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Credit Insights

Deluge of New Issues Pressures Corporate Credit Spreads

New issue supply starting to overwhelm demand.

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The corporate bond market experienced a bout of indigestion last week. For the third week in a row, the new issue market was exceptionally strong as more than $50 billion worth of new bonds were priced. Even though there continues to be strong demand for corporate bonds, this amount of supply, in conjunction with the weakening equity markets and falling oil prices, caused credit spreads to widen. In the investment-grade market, the Morningstar Corporate Bond Index widened 6 basis points to end the week at +134. High-yield corporate bonds widened even further as the Bank of America Merrill Lynch High Yield Master Index widened 26 basis points to +468. With oil prices falling back toward their lows, the energy sector was one of the worst-performing sectors, as it widened 13 basis points in the investment-grade market and 37 basis points in the high-yield market. As the equity market sank, investors rotated assets in the Treasury market, which pushed yields on 5-, 10-, and 30-year Treasury bonds down by 12-14 basis points.

Even though corporate credit spreads widened last week, corporate bonds should remain well bid over the next few months. As the European Central Bank's asset-purchase program prints new money to purchase sovereign bonds and asset-backed securities, the path of least resistance will be to reinvest those proceeds in corporate bonds. Considering the all-in yield on European bonds is much lower than in the United States and the U.S. dollar continues to strengthen versus the euro, global investors have been reallocating principal to the U.S. market. Much of the recent demand in the U.S. corporate bond market has been attributed to foreign investors in developed markets looking to pick up the higher all-in yield 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 remains near its historically widest level at +185 basis points. In addition, the Bank of Japan continues to weaken the yen with its own asset-purchase plan which has prompted some Japanese fixed-income investors to also reallocate their asset mix to the U.S. corporate bond market.

After a six-week streak of inflows into the high-yield asset class, the momentum reversed as $2.1 billion of proceeds were redeemed out of open- and closed-end high-yield mutual funds. Considering that the amount of inflows over the prior six weeks was the highest of any consecutive six-week period since the credit crisis, the recent outflows last week do not constitute a threat to the liquidity or trading of high-yield bonds in the near term.

New Issue Supply Starting to Overwhelm Demand
The prior week, we noted that the huge amount of new issues being priced were easily digested by the market; however, the amount of new issues brought last week were more than enough to satiate demand and left some bonds still looking for a permanent home. While trading in the secondary market on the break was a little sloppy for some issues, we did see value in a number of new deals. For example, Zimmer (ZMH) (rating: BBB+, wide moat) priced $7.65 billion of debt to help fund its acquisition of Biomet. Although we expect Zimmer's pro forma debt/EBITDA (excluding anticipated synergies) will rise to about 4.0 times after the planned acquisition, management intends to actively deleverage thereafter. We estimate debt/EBITDA will decline over the next few years but will stay above 2 times until about 2018, which informs our BBB+ rating. Strategically, we think Zimmer merging with Biomet makes sense for both parties, and we believe the merged firm will operate with a wide economic moat. Based on the firm's credit risk pro forma for the transaction and relative to comparables, we think the pricing on the new bonds was anywhere from 5 to 10 basis points cheap to our fair value estimate.

Within the high-yield market, we thought the new bonds to fund Valeant's (VRX) (rating: BB, narrow moat) anticipated acquisition of Salix were priced about 50-60 basis points cheaper than our fair value estimate. However, Endo International (ENDP) (rating: BB, narrow moat) has reportedly topped Valeant's offer, which implies that Valeant may have to raise its offer to get the deal done. If the acquisition is not completed by Aug. 20, Valeant will be required to redeem the new notes at 100% of the issue price plus accrued interest.

Among those deals that we thought were expensive, Cigna (CI) (rating: none, BBB-) issued 10-year bonds at a spread of +115 basis points over Treasuries. We continue to recommend underweighting Cigna's bonds relative to its managed-care peers. We see better value in higher-rated peers, such as Aetna (AET) (rating: BBB+, narrow moat), Anthem (ANTM) (rating: BBB+, narrow moat), and Humana (HUM) (rating: BBB, no moat). Aetna's, Anthem's, and Humana's notes due 2024 recently traded at +103, +112, and +134 bps, respectively. We view bonds from these issuers as about fairly valued. Since we believe Cigna remains a weaker credit than all of these issuers, we would require a wider spread on its bonds than on Humana's notes. In our view, the fair value for Cigna's new notes lies closer to +150 basis points over Treasuries.

Plunging Oil Prices Reduce, and in Some Cases Eliminate,
Economic Moats in Energy Sector

As a result of the emergence of low-cost U.S. oil production, Morningstar's energy research team has revised its midcycle oil price forecasts. We have reduced our assumption for midcycle Brent oil to $75 per barrel from $100 and lowered our West Texas Intermediate forecast to $69 per barrel from $90.

Through its growth potential and ability to quickly scale activity up and down, U.S. shale oil has effectively made the U.S. the world's newest swing producer. Current depressed oil prices will lead to a meaningful decline in near-term production as producers cut spending dramatically: however, oil price increases will be limited. The short-cycle nature and strong economics of the major U.S. liquid oil fields will drive production higher as oil prices recover. We forecast U.S. unconventional oil production will be able to meet nearly 40% of global incremental supply requirements in the coming years, which will serve to effectively crowd out higher-cost oil sands mining and marginal deep-water plays for the foreseeable future. Our forecasts show higher-quality deep-water projects will be the highest-cost source of supply needed during the rest of the decade. This meaningful move down the cost curve drives our revised midcycle oil price forecast.

We also revised our U.S. natural gas midcycle price forecast to $4.00 per thousand cubic feet from $5.40. Our revised outlook is justified by ongoing cost pressures from efficiency gains and excess services capacity, as well as the crowding out of higher-cost production by world-class resources like the Marcellus Shale and associated volumes from oil-rich areas like the Eagle Ford and Permian. While U.S. gas production is likely to slow in the near term as oil-directed drilling hits the brakes, the wealth of low-cost inventory in areas like the Marcellus points to continued growth through the end of this decade and beyond, with the Marcellus being the single-biggest growth driver in our forecast. Increased gas consumption should provide an outlet for this abundance of low-cost supply. Recent reforms to Mexico's energy industry should boost demand for gas in that country (most easily supplied through U.S.-to-Mexico pipelines), while liquefied natural gas exports from the United States are set to become a reality starting next year, with a meaningful ramp-up in volumes likely through the end of the decade. U.S. industrial consumption should also increase, given recent greenfield investments and natural gas' cost advantage in petrochemical manufacturing. Despite our expectation for continued growth in demand, there is more than enough low-cost supply to justify the reduction in our midcycle U.S. natural gas price forecast.

In light of the revised price forecasts, Morningstar's moat committee has reviewed our economic moat ratings across the energy sector. Moats in the exploration and production subsector were reduced to none from narrow if the company is a relatively high-cost producer, which, given the new midcycle prices, depresses returns on invested capital to below weighted average cost of capital over our forecast period. In the integrated space, moats on the European majors were reduced to none from narrow as their European downstream assets continue to weigh on returns on invested capital, which remain below weighted average cost of capital over our forecast period. Following are those companies for which we removed our economic moat rating.

 

Issuer/Ticker

New Moat Rating

Previous Moat Rating

 

Canadian Natural Resources (CNQ)

None

Narrow

ConocoPhillips (COP)

None

Narrow

Devon Energy (DVN)

None

Narrow

Hess (HES)

None

Narrow

Royal Dutch Shell (RDS.A)

None

Narrow

Total (TOT)

None

Narrow

BP (BP)

None

Narrow

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