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Credit Insights

Back to Precrisis Credit Spreads

While we continue to expect credit spreads to tighten over the course of the year, we expect the pace to slow dramatically.

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As we wrote at the beginning of December, we expected the U.S. credit market to quickly recapture the spread widening from the European sovereign credit crisis last November. Consequently, the Morningstar Corporate Bond Index tightened to +147 last week, which is a couple of basis points tighter than before the last European sovereign credit crisis. Since Dec. 2, the Morningstar Corporate Bond Index has tightened 15 basis points.

While we continue to expect credit spreads to tighten over the course of the year, we expect the pace to slow dramatically. Because of this, we recommend investors to take some profits off the table and return to a normal cash position, which will provide liquidity to take advantage of the significant amount of new supply on the docket (and resulting new issue concession) as well as dry powder to take advantage of the next sell-off when European credit issues lead to credit spread widening in the United States again.

Credit concerns in Europe continue to fester and will be a headwind to the generally improving credit environment in the U.S. We expect European volatility over the course of this year will lead to other credit sell-offs in the U.S., but we would view these sell-offs as opportunities to generate excess returns. While economic reports may not show that the economy is improving as quickly as many economists would like, earnings continue to improve, which leads to stronger cash flows and credit metrics, banks are beginning to expand their loan books, and risk appetite remains high. All of these factors lead to lower default risk and continued credit spread compression.

The year couldn't start without new fireworks in Europe. After regulators released a new proposal that bondholders should share the future cost of providing bailout financing for European banks, credit spreads gapped out for European bonds. In fact, the spread between general European corporate issuers and European financial issuers has reached a new high. We expect this spread to widen until European regulators clarify in which instances bondholders of financial institutions will be required to suffer principal reductions or other restructurings.

In conjunction with the widening in European banks, sovereign credit default swaps widened across the board on the news, either nearing or surpassing previous highs. The credit markets set their sights on Belgium last week as five-year CDSs widened 20 basis points to +237 from the prior week and about 100 basis points just since the middle of November.

New Issue Market
The new issue market opened the year with record volume as companies locked in low-cost financing thanks to combined low interest rates and tight credit spreads. With the European credit markets in turmoil because of sovereign credit issues, many European banks have issued new dollar-denominated bonds. European banks are racing to price new dollar-denominated deals to lock in the lower spread for dollar-denominated bonds compared with euro-denominated bonds and beat sovereign issuers to market.

 AmeriGas Partners (ticker: APU; rating: BB+) issued $470 million of senior notes due May 2021 at an interest rate of 6.50%. The proceeds from the issuance will be used to finance the partnership's tender offer for its outstanding 7.25% senior notes due May 2015 and to repay borrowings outstanding under the bank credit agreements of AmeriGas Partners' operating partnership, AmeriGas Propane. We estimate that $430 million of proceeds will be used to retire the outstanding 7.25% senior notes due 2015 ($415 million of face value at a call price of 103.625), with the remainder of the proceeds after fees used to pay down a portion of the revolver. AmeriGas had $91 million outstanding under its revolver as of Sept. 30. At a spread of T+302, the 2021 notes look fairly valued relative to our BB+ rating. We would prefer to hold the shorter-dated 7.125% notes due 2016, which trade at a spread to worst of T+478.

 Dr Pepper (ticker: DPS; rating BBB+) issued five-year bonds at T+85. Even with our BBB+ rating one notch ahead of the agencies, we think that spread is too tight and would expect the bonds to struggle in the secondary market.

Click here to see more new bond issuance for the week ended Jan. 8, 2011.

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