Strong Employment Growth Forces Market to Accept That Fed Will Begin to Raise Rates This Summer
Huge new issue supply easily digested by market.
U.S. Treasury bonds fell precipitously Friday as the strong employment report finally forced the market to accept that the Fed will most likely begin to raise short-term rates this summer. The nonfarm payroll report indicated that employment grew by 295,000 in February, easily surpassing the consensus estimate of 230,000, and the unemployment rate fell to 5.5%. With employment growing strongly and unemployment now at the top of the Federal Reserve's estimated range of central tendency, it's increasingly difficult for the Fed to make the case that the federal funds rate should still be zero. The current zero interest rate policy, put in place in December 2008, was originally intended as an emergency measure to support the entire financial system during the financial crisis, which would normalize soon thereafter. While headline inflation will decline in the short term as lower oil prices flow through the economy, inflation excluding energy continues to run near 1.5%, not that much lower than the Fed's 2% target.
The yields on 5-, 10-, and 30-year Treasury bonds rose 20-24 basis points last week, with more than half the increase in yield occurring Friday. Credit spreads tightened at the beginning of the week and then traded in a relatively narrow range for the remainder of the week. The average spread of the Morningstar Corporate Bond Index tightened 6 basis points to +127 and the average spread of the Bank of America Merrill Lynch High Yield Master Index tightened 4 basis points to +442.
Even though Treasury bond yields rose and corporate credit spreads widened Friday, the amount that fixed-income securities will decline over the near term will be limited by the strong international demand for U.S. dollar-denominated fixed-income securities. Much of the recent demand has been attributed to foreign investors in developed markets looking to pick up the higher all-in yield that U.S. corporate bonds offer and invest in the safety of the strengthening dollar. Highlighting this differential in yields, the spread between the 10-year U.S. Treasury and 10-year German bund has risen to +185 basis points, the widest spread that Treasuries have ever offered over bunds.
As the European Central Bank begins its quantitative easing program today and the Bank of Japan continues to weaken the yen with its own asset-purchase plan, we expect global fixed-income investors with the ability to invest wherever they choose will continue to reallocate increasing amounts of their portfolios into U.S. dollar-denominated corporate bonds. As such, based on this demand, corporate credit spreads should continue to strengthen in the near term.
For the sixth week in a row, new funds continued to pour into the high-yield asset class. Last week, $1.1 billion of new money was invested in high-yield mutual funds and exchange-traded funds. This brings the cumulative amount of money flowing into the sector over the past six weeks to $12.5 billion. Since the 2008-09 credit crisis, this is the greatest amount of funds over a consecutive six-week period that has been invested in the high-yield market.
Huge New Issue Supply Easily Digested by Market
Following the deluge of new issuance the prior week, the market was once again inundated with a multitude of new issue offerings last week. Typically, we would expect new issue concessions to widen in the face of such ample supply, but the demand for U.S. dollar-denominated corporate debt easily soaked up the bonds. In fact, not only did new issue concessions evaporate, but many of these new issues priced 25-30 basis points inside the whisper price talk and traded even tighter in the secondary market. For example, Actavis (ACT) (rating: BBB-, wide moat) issued $21 billion of new notes ranging from an 18-month floating-rate note to a 30-year fixed-rate bond. Proceeds will help fund the acquisition of Allergan (AGN) (rating: BBB-, wide moat). Including synergies, we estimate pro forma debt leverage will increase to the mid-4 times area at the deal's closing, up from an adjusted 3.3 times for Actavis at the end of December. Management intends to deleverage to less than 3.5 times within one year of the deal's closing. That commitment to deleveraging, along with the firm's increasing size, diversity, and wider moat, helped keep the combined entity's rating in investment-grade territory. The original whisper talk on the 10-year and 30-year maturities of +200 and +240, respectively, appeared attractive compared with our fair value estimates of +180 and +220. However, the notes were priced tighter at +175 and +210. Even after pricing significantly tighter than the whisper talk, the notes rallied in the secondary market and ended the week at +148 and +188.
However, Quest Diagnostics' (DGX) (rating: BBB+, narrow moat) new issue did not fare as well in the secondary markets. The firm issued new 5-, 10-, and 30-year bonds at spreads of +100, +140, and +200, respectively. In our view, these spreads were fairly valued at the 5- and 10-year maturities and 20 basis points cheap on the 30-year point. However, these bonds performed poorly in the secondary markets and are currently trading at spreads 3-5 basis points wider than the new issue spread. We are maintaining our market weight recommendation on the Quest notes and reaffirming our overweight recommendation on the bonds of competitor LabCorp (LH) (rating: BBB+, narrow moat). While both issuers are operating with inflated debt leverage related to acquisitions, given their similar credit profiles, we prefer the higher compensation available in LabCorp's existing notes. LabCorp's 10-year notes are indicated at +155.
Last week we highlighted the emerging trend for domestic issuers to take advantage of the record-low underlying yields in Europe and issued bonds denominated in euros. We expect this trend will continue over the near term. For example, PPG Industries (PPG) (rating: BBB+, narrow moat) issued EUR 1.2 billion of 7- and 12-year debt, Kellogg (K) (rating: BBB+, narrow moat) issued EUR 600 million 10-year notes, and Delphi Automotive (DLPH) (rating: BBB, narrow moat) issued EUR 700 million 10-year notes.
Banks Breeze Through Federal Reserve's Annual Quantitative Stress Tests
The Fed released the results from the supervisory stress tests conducted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. This year, the stress test differed from prior years in that the Federal Reserve used two scenarios, "adverse" and the newly added "severely adverse," with the latter characterized by a substantial global weakening in economic activity, including a severe U.S. recession, large reductions in asset prices, significant widening of corporate bond spreads, and a sharp increase in equity market volatility. All 31 of the banks subject to the stress test passed, as the minimum of their Tier 1 common ratios stayed above 5% under both the severely adverse and adverse stress-case scenarios. The results are no surprise to us, as they are generally in line with Morningstar's own stress test analyses.
Over the past few years, among the U.S. banks that we rate, we have recognized the strengthening of their balance sheets and declining credit risk as our upgrades have significantly outpaced our downgrades in the sector. However, there could be some market turbulence in the sector later this spring once S&P concludes its re-evaluation of its bank rating methodology for additional loss-absorbing capital and its assessment of extraordinary government support. Earlier this year, S&P downgraded a number of European bank holding companies after it changed its assumptions regarding extraordinary government support from several countries to unlikely and other to less predictable. If S&P's current review of U.S. banks leads to similar downgrades in the United States, many of the banks that are rated single A or A- could be downgraded to BBB+ or BBB. This could lead to selling pressure from investors that are mandated to invest in bonds rated single A or better.
Next on the calendar for the Fed is the March 11 release of the results from the Comprehensive Capital Analysis and Review. The CCAR takes into account each company's capital plans, such as dividend payments, stock repurchases, or planned acquisitions, along with a qualitative assessment of the bank's capital planning process. The Fed basically evaluates whether each bank would still pass the stress test even after planned capital releases. We think the capital return plans of the U.S. banks we cover will be accepted by the Fed, given these banks' prior experience with the process.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.