Summer Slowdown Takes Hold in Secondary Markets, but Idiosyncratic Risk Remains
Curtain coming down on Greek tragedy.
With organic growth extremely tough to generate in the low-growth global environment, management teams have looked to strategic mergers and acquisitions as well as financial engineering to enhance shareholder value. This company-specific idiosyncratic risk, which often leads to downgrades, has been the biggest risk to bondholders over the past few years. The health-care industry has been one of the most active sectors engaging in M&A, and that trend is continuing. Julie Stralow, Morningstar's health-care credit analyst, first pointed out this emerging theme in her third-quarter 2012 outlook and further detailed the potential for a long-term trend toward strategic acquisitions in her report "Spread-Widening Events Possible in Big Pharma Niche," published in August 2012.
Most recently in the health-care sector, reports have surfaced that major players in the managed-care industry were seeking to merge, but because no deals have been agreed upon, we have kept all our credit ratings intact for now. However, we recommend using caution when considering bonds of key players, given the potential for debt leverage to rise substantially if deals are made. In addition to Cigna (CI) (rating: BBB-, no moat) already at an underweight recommendation, we have changed our bond recommendations on potential acquirers Anthem (ANTM) (rating: BBB+, narrow moat) and Aetna (AET) (rating: BBB+, narrow moat) to underweight on the basis of these reports.
In addition to the risk from M&A, spin-offs and split-ups have also heightened credit risk among some issuers. Last week, Darden (DRI) (rating: BBB-, no moat) announced that it plans to spin off 430 properties into a real estate investment trust and conduct a sale-leaseback transaction on another 75. Darden intends to pay down $1 billion of its $1.5 billion debt load through proceeds from the sale leasebacks, a cash distribution from the capitalization of the new REIT structure, and cash on hand. Lease-adjusted leverage, currently at 3.2 times (which we view as high for a cyclical investment-grade credit), would decline to 2.9 times. Even though Darden is paying down two-thirds of its debt load, lease-adjusted leverage is projected to decline only modestly due to the additional rent expense that is capitalized by 8 times through our lease adjustments.
Trading in the secondary market remained muted, and the new issue market was especially lackluster last week. Market participants continued to bemoan the lack of liquidity as trading occurred in fits and starts. Over the course of the week, spreads in the investment-grade market were weaker more often than not, and the average spread of the Morningstar Corporate Bond Index ended the week where it began at +147. However, in the high-yield space, the average spread of the Bank of America Merrill Lynch High Yield Index tightened 7 basis points to +465.
In our first-quarter outlook published late last year, we made our case on why we expected the high-yield market to outperform investment grade this year. Although much of the outperformance we expected in high yield for this year has already occurred, we continue to expect that high-yield bonds will provide a better return than investment grade. The high-yield segment has a much lower correlation to underlying interest rates than investment-grade bonds and is more dependent on economic conditions. Even though the contraction in GDP for the first quarter was disappointing, Robert Johnson, Morningstar's director of economic analysis, projects full-year GDP growth of 2.0%-2.5%. This should be enough to hold down default rates, which will in turn support the high-yield market.
Curtain Coming Down on Greek Tragedy
In a surprise move at the end of last week, Greek Prime Minister Alexis Tsipras called for a referendum to vote on the terms that were being offered by the official creditors in order to extend further rescue financing. Greek finance officials had requested an extension to accommodate the referendum, but the official lender group has denied the extension request and as such, the bailout financing will expire June 30. In addition, the European Central Bank has decided not to extend any further funding under the emergency liquidity assistance program. Over the past few weeks, we have highlighted the growing impatience and lender fatigue experienced by Greece's creditors, and the call for a referendum appears to be the straw that broke the lenders' back.
Without any further funding from the ECB's ELA program, Greece has announced that it will close the country's banks until July 6 and implement capital controls to eliminate any further cash from leaving the country. While the markets may experience a bout of volatility in the short term, we don't necessarily see a fundamental reason for corporate credit spreads to widen meaningfully.
Over the past few weeks, market volatility has been relatively low in the face of the increasing probability that Greece would be unable or unwilling to negotiate additional bailout financing. In our view, it makes sense that the market is treating a Greek default and/or Grexit as a non-event. The current situation is unlike the conditions in 2010, when a Greek default had the potential to initiate systemic risk and counterparty failures in the financial system. At that time, 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 restructured most of its debt and drew upon loans from official creditors, almost 80% of its debt is now held by organizations such as the International Monetary Fund, European Financial Stability Facility, and ECB. 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. A Greek default is more a political issue than a financial issue, as politicians will have to explain to their constituents why they will most likely experience losses on their exposure, which will need to be absorbed by taxpayers. Depending on the size of losses experienced, this could have implications during the next round of elections across the eurozone.
While credit spreads in the investment-grade market have widened year to date, the spread widening has been driven more by rising interest rates and economic contraction in the first quarter than by the concern that a Grexit would lead to systemic financial contagion. The high-yield market (which would be more adversely affected by the ramifications of systemic risk) has seen credit spreads tighten thus far this year, even in the face of heightened Grexit risk.
Chinese Stocks Correcting; Emerging-Market Bonds Susceptible If Crash Comes
Over the past 52 weeks, the Shanghai Index had risen almost 154% at its peak on June 12; since then, however, the index has fallen 18.8% over the past nine trading sessions. In the face of equity prices skyrocketing, economic activity had been waning over the same period. While the Chinese economy reportedly grew at a 7% rate in the first quarter, that pace of growth was a sequential decrease from the 7.3% recorded in the third and fourth quarters of 2014 and a decline from 7.5% in the second quarter and 7.4% in the first quarter. Recent economic indicators also show that the Chinese economy continues to decelerate. For example, Markit's HSBC Flash China Manufacturing Purchasing Managers Index remains below 50, which is the demarcation between growth and contraction. The estimate for June rose to 49.6 compared with the 49.2 reading in May and 48.9 in April, but it is the fourth consecutive reading below 50.
To combat flagging economic growth, the Chinese central bank has lowered short-term interest rates several times this year as well as cut banks' reserve requirement ratios. Furthermore, the central bank has lowered the down payment required for a second home in an attempt to bolster dwindling property prices. However, these rate cuts and lower reserve requirements have not been enough to stimulate the Chinese economy. During the second quarter, policymakers instituted a program to swap short-term loans to local governments for long-term bonds that can be pledged as collateral with the central bank for low-cost financing in order to free up liquidity and take pressure off refinancing near-term debt. This program will lengthen the maturities of local government loans, reduce interest rates on the debt owed by these local governments, and free up capital to make new loans.
With the Chinese property market in the doldrums, it appears that many investors have switched their preference from buying property to buying stocks. The number of new retail trading accounts being opened in China is currently multiple times higher than any point over the past eight years, including when the Shanghai Index was at its all-time highs in 2007. Anecdotal evidence suggests that many of the ingredients to form a bubble are currently in place. For example, according to a Bloomberg article in April, "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."
Thus far this year, emerging-market bonds have performed well. However, emerging markets are notorious for being an extremely volatile asset class in a risk-off scenario. For example, in 2013, the Morningstar Emerging Markets Composite Bond Index fell 4.43% as investors looked to repatriate cash during the taper tantrum (when interest rates rose sharply as the market priced in the end of the Federal Reserve's asset-purchase program). Investors in emerging-market bonds should keep an eye on the Shanghai Index. If it continues its rapid decline, the risk-off sentiment would probably sweep across all assets in the emerging markets.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.