Credit Outlook: Shareholder Activity Adds to Credit Risk for Bondholders

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• We forecast credit spreads will tighten...
   
• ...But shareholder-friendly activities are increasing, and we expect more strategic acquisitions and LBOs. Covenant analysis will be important for bond investors.
   
• Continued negative headlines from European sovereign issuers will cause short-term volatility.
   
• As we expected, interest rates have bounced off their lows, and we recommend that investors begin to leg into longer durations.

While another sovereign credit crisis surfaced last quarter and caused a brief backup in corporate credit spreads, the impact was limited and the market quickly shrugged it off. The attitude among most U.S. corporate credit investors was "we've seen this movie before, and we know how it ends."

Bailouts for the struggling periphery European countries are now considered de rigueur. Strong third-quarter earnings reports, improving credit metrics, and generally improving economic indicators easily overpowered sovereign concerns and potential European bank contagion.

While the economy as a whole may not be healing itself as quickly as most would like, corporate credit risks are declining. Improving cash flow, stronger balance sheets, and a small glimmer of hope in banks' willingness to lend has led to declining default rates. Firms that may still be struggling have found a greater willingness for lenders to restructure covenants and have taken advantage of improved access to the public bond markets to ladder their bond maturities. As default risk continues to decline, we think corporate credit spreads will also continue to decline overall.

We hasten to add, however, that we are finding management teams are increasingly directing their attention to providing shareholder value. This change in focus toward shareholder-friendly activity in 2011 will cause issuer-specific credit widening to the detriment of some bondholders. In addition to dividend hikes and share buybacks, we expect to see more focus on growth initiatives. For the past two years, management teams have been focused on survival and have concentrated on their balance sheets and liquidity. As the belief that the worst of the storm is behind us continues to develop, the focus is shifting from the balance sheet to the income statement. As meaningful growth is still hard to come by, we expect to see additional capital spent to drive organic growth through new product innovation, increased capital expenditures, and higher marketing spending, which could pressure the generally elevated operating margins firms have generated. In addition to the drive for organic growth, we expect an increase in strategic acquisitions as firms look to expand in faster-growing categories and geographic markets.

An increase in strategic acquisitions will make portfolio managers' individual security selection even more important in 2011. Even though interest rates have recently bounced off their lows, we think the combination of relatively low interest rates and reasonable credit spreads make debt-funded acquisitions attractive. While firms typically try to structure strategic acquisitions to be credit neutral, we believe there is a heightened risk that management teams may be willing to take on greater debt leverage and risk ratings downgrades to provide greater upside potential for shareholders. Bondholder returns will vary greatly depending on whether the investment is in the acquiring company or the company to be acquired, as well as the specific bond covenants.

Adding to the credit risk for bondholders, we think shareholder activism and private equity LBOs will pick up as well. Private equity funds have a significant amount of capital available and time will start running out for them to put that capital to work. The constraint that has been holding LBOs back has been the lack of available financing. However, as banks close their books for 2010, they have stated that they are freeing up capacity to provide commitment letters in 2011. The market for structured financing vehicles such as collateralized loan obligations (CLOs), which financed a significant portion of the LBOs earlier this decade, has also finally found its footing. A few new CLOs were financed late in 2010, and we suspect there are a number of other CLOs in the pipeline ready to be launched in the beginning of 2011. We expect that LBOs will be smaller and less leveraged in 2011 than we had seen prior to the credit crisis. But with commitment letters in hand, plenty of debt capacity available, reasonable credit spreads, and private equity money looking to be put to work, the pieces are falling into place for an active year in buyouts.

While covenants haven't played a very significant role in trading levels during 2010, we expect them to become increasingly important in 2011. We highly recommend bond investors to carefully examine covenant packages to identify the protections afforded to them and steer away from bonds that don't provide downside protection.

Sovereign Debt Crisis Not Over
Unfortunately, we do not believe that the sovereign debt crisis is over. Over the course of 2011, we think there is a high likelihood that additional headline risk will emanate from Europe as other countries will likely require bailout financing. While the Irish bailout has alleviated another symptom in the near term, it appears to us the disease continues to linger. Without additional structural reform among troubled governmental entities and reduced sovereign risk exposure within the European banks, we expect only a brief respite before the next crisis. These issues cannot be solved with temporary bailout packages; it will take a significant amount of time and effort by the respective governments to bring budgets under control and for the Eurozone to create a program to restructure the debt of insolvent governments.

From a U.S. corporate credit perspective, the shock of the sovereign debt crisis has quickly worn off. The initial crisis caused by Greece caused a 60 basis point widening in the Morningstar Corporate Bond Index; the more recent crisis caused by Ireland led to only a 12 basis point widening. The moral hazard implicit in these bailouts may lead to increased risks down the road for the global financial system, but for now, we suspect the impact of subsequent headlines on corporate credit spreads will further decrease. The risk is if a bailout is not forthcoming for whichever country faces the next liquidity crisis, causing a systemic credit panic.

Rising Interest Rates
Between the end of the third quarter and Dec. 21, the 10-year Treasury and 30-year Treasury rose 81 and 74 basis points to 3.33% and 4.43%, respectively. In our last quarterly outlook, we recommended that investors focus on medium-term duration securities as we believed interest rates were poised to rise. Based on Bob Johnson's outlook for GDP growth of 3.5% to 4.0% in 2011, compared with about 3.0% in 2010, we expect interest rates will have further to rise over the course of the year. Having said that, with the sharp rise in interest rates over the past few weeks, we recommend investors consider legging into a longer-duration profile this quarter to take advantage of any near-term declines in interest rates. Don't go all-in, and leave enough dry powder to buy additional long-duration securities as rates rise over the course of the year. As investors extend duration, we recommend that you focus on those firms with stable, wide economic moats.

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