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Credit Insights

AT&T Prices Third-Largest Corporate Bond Deal

The transaction is heavily oversubscribed.

Earnings season has swung into full gear, but thus far very few surprises have emerged. The average spread of the Morningstar Corporate Bond Index rebounded from last week's widening and tightened 2 basis points to end the week at +130. The action was similar in the high-yield market as the Bank of America Merrill Lynch High Yield Index tightened 10 basis points to +456. Oil prices continued to recover, rising to a little over $57 a barrel from $56. As oil prices have generally risen since we noted in our Jan. 12 publication that oil prices had appeared to bottom out in the mid-$40s, the energy sector has outperformed the rest of the corporate bond market. In the investment-grade market, the average spread of the energy sector in the Morningstar Corporate Bond Index tightened 8 basis points to +181 last week and in the high-yield sector, energy tightened 11 basis points to +665. Since the end of last year, the energy sector has tightened a total of 53 basis points in investment grade and 91 basis points in high yield.

The new issue market re-emerged from its quiet-period-induced hibernation with a start, as AT&T (T) (rating: BBB, narrow moat) priced $17.5 billion worth of bonds among several different maturity tranches to fund its acquisition of DirecTV. This transaction is the third-largest corporate bond deal behind Verizon's (VZ) (rating: BBB, narrow moat) $49 billion megadeal in September 2013 and Actavis' (rating: BBB-, wide moat) $21 billion deal in March. We thought initial whisper talk on the notes was especially cheap, and considering how much the price talk was driven tighter when the deal was priced, we were not alone. Reportedly, the offering was almost 4 times oversubscribed as there was more than $65 billion worth of orders for the transaction. The company has been on a bit of a shopping spree; it reported $19.5 billion of acquisitions in the first quarter, with $2.5 billion to fund the acquisition of a Mexican wireless operator and the remaining $17 billion to fund the balance of the wireless spectrum bill. AT&T ended the first quarter with net leverage of 2.3 times, compared with 1.8 times at the end of 2014. If the DirecTV acquisition is completed by year-end, using our forward EBITDA estimates for both companies, we estimate that the pro forma net leverage of the combined company would be around 2.5 times.

High-yield mutual funds and exchange-traded funds experienced the first week of negative inflows over the past five weeks. Some investors appear to be getting increasingly concerned that if Greece is unable to successfully refinance its maturing debt and defaults, that event could cause negative shocks throughout the financial system. In our view, the current situation is nothing like it was in 2010 when a Greek default had the potential to initiate systemic risk in the financial system. 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. After Greece has restructured most of its debt and drawn down upon the loans from official creditors, almost 80% of its debt is now held by organizations such as the International Monetary Fund, European Central Bank, and European Financial Stability Facility. 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 as before.

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.

Bond to Avoid Time Warner Cable's Merger With Comcast Quashed: What Now?
After more than a year of waiting, the proposed merger of Comcast (CMCSA) (rating: AA-, wide moat) and Time Warner Cable (rating: BBB-, narrow moat) was terminated after news broke that staff at the U.S. Department of Justice was preparing to file suit to formally block the transaction. We had placed Time Warner Cable's notes on our Bonds to Avoid List in July 2014 as we thought they were trading at levels that fully reflected the proposed merger with Comcast with no weight given to potential adverse regulatory scenarios.

Even though Time Warner Cable's notes have widened anywhere from 70 to 90 basis points from where they were trading before the news broke, we continue to maintain our underweight recommendation. Our current rating is based on the company continuing to operate as a stand-alone service provider with net leverage sustainable around 3.0 times EBITDA or better over the next five years. However, if management reduces its liquidity or financial flexibility through more aggressive capital allocation or the pursuit of alternative M&A scenarios, we believe the rating could weaken. In addition, Charter Communications (CHTR) (not rated), which had previously bid for TWC, may revive its interest. The potential for Charter to rebid for the company still represents a significant source of potential downside for bondholders as its prior buyout offer probably would have doubled Time Warner's leverage

Chinese Central Bank Eases Monetary Policy
China cut its reserve requirement ratio by 100 basis points to 18.5%, lowering the amount of reserves that a bank must hold against loans. This follows a 50-basis-point cut in February and is the central banks biggest move since 2008. The move came shortly after China's central bank governor publicly remarked at the end of March that China's growth rate and inflation rates were declining too much and that the central bank has the capacity to ease additional policies and lower interest rates. By reducing reserves, China's central bank is freeing up liquidity for the banking system to make additional loans, which in turn should help prop up China's flagging economic growth rate. Two weeks ago, China reported that its GDP rate grew 7.0% in the first quarter on a year-over-year basis, a decrease from the 7.3% rate recorded in the third and fourth quarters of 2014 and 7.5% in the second quarter last year.

In addition, China's central bank will allow banks to use local government bonds from state-owned enterprises as collateral to borrow against the central bank. This move will help to inject a substantial amount of additional liquidity into the banking system. Reports estimated that there is CNY 1 trillion of local government bonds that are eligible to be utilized under this program. These moves come at the same time that a major Chinese real estate developer defaulted on its U.S. dollar-denominated debt, which is raising concerns that Chinese corporate bonds could be at the beginning of a significant default cycle.

With the property market in the doldrums, it appears that many Chinese investors have switched their preference from buying property to buying stocks. Last week we highlighted the parabolic rise in the Shanghai Index and the levitation in Chinese stocks starting to pull stocks in the Hang Seng Index upward as well. The Shanghai Index rose another 2.5% last week and the Hang Seng rose 1.5%. 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 have severe implications for the Chinese economy and, considering that China is the second-largest generator of global GDP, 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.