Credit Outlook: Headlines May Change, but the Themes Remain the Same
Despite numerous headwinds, we expect strong underlying fundamentals will continue to support further tightening in corporate credit spreads.
Over the past year, improving economic fundamentals underpinning the strength in corporate credit have outweighed what seems like a continual barrage of financial and environmental crises. The ongoing recovery has led issuers to generate strong free cash flows, increase liquidity, and strengthen balance sheets. Even with the 10 basis-point backup in credit spreads in mid-March due to the disaster in Japan, credit spreads tightened by 4 basis points last quarter.
In addition to continued improvement in the underlying fundamentals, the technical backdrop in the market has been positive. Demand for corporate bonds continued at a healthy rate as investors deposited $4 billion in investment-grade and high-yield mutual funds thus far this year.
Although there continue to be numerous headwinds, we expect the strong underlying fundamentals will continue to support further tightening in corporate credit spreads.
Credit Deterioration Likely to Be Self-Inflicted
Many management teams are increasingly directing their attention to increasing shareholder value, often to the detriment of bondholders. Companies across a wide swath of sectors are directing an increasing amount of cash flow toward dividend hikes and share buybacks. In addition, organic growth opportunities are few and far between, and firms are focusing on strategic acquisitions as management teams look to expand in faster-growing categories and geographic markets.
Adding to the credit risk for bondholders, shareholder activism and private equity leveraged buyouts (LBOs) are picking up as well. Private equity investors have a significant amount of committed capital available, and time is starting to run out for them to put that capital to work. The constraint that held back LBO activity was the lack of available bank financing to support commitment letters. This constraint is quickly being lifted as banks have begun to free up capital to issue commitment letters. For example, JP Morgan supported AT&T's (T) intention of purchasing T-Mobile's wireless business with a whopping $20 billion commitment letter.
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.
The increased focus on shareholders is making individual security selection increasingly important. Outperformance will be driven by both avoiding issuers that inflict these self-induced wounds as well as selecting individual bonds that are better protected by covenants. Covenants did not play a significant role in trading levels during 2010, but we expect them to become increasingly important. Investors should carefully examine covenant packages to identify the protections afforded to them and steer away from bonds that don't provide downside protection.
Credit Implications of the Disaster in Japan
While the human consequences of the disaster in Japan are devastating, the economic impact does not appear to be as dire. As such, we do not see a significant near-term impact on the U.S. corporate fixed-income market. The Morningstar Corporate Bond Index widened out about 10 basis points due to the catastrophe, but the widening was limited to those sectors that investors believed could directly be impacted. For example, the Japanese auto manufacturers experienced the brunt of the selling pressure and initially widened 30 to 40 basis points before regaining some of the loss.
Domestic utilities with nuclear facilities and insurance companies with business in Japan also widened 20 to 30 basis points, but likewise recovered some of their losses as the stronger credits are only 10 basis points wider. Other high beta sectors such as banks and finance were 5 to 10 basis points wider, while defensive sectors such as consumer products and telecom were relatively unchanged. This performance goes to show the strength of the fundamental and technical aspects in the corporate bond market. The resilience of the corporate bond market has been remarkable as each successive crisis over the past year has led to a consecutively smaller widening and quicker rebound.
In several instances, we think the sell-off has provided a buying opportunity, especially among the domestic utility sector. Typically, credit spreads in the utility sector are much tighter than comparably rated bonds in other sectors. Due to a bout of selling pressure among utilities with nuclear generation exposure, many of these names have traded to credit spreads equal to, or wider than, an equivalent rated index. Given that these entities are often fully regulated utilities, any new regulations that would cause an increase in capital expenditures or operation and maintenance costs would likely be passed on to customers after regulatory review.
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David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.