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Corporate Bond Market Volatility Remains Low After Spain Successfully Bails In Failing Bank

With the U.S. media focused on former FBI Director James Comey's congressional testimony last week, the most important news to the global corporate bond markets was given short shrift. In our view, the bail-in of Banco Popular by Spanish banking regulators was the most underreported story of the week and has significant implications. While it was long known in the marketplace that Banco Popular required additional capital, a run on the bank's deposits quickly changed from a situation in which the bank would need to either raise capital or sell itself to a situation in which Spanish banking regulators had to conduct a bail-in. The regulators wiped out Banco Popular's contingent convertible bonds and equity and then sold the bank to another Spanish bank for EUR 1. This resolution occurred relatively quickly, as Banco Popular's contingent convertible bonds had been trading at par as recently as the end of March, and just before being wiped out, the equity had a market valuation of over EUR 1 billion.

In 2011 and 2012, the credit spread on Spanish and Italian sovereign bonds widened dramatically as investors became increasingly concerned that those countries' banking systems would require more capital than the sovereign governments could support, possibly leading to an economic disaster. It became a circular problem as weakening bank credit risk led to weaker sovereign risk, which further weakened the banks' capital positions. This downward spiral was halted in July 2012 when European Central Bank President Mario Draghi gave his "whatever it takes" speech, in which he committed the ECB to provide a backstop for the euro system.

Unlike prior banking bailouts, in which the country of the bank's headquarters had to inject public funds, this bail-in has not appeared to cause significant dislocations in the asset markets. In fact, after the market digested the news and realized that Spain did not inject any equity, this successful bail-in reduced the market's perception that resolving a failing bank would require government-provided capital. As such, Spanish and Italian bonds rose, sending the yields on those sovereign bonds down, and their credit spreads tightened. For example, Spain's 10-year bond fell 13 basis points to 1.44% and Italian 10-year bonds fell 17 basis points to 2.09%. In comparison, German's 10-year bond tightened only 1 basis point to 0.26%. Italian yields have been trading much wider than other European Union countries as investors have been concerned that the country may need to support several undercapitalized Italian banks, which probably require additional capital injections.

In the United States, interest rates rose modestly as Treasury bonds fell slightly. Across the yield curve, the 2-, 5-, 10-, and 30-year Treasury bonds rose 4-5 bps, ending the week at 1.33%, 1.77%, 2.20%, and 2.86%, respectively. The increase in the short end of the curve has boosted the 2-year Treasury to near its March 2017 peak of 1.40%, its highest yield since November 2008. The yield on short-term rates has risen in conjunction with the increase in the federal funds rate. Currently, the interest rate market is pricing in a 100% probability that the Federal Reserve will raise the federal funds rate by 25 bps to 1.00%-1.25% following the Federal Open Market Committee meeting that ends June 14. The market also expects at least one more interest rate hike this year, as the market-implied probability of another increase by year-end is 55%.

The average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) tightened 1 basis point to + 117, whereas the BofA Merrill Lynch High Yield Master Index widened 4 bps to +373. The main impetus for the widening in the high-yield market was the decline in oil prices to below $46 per barrel, which pushed the credit spread of the energy sector 24 bps wider last week. Year to date, the Morningstar Corporate Bond Index has tightened 11 bps; at its current level, the index is significantly tighter than its long-term average of 167 bps. Since January 2000, the average spread of the index has only been tighter than the current level 25% of the time. Similarly, the BofA Merrill Lynch High Yield Master Index has tightened 48 bps year to date and is 240 bps tighter than its long-term average of 609 bps. Since January 2000, the index has registered a lower spread only 15% of the time.

In the new issue market, one of the noteworthy transactions was completed by HCA Healthcare (rating: BB, stable), which issued $1.5 billion of 30-year senior secured notes. This represents one of the few instances in which an issuer rated below investment grade has been able to sell bonds with a 30-year maturity. Typically, high-yield-rated companies have been limited to 10-year maturities. Our BB issuer-level rating for HCA reflects our view that the firm may have trouble generating economic profits in the long run, along with its substantial leverage. Although HCA remains one of the largest hospital systems in the U.S., we generally view this business as very challenging because of strong customer and supplier groups, which may make it difficult for HCA to generate profits above capital costs in the long run. Also, regulatory changes, such as the ones recently proposed by Republicans, could swiftly change prospects for profitability, given the firm's significant fixed-cost infrastructure.

Another high-yield company in the healthcare sector, Tenet Healthcare (rating: B-, stable), announced plans to refinance $3.5 billion in existing notes by issuing $3.8 billion of new notes. Our B- issuer-level credit rating for Tenet reflects the company's elevated leverage and ongoing strategy of pursuing acquisitions. Although Tenet is one of the largest hospital systems in the U.S., we generally view this business as very challenging because of strong customer and supplier groups, which may make it difficult for the company to generate profits above capital costs for the long run. At the end of March, the firm's net debt/adjusted EBITDA stood in the low 6 times area. This inflated leverage is primarily from the acquisition of Aspen Healthcare, a former United Surgical Partners International system in the United Kingdom, and a joint venture with USPI to combine ambulatory surgery, short-stay surgical hospital, and imaging center assets, which were both completed in mid-2015. With Tenet planning to reach nearly full ownership of that joint venture by the end of 2019, management does not target leverage to fall below 5 times until that year.

Total high-yield fund flows into open-end mutual funds and exchange-traded funds totaled $0.6 billion last week, comprising $0.4 billion inflows into high-yield ETFs and $0.2 billion of inflows into high-yield open-end mutual funds.

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