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Credit Insights

Investment-Grade Credit Spreads Hit Widest Level in Two Years

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Credit spreads in the investment-grade sector continued to leak wider last week as the average spread of the Morningstar Corporate Bond Index widened 4 basis points to +154. Year to date, credit spreads have widened 14 basis points and are now at their widest level of the past two years. Over the past few months, credit spreads in the investment-grade space have been driven wider by a combination of idiosyncratic risk along with a general widening across the investment-grade bond universe. With the Federal Reserve intimating to the market its intention to begin raising short-term rates later this year, fixed-income investors have looked to reduce interest rate exposure.

Idiosyncratic risk has mainly been driven by two factors. First, with organic revenue growth among global corporations constrained and operating margins near their historical peaks, strategic acquisitions have continued to flourish this year as management teams delve for opportunities to expand their businesses. Second, with the stock market providing lackluster gains thus far this year, shareholder activists continue to press management teams to enact financial engineering in an attempt to enhance equity value, which often comes at the detriment of credit quality.

Of the sectors that have widened the most year to date, many have been beset by M&A activity, which has damaged credit metrics and weakened balance sheets. For example, in the health-care sector, Celgene's (CELG) (rating: A/UR-, narrow moat) bonds widened last week after the firm announced it was spending $7.2 billion to acquire Receptos (RCPT) (not rated). In the media sector, we suspended our rating of Time Warner Cable (TWC) (rating: SUS, wide moat) in anticipation of its merger with Charter Communications. To finance the acquisition, Charter announced the issuance of $15.5 billion of new first-lien notes. Under the proposed structure, TWC will be incorporated into Charter as a direct subsidiary of Charter Communications Operating LLC. Including the new notes, we expect pro forma leverage at CCO to increase to around 3.5 times 2014 combined EBITDA. In our view, this level would be inconsistent with an investment-grade rating without a comprehensive plan to reduce leverage after the merger closes.

Investors in the United States have been focused on the increasing probability that the Fed will begin to raise the federal funds rate later this year. Federal Reserve Chair Janet Yellen reinforced this notion last week. In her congressional testimony, she said she continues to expect the Fed will begin to raise interest rates later this year, albeit at a gradual rate of increase. As the Fed begins to normalize monetary policy by raising short-term rates, the yield on long-term bonds may also rise. In our view, based on a modest economic growth rate for the second half of the year, a more normalized range of the yield on the 10-year Treasury bond is 3.0%-3.5%.

While credit spreads in the investment-grade sector have widened, spreads in the high-yield sector have tightened slightly year to date. Last week, the average spread of the Bank of America Merrill Lynch High Yield Index tightened 2 basis points, and year to date it has tightened 9 basis points, ending the week at +495. The demand for high-yield bonds picked up last week after the Greek government acquiesced to the European Union's conditions to provide further bailout funding. More than $1.1 billion of funds flowed into high-yield mutual funds and exchange-traded funds last week, and year to date, approximately $4.7 billion of money has flowed into the asset class. With its lower correlation to interest rates due to its lower duration and the benefit of higher carry from the wider spreads that high-yield bonds offer, the high-yield market has significantly outperformed investment grade thus far this year.

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, in our recently published third-quarter outlook, we opined that we continue to expect high-yield bonds will provide a better return than investment grade over the second half of the year. 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 level of growth should be enough to hold down default rates, which will in turn support the high-yield market.

Large Universal Banks Post Solid Results;
Recommendation on JPMorgan Raised to Overweight

The large universal U.S. banks reported generally solid results for the second quarter. Generally, the results were characterized by higher net income compared with year-earlier periods (although net income was mostly flat with the levels reported in the first quarter), improved credit quality, and stronger capital ratios.

Other than Goldman Sachs (GS) (rating: BBB+, narrow moat), which was hit by a $1.45 billion legal charge for legacy mortgage-backed securities practices, operating results benefited from normal levels of legal and restructuring expenses. Over the past few years, heightened legal settlements and costs have decimated the profits of many universal banks. Total revenue at the large banks was largely unchanged versus the year-earlier period as net interest income stabilized and fee-based revenue sources failed to produce any standouts. Within the group's investment banking and trading segments, most banks reported investment banking fees that were 10%-20% higher than a year earlier. Trading results were modestly below year-earlier levels, with decreases in fixed-income trading (down 20% year over year) due to weakness in credit and commodity trading, which outweighed improvements in equity trading. The banks generally credited the strength in equities to the Asian markets and generally strong levels of client activity across most equity products.

Modest economic growth and underwriting discipline have contributed to increasingly strong credit quality across the banking sector. Nonperforming loans and loan-loss charge-offs continue to decline to precrisis levels while steady reserves improved coverage metrics. The banks reported loan growth in the mid-single-digit area driven mainly by growth in commercial and commercial real estate loans. Solid profits and restrained returns to shareholders combined to boost capital levels during the quarter. Each member of the peer group reported higher levels of tangible capital relative to tangible assets, higher regulatory capital in the form of common equity Tier 1, and a higher supplementary leverage ratio, a newer metric that compares Tier 1 capital with on- and off-balance-sheet exposures. Capital levels finished the quarter well above current minimum requirements.

JPMorgan Chase's (JPM) (rating: A-, narrow moat) improved results, credit quality, and higher capital ratios, along with wider spreads on the company's bonds, led us to change our recommendation to overweight from market weight. Although the legal settlement marred Goldman's second-quarter results, we maintained our overweight recommendation on the firm's bonds. We maintained our overweight recommendation on Citigroup (C) (rating: A-, narrow moat) and market weight recommendation on Bank of America (BAC) (rating: BBB, narrow moat).

The Cure Is Worse Than the Cold:
Why China's Market Rout Matters and Why It Doesn't

The following is a synopsis of a report published by Daniel Rohr, CFA, on July 13.

The Chinese government's scramble to prop up its stock market in the face of a mass sell-off in the past couple of weeks could prove more damaging than the rout itself. Had the government not intervened, the sharp drop in share prices would have probably had a limited impact on the "real" economy. Beijing's actions cast doubt on its willingness to cede control in more important markets: credit and currency. A stalled reform agenda on these fronts risks further buildup of excess capacity and debt within the economy and undermines efforts to rebalance to a more sustainable growth model. Finally, by staking its reputation on halting the sell-off, the government's struggles risk a crisis of confidence, which could undermine the efficacy of future policy moves aimed at stoking growth.

By itself, the precipitous decline in the equity market should not significantly reduce consumer spending or affect corporate funding. Through its ownership of listed companies, the Chinese government is the dominant equityholder in China, whereas we estimate that stocks account for only 10%-12% of Chinese household financial assets. As such, the historical correlation between China's equity market performance and consumer spending is rather weak. In fact, retail sales slid over the first five months of 2015, despite the remarkable rise in the equity markets. In addition, while the decline in equity prices have reduced the equity market capitalization of the Chinese stock indexes by several trillion dollars from its peak, it is worth noting that the current value of the equities still remains $3.6 trillion higher than a year ago.

The decline in equity prices should not materially affect corporate funding for Chines companies. While equity issuance has soared 261% this year compared with last, totaling $46 billion in the first five months of the year, it pales in comparison with the bank debt market, which provides the dominant source of corporate funding. Over the same period, net new bank loans totaled $849 billion. Thus far, the decline in the equity market has not spilled into the local credit markets.

We see three main risks that we believe are more dangerous than the equity market decline itself.

  • Beijing's decision to intervene in the stock market casts doubt on key reforms.
  • Failure to implement key reforms would heighten the risk of a debt crisis and diminish the economy's long-term growth trajectory.
  • Beijing's initial failure to halt the rout risks denting its credibility as an economic steward.

The Chinese government has built up enormous credibility over the past several decades in its ability to steer its economy. This credibility has helped policymakers keep China's investment-led growth model running longer than any other investment boom that has come before it. However, just as confidence has been critical in keeping growth elevated, a loss of confidence would prove just as self-fulfilling. This credibility may currently be tested by the commodity markets. For example, copper prices have fallen 7% from the stock market's peak June 12 and iron ore prices are down 32%. Initially, copper prices ebbed only slightly as the Shanghai composite index lost 29% of its value in the three weeks after it peaked. It was only after the government's failed intervention that copper posted its big drop, falling from $2.63 per pound to $2.45 in two days. A loss of confidence in the government could have major consequences for the real economy, more so than any stock market crash.

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