Credit Markets Off to the Races

"Just close your eyes and buy it" is how one credit trader described the fixed-income market this past week. After the Fed put the official stamp on QE2--the second round of "quantitative easing" through which it will buy an additional $600 billion of long-term bonds in a bid to lower long-term rates and stimulate growth--the asset markets were off to the races.

Although the Morningstar Corporate Bond Index tightened just 3 basis points to +152, it felt like the credit market had tightened a lot more. In fact, in the derivative market, investment-grade credit default swap indexes tightened 8 basis points, which took credit spreads back to the levels experienced this spring. As a point of reference, this credit cycle mirrors the tightening cycle earlier this year. It took 74 days for CDS spreads to tighten approximately 30 basis points from +106 in February to +77 in April. In this recent cycle, it took 67 days for CDS to tighten the same 30 basis points from +106 in August. The equity markets have performed similarly, as the S&P 500 increased 15.2% from February to April and 16.8% from August to Friday's close.

As a result of the recent mortgage scandals in the banking sector, credit spreads among financials have lagged industrials in the recent tightening compared with earlier this year. If investors become more comfortable estimating the impact of potential mortgage put-backs to bank credit quality, we would expect the financials sector to catch a bid and lead to additional spread tightening in the Morningstar Corporate Bond Index.

Fixed-income investors coming into the markets with new money were disappointed by the lack of secondary inventory on dealer desks. As one investor put it, "Anything you want to buy, you can't." The new issue market ramped up to fill the void, but even with surging new issuance, investors were still clamoring for more paper.

Over the near term, we expect credit spreads to continue to tighten. With the Fed adding more than $100 billion of liquidity to the market every month until June 2011 and continued demand from institutional and retail investors for fixed income, there doesn't appear to be enough supply to satisfy demand. Exacerbating the lack of supply, Citibank announced in its recently filed 10-Q that it has $40 billion of long-term debt maturing in 2011, of which it expects to reissue only $20 billion. In addition, Citibank does not expect to refinance $58 billion of Temporary Liquidity Guarantee Program debt maturing in 2011 and 2012. If we assume the other large banks have similar maturing and funding requirements, that's a lot of paper coming out of the market.

Over the longer term, we are concerned that one possible unintended consequence of QE2 could be a systemic increase in debt leverage. Companies that pay a high dividend currently have a built-in incentive to issue debt and increase leverage to repurchase equity. For many companies, the aftertax cost of debt is lower than the dividend yield, and the resulting leveraged recapitalization is self-financing and earnings-accretive. These leveraged recapitalizations could cause spreads to widen to account for the additional debt leverage.

Another possible unintended consequence of QE2 is a steepening of the interest rate curve between the 10-year and 30-year Treasury bonds. As seen in the following chart, the 30-year Treasury bond is trading at a historically wide spread to the 10-year. Part of this spread widening is due to dealers pushing up prices in the middle of the curve as they front-run Fed purchases, but we believe this widening is also an indication that investors are beginning to anticipate higher long-term inflation.

The New Issue Market
As the pace of third-quarter earnings releases began to slow, the market shifted its focus to the new issue market, where issuers found investors flush with cash looking to be put to work. The water is warm, so below-investment-grade firms are jumping in the debt issuance pool. Having achieved all-time low coupons, bond offerings from strong investment-grade credits like  Microsoft (ticker: MSFT, rating: AAA) and  Wal-Mart (ticker: WMT, rating: AA) have sparked the interest of firms with weaker balance sheets, consistent with our expectations. For example,  Hanesbrands (ticker: HBI, rating: BB) and  New York Times (ticker: NYT, rating: BB-) tapped the debt markets last week. Hanesbrands issued $1 billion of 10-year notes at 6.375%, which compares with an 8% coupon on the firm's $500 million seven-year notes issued less than a year ago. The spread was roughly 150 basis points tighter, and we'd argue the firm's credit quality is unchanged since that time. The proceeds will be used to refinance existing debt, which we estimate will slightly lower total borrowing costs as pricing on the firm's revolver was 6.75% at year-end.

New York Times issued $225 million of six-year notes at a coupon of 6.625%. These notes will probably refinance a 14% loan from early 2009. We estimate that this will reduce New York Times' annual interest expense by a third to roughly $60 million, greatly improving the firm's interest coverage ratios.

Debt issuance wasn't confined to below-investment-grade companies. Not to be outdone by Wal-Mart's low coupons a few weeks ago,  Coca-Cola (ticker: KO, rating: AA-) issued $4.5 billion in debt with its three-year tranche achieving the same all-time-low coupon as Wal-Mart, 0.75% (although the spread was a bit wider).

Click here to see more new bond issuance for the week ended Oct. 29, 2010.