen to 5.6% and labor conditions had again improved over the past few months.

While credit spreads have been volatile recently, credit conditions are still favorable. New issuance in the bond market is strong, credit flows to nonfinancial firms is rising, and commercial and industrial loans on banks' books is expanding. Both commercial real estate loans and consumer credit are in accommodative modes, and even though residential mortgage conditions are tight, availability is becoming less restrictive.

Taking all of these indicators into account, the FOMC forecasts that real GDP will rise faster in 2015 and 2016 as compared with 2014. Unless there is a rapid deceleration in economic activity or a sharp rise in unemployment over the next few months, it is becoming increasingly harder to understand why the Fed is continuing to hold short-term interest rates at zero.

Corporations Benefit in New Issue Market
as Demand Drives Cheaper Financing

Corporations that issued in the new issue market last week benefited from this demand for corporate bonds as credit spreads on many new issue bonds were much tighter than we thought represented fair value. For example, AmerisourceBergen (ABC) (rating: A/UR-, wide moat) issued 10- and 30-year bonds at spreads of +117 and +152, respectively. Proceeds will be used to fund an acquisition that by our estimates will increase debt leverage by about one turn to the mid-2s, which may warrant a rating downgrade. Relative to competitors, we thought fair value for the new notes is +130 and +165, about 13 basis points wider than where the bonds priced. With AmerisourceBergen's credit profile deteriorating at least in the short term, we would continue to favor Cardinal's Health (CAH) (rating: A, wide moat) notes in the pharmaceutical distribution niche, which include 2024s and 2044s that recently traded at +125 and +157 basis points over the nearest Treasury, respectively.

Among other new issues last week, Boeing (BA) (rating: A, narrow moat) issued debt that we thought was about 10 basis points tighter than our fair value estimates. Waste Management (WM) (rating: BBB+, narrow moat) hit the market with a multitranche offering that, depending on the maturity, we thought was anywhere from 5 to 25 basis points too expensive. Finally, PNC Financial Services' (PNC) (rating: A-, narrow moat) bank issued 3- and 10-year bonds that we thought were 3 and 7 basis points too expensive. The only transaction that we saw value in last week was from Huntington Bancshares' (HBAN) (rating: BBB+, narrow moat) bank, which issued 3- and 5-year notes at +70 and +85, which we thought were 5 and 10 basis points cheap, respectively.

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