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Credit Insights

Dearth of New Issue Supply Allows Corporate Credit Spreads to Tighten

Corporate credit spreads tightened across the board last week. As we enter earnings season, many corporations are in their quiet periods, leading to a dearth of new issue volume over the past two weeks. This has allowed the market to digest the voluminous amount of bonds priced in March. In addition, rising oil prices boosted bond prices in the beleaguered energy sector. In the investment-grade market, the average spread in the Morningstar Corporate Bond Index tightened 6 basis points to +130. Much of this tightening was led by the energy sector, which tightened 14 basis points as oil rose above $50 a barrel. The energy sector has outperformed the rest of the corporate bond market universe this year and has tightened 66 basis points since our Jan. 12 publication, in which we noted that oil prices had appeared to bottom out in the mid-$40s.

In the high-yield sector, the average spread of the Bank of America Merrill Lynch High Yield Master II Index tightened 22 basis points to +460. The energy sector in high yield easily outperformed the broader high-yield market as it tightened 50 basis points to end the week at +693. Investor demand has helped to push prices up, as there have been three solid consecutive weeks of positive fund flows entering high-yield mutual funds and exchange-traded funds.

Switzerland Sells 10-Year Notes at Negative Yield;
Mexico Finds Buyers of 100-Year Bonds

We are only beginning the second month of the European Central Bank's planned 18-month asset-purchase program, but already we are seeing unusual events in the eurozone bond markets. For example, for the first time, a country sold its sovereign 10-year bonds at a negative yield. While the Swiss 10-year bond started trading at a negative yield in the secondary market in January 2015, in the primary market, Switzerland just sold a new issue at a negative yield of 0.06% last week. In addition, for the first time, a sovereign issuer sold 100-year bonds denominated in euros. Mexico (which is rated A3/BBB+ by Moody's and S&P) issued EUR 1.5 billion 4.20% bonds due 2115.

Elsewhere in the eurozone, interest rates continue to trade at or near their historical lows. The yield on Germany's benchmark 10-year bund has even dropped further to 0.16%, and the lower-rated peripheral eurozone countries such as Italy and Spain ended the week at 1.27% and 1.22%, respectively. While some economic indicators in the eurozone are pointing to near-term stabilization, the financial system in several countries continues to weaken. For example, according to the Bank of Italy, gross nonperforming loans in the country rose 15.3% year over year in February, following a similar 15.4% increase in January. The total amount of nonperforming loans held by Italian banks is estimated at about 15% of total loans.

There is reportedly more than EUR 2 trillion of euro area government bonds that are currently trading at negative yields. Most of these bonds are issued from the core European governments with maturities of up to 7 years. By purchasing a bond at a price that would generate a negative yield if held to maturity, investors are locking in a guaranteed loss if they hold the bonds until they are repaid. Fundamentally, this would only make economic sense is if an investor is expecting a significant deflationary event that would decimate other asset values across the world. Otherwise, the only way for an investor to make money on these bonds is to sell them to another investor at a price that locks in an even greater loss. In this case, speculators expect that they will be able to sell the bonds to the ECB, which has stated that it would buy debt trading at a negative yield.

Considering that interest rates on sovereign bonds in developed markets are near their historically lowest levels, we think corporate bonds should perform well on a relative basis. The proceeds from the ECB's purchases of sovereign debt and asset-backed securities 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. As corporate credit spreads in Europe contract, we think this will pull credit spreads tighter in the United States as well.

Megabuyouts Return to the Forefront
As management teams struggle to generate organic growth in a low-growth world, strategic M&A activity has been robust over the past few years. Royal Dutch Shell (RDS.A) (rating: AA-/UR-, no moat) announced an agreement to acquire BG Group (not rated, narrow moat) for $70 billion of cash and stock.  This is the largest buyout announced this year, one of the largest takeovers in the oil sector over the past 20 years, and one of the top 15 largest buyouts ever. BG's assets complement Shell's by providing access to Brazil's attractive deep-water and North American shale plays. We had placed Shell under review with negative implications on March 13 after revising our midcycle energy outlook, when we lowered our long-term Brent crude oil forecast to $75 per barrel from $100. As a result of the lower price deck, we also lowered our moat rating on Shell to none from narrow. We plan to leave Shell under review with negative implications as we assess the implications of the BG transaction, the proposed asset-sale program, and the current backdrop of low commodity prices on Shell's credit and liquidity strength.

While smaller than Shell's acquisition of BG Group, Mylan (MYL) (rating: BBB-, narrow moat) announced its pursuit of Perrigo (PRGO) (rating: BBB, narrow moat) as a merger target April 8. While Perrigo's management team has yet to respond, Mylan reportedly has offered $205 per share, or about $29 billion in equity and about $34 billion in enterprise value by our estimates, still a sizable deal on its own accord.

However, this transaction is far from a done deal. If Perrigo is willing to sell itself, we imagine other competitors like Teva (TEVA) (rating: A-, narrow moat), Actavis (rating: BBB-, wide moat), and Valeant (VRX) (rating: BB, narrow) could be interested as well. Perrigo is one of the last few sizable generic firms with unique niche attributes. Perrigo's large private-label over-the-counter and prescription topical businesses offer manufacturing, product, and sales channel diversification for potential acquirers such as Mylan that remain heavily exposed to the volatility of the U.S. retail pharmacy generic drug industry.

Chinese Stocks Skyrocket as Investors Bet on More Monetary Easing
Recently released economic indicators show that the Chinese economy has been rapidly slowing in January and February, with many of these indicators hitting multiyear lows. Yet in just the past four months the Shanghai Index has increased 50% and over the past year it has doubled. To combat a slowdown in the Chinese economy, China's central bank cut its benchmark lending rate in November 2014, its first reduction since 2012. This cut was followed by another reduction in February 2015. In addition to the rate cuts, the central bank has eased some regulations, such as lowering the down payment required for a second home in an attempt to bolster property prices.

At the end of March, China's central bank governor said China's growth and inflation rates are declining too much and the central bank has the capacity to ease policies and interest rates even further. His statements bolster the Street's consensus forecasts that China's central bank will cut benchmark lending rates as well as lower banks' required reserve ratios in the near term. Speculation is building that China is close to launching its own quantitative easing program in order to further loosen monetary policy.

Recently, the Hang Seng Index has started to follow suit, increasing more than 10% in just the past two weeks. This increase has been attributed to the news that China is increasing the current stock quota, which limits how much mainland and Hong Kong investors can purchase in each of the jurisdictions' equities. This has allowed the floodgates to open as mainland investors have rushed into Hong Kong-listed stocks.

With the property market in the doldrums, it appears that many investors have switched their preference from buying property to buying stocks. Anecdotal evidence suggests that many of the ingredients to form a bubble are in place. For example, a Bloomberg article said, "The use of margin debt to trade in mainland shares has climbed to all-time highs, while investors are opening stock accounts at a record pace. More than two thirds of new investors have never attended or graduated from high school." Chinese policymakers will need to walk a tightrope over the next several months. On one hand, easing monetary conditions may help to prop up a flagging economy; however, too much easing risks stoking a speculative equity bubble, which when it pops may not only have severe implications for the Chinese economy, but considering that China is the second-largest generator of global GDP, could have international implications as well.

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