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Credit Insights

Liquidity in Corporate Bond Market Drying Up

An increasing number of exogenous factors are affecting available capital.

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In last week's Bond Strategist, we wrote that if the credit market opened last Monday to the upside, we expected a relief rally to ensue; however, we warned that if the credit markets were unchanged or wider, it would indicate a lack of confidence in the Europeans' ability to stem further degradation in Europe and lead to further downside.

As it turns out, the credit market was weaker last Monday, the sovereign debt markets began to drop precipitously Tuesday, and the corporate credit market widened throughout the week. The Morningstar Corporate Bond Index widened more than 10 basis points to +241. While it appears that the European Central Bank intervention has halted the widening in Italian and Spanish yields for now, we think the overhang of systemic risk from Europe will push corporate credit spreads wider.

Liquidity in the corporate bond market has been drying up for several months and worsened last week. We heard stories of high-quality but off-the-run bonds hitting what dealers thought were throwaway bids and then immediately being offered cheaper on the follow once traders saw the print. This pattern is reminiscent of the type of trading we encountered in the 2008-09 credit crisis. Besides the typical year-end positioning when dealers reduce the size of their books to bolster their balance sheets, an increasing number of exogenous factors are affecting available capital. First, we have the daily barrage of headlines and continual overhang of systemic risk from Europe, which worsened last week. Second, layoffs on the sell side began in earnest over the past few weeks and many traders (the ones who have survived thus far) are no longer managing their books for profitability, but managing in order to keep their seats. Third, we suspect that Yankee banks have been reducing the size of their trading books and instead sending capital back to the parent banks in Europe. Lastly, while we think it will probably be a non-event, the congressional super committee's deadline to agree on a plan to cut the deficit is Wednesday.

Throwing another wrench into the system, we suspect that liquidity is drying up in other asset markets as well. Considering that a substantial amount of capital is locked up in bankruptcy court because of MF Global's collapse and that $600 million is still reported "missing," we suspect the futures markets have had to make do with fewer market-makers, much less capital, and investors who are sweeping cash nightly out of any nonbank holding companies that they trade through. As we enter the holiday season, we don't foresee liquidity getting better anytime soon. This is likely to lead to wider bid/ask spreads and lower trading volume. Dealers will be happy to work an order, but will be loath to provide a firm bid.

All of this bad news overwhelmed the good news this past week. Retail sales continued to grow at a moderate but steady rate. Both PPI and CPI were contained, industrial production rose at a faster-than-expected rate, jobless claims continued to decline, and the leading economic indicators were substantially better than consensus. Even the beleaguered housing industry showed some improvement as delinquent mortgages dropped to 8% in the third quarter from 8.4% in the second quarter and 9.1% last year.

ECB Trying to Apply the Brakes
After a lull in October, the European debt crisis felt like it was picking up speed again over the past two weeks, but the ECB intervened in the sovereign debt markets in the latter half of the week to apply the brakes by purchasing Italian and Spanish bonds. Even after the purchases, however, credit default swaps of Italy and Spain remain near record levels. And the contagion is spreading: CDS of other countries such as France, Belgium, and Hungary are also near record levels. These levels probably understate the market's true underlying gauge of credit risk, given that the value and efficacy of owning CDS are under a cloud of doubt thanks to the "voluntary" haircut for Greek debt that failed to trigger the event of default provision.

Italy's new prime minister has formed a government and will attempt to overhaul the structural problems that have restricted the country's labor market and economic growth. It remains to be seen if technocrats can implement these measures where the politicians failed. On one side of the coin, they do not have populist support, as they had not been elected, and do not have support from the political class. On the flip side, since they are not elected officials, they can implement the reforms without worrying about re-election campaigns, allowing them to serve as the scapegoat that the political class can blame for painful and unpopular measures. 

The markets have artificially identified a 7% yield as the litmus test as to whether a country can remain financially sustainable. After watching yields on Italian bonds blow through 7%, reaching a high of 7.40% two weeks ago, the ECB has reportedly stepped into the market numerous times to purchase enough bonds to bring the yield down to 6.63%. Spanish yields, which until the beginning of November had been behaving, began a swift rise toward 7%. Rightly or wrongly, the market has identified a 7% yield as the demarcation line between countries that still have the chance to right their finances and remain financially sustainable and those that don't.

Liquidity is drying up among Italian banks. Jim Leonard, our credit analyst for the banking sector, wrote  a note highlighting that  UniCredit (ticker: UCG, rating: BBB) has requested the ECB to extend access to funding for Italian banks by widening the range of collateral that can be offered to get funds. He believes this indicates that other banks are refusing to lend to Italian banks in the interbank market. Further proof lies in the swap markets, where the cost of interest rate swaps, repos, and exchanging euros for dollars has risen, in some cases to the highs experienced during the credit crisis. Illustrating the lack of confidence in the European banks,  Norfolk Southern (ticker: NSC, rating: BBB+) reportedly refused to allow any European banks into its credit facility. If companies are so concerned that a European bank may not be able to fund a draw under a revolver, this is surely indicative that many CFOs of international companies would pull deposits from weaker banks in Italy and Spain and transfer those deposits into stronger, core European banks, leading to a digital run on these banks.

The European Financial Stability Facility 10-year bond, which was issued two weeks ago, continued to widen and ended the week at +200. This represents about a 2-point loss as the bonds have widened out 23 basis points from the issue spread. We highlight this loss as investors will become increasingly hesitant to participate in new issues from the EFSF if spreads continue to widen. Italian 10-year bonds swung wildly over a 5-point range, but ended the week at 87.375 (6.62%, +466), up 1.375 points. Spain's new 10-year bond, issued Wednesday at 92 (6.98%, +518) also traded across a 5-point range, breaching the 7% threshold, but strengthened and ended he week at 94 (6.65%, +466).

No new details were released relating to the expansion of the lending capacity of the EFSF. Policymakers have previously stated that they intend to announce a plan by the end of November and that the new structure would be ready by mid-December. However, the clock is ticking loudly. Every day that goes by without a detailed framework to effectively leverage the EFSF and provide a backstop for sovereign debt requirements increases the likelihood that they will not be able to accomplish the leverage they announced.

Further pressuring the need to get backstop financing in place for the peripheral nations, growth in the eurozone has dropped to a snail's pace. Third-quarter GDP rose at 0.6%. Considering that Germany and France reported 2% and 1.6% growth, respectively, the rest of the eurozone must have contracted. Even worse, Italy and Greece didn't release GDP figures--and that can't be good news. If the eurozone slips into a recession, the sovereign debt metrics are likely to decline and in turn the market will want greater credit spreads to be compensated for rising default risk. Based on the volatility in the sovereign debt markets, we wonder if the ECB has the wherewithal to continue to support the sovereign debt markets until the EFSF is ready for primetime.

Germany Seeking Provision to Let Eurozone Members Exit
One news headline that did not get the attention that it deserved was that in Germany, the Christian Democratic Union party passed a resolution to request changes to allow a eurozone member to "voluntarily" leave the eurozone without having to leave the European Union. If this change becomes effective, this would almost guarantee that the current members of the eurozone would not be the same members going forward. That would have huge implications for the debtholders of countries that exit the eurozone and redenominate into a new currency and could radically change the value of the euro versus every other currency in the world.

Headlines on the Horizon
Time has essentially run out for the U.S. deficit super committee. The deadline is Nov. 23, and it does not appear that the committee will reach a compromise. The market, however, appears to be unconcerned as most investors we've talked to don't think it will be a market-moving event if the committee fails to reach a plan. In fact, if the committee does reach a compromise and puts forth an actual deficit-reduction plan that does not rely on budgetary gimmicks, that would provide a pleasant surprise and give the markets some lift. The two economic indicators to watch this week are the preliminary GDP release Tuesday for revisions from the advance GDP released in October and durable goods orders Wednesday. Otherwise we expect (hope) that it will be a relatively quiet Thanksgiving week as sovereign debt auctions on the calendar (Germany and Japan) should not be a cause for more market dislocation. 

New Issue Commentary
 Bank of New York(ticker: BK, rating: A) issued new benchmark three-year and five-year notes last week. The bonds priced at 135 basis points above Treasuries for the three-year and 158 basis points above Treasuries for the five-year, which appeared to be about 25 basis points cheap to existing. Overall, we are very positive on the name from a credit standpoint, as its strong Tier 1 capital ratio and leading market position in the global custody business make the name hard to beat. However, thanks to the scarcity of the name, its bonds trade with very tight spreads when compared with other financials. For example,  J.P. Morgan's (ticker: JPM, rating: A+) five-year, which is rated one notch higher, trades about 100 basis points wider than where this new issue was priced. Investors who are filled up on the J.P. Morgan credit had to pay a fairly significant premium to diversify their portfolio into more of the hard-to-find Bank of New York bonds. However, when compared with  State Street (ticker: STT, rating: A-), another scarce name, the comparison looks better, as the current State Street five-year trades in the area of 120 basis points above Treasuries.

 Duke Energy (ticker: DUK, rating: BBB+) issued $500 million of five-year bonds. Our BBB+ rating is one notch higher than Moody's Baa2 issuer rating, but one notch lower than S&P's A- issuer rating. We had thought that the deal would be oversubscribed based on the recent popularity of investment-grade utility debt, and as such we expected very little new issue concession. Duke most recently issued 10-year debt in August at 145 basis points over Treasuries, which has subsequently tightened to 108 basis points over Treasuries. We thought that would put a new five-year offering around 100 basis points over Treasuries, but the notes priced cheaper at +125. We think the new issue offers value relative to  Xcel Energy (ticker: XEL, rating: BBB+), which has a 30-year bond that recently traded around 115 basis points over Treasuries.

Duke Energy is securing regulatory approval for its acquisition of  Progress Energy (ticker: PGN, rating: BBB+). We expect more issues from Duke in the coming months, likely at the utility level. Its Carolina utilities have $750 million of 6.25% senior unsecured notes due January 2012, and its Ohio utility has $500 million of 5.70% debentures due September 2012. We expect the company to refinance both of those issues at the utility level.

On Monday,  Express Scripts (ticker: ESRX, rating: A-) issued 3-, 5-, 10-, and 30-year debt to fund the pending merger with  Medco (ticker: MHS, rating: A-) merger. As we've stated in the past, we anticipate keeping our A- rating for Express Scripts whether it is a stand-alone or combined entity. We would maintain our rating for the same reason regulators may reject the merger: the unprecedented leverage that the combined entity would have over suppliers, putting competitors at a significant disadvantage. That increased power and scale could cause us to increase our moat rating to wide for the combined entity from narrow for the stand-alone entities; that change would elevate our Business Risk score enough to offset the expected increase in leverage for the combined entity. Management aims to reduce its leverage to more normal levels between 1 and 2 times EBITDA within 18 months of the deal's closing, when it is expected to be at 2.9 times EBITDA. This plan to deleverage reinforces our A- view of the combined entity.

Since the agencies rate Express Scripts two notches lower on average than we do, we thought the market might offer these notes at attractive spreads, and we were not disappointed. For the average A- rated firm, we expect a 10-year maturity to price around 150 basis points above Treasuries. However, the Express Scripts 10-year issue priced at 280 basis points above Treasuries, which was about 30 basis points wider than we'd expect the average BBB rated firm to trade. Overall, we think the market is giving investors a compelling opportunity to generate higher returns for the risk than warranted with Express Scripts' notes.

 General Mills (ticker: GIS, rating: A) issued $1 billion of 10-year notes Thursday at a spread of +125. Before the new issue, we last saw General Mills' existing 2019 notes trade around 112 basis points above Treasuries, and based on where existing bonds and comparables are quoted, we expected General Mills' new 10-year notes to price a slight concession and then tighten in the secondary market to +125. Considering that our A rating is two notches higher than the rating agencies, we think these bonds provide good value in the consumer sector and should trade closer to other single A rated credits over time, which would put the new issue in the area of 115-120 basis points above Treasuries. As a comparison,  McCormick's (ticker: MKC, rating A+) recently issued 2021s were quoted around 115 basis points above Treasuries and  Heinz's (ticker: HNZ, rating: A-) recently issued 10-year notes were last trading at 116 basis points above Treasuries.  Dr Pepper (ticker: DPS, rating: BBB+), which we rate two notches lower than General Mills, has 3.20% senior notes due 2021 trading at 127 basis points above Treasuries, slightly wide of its new issue spread.  Kellogg's (ticker: K, rating: A-) 4% senior notes due 2020 are indicated around 126 basis points above Treasuries.

Kellogg brought $500 million of five-year notes to market Monday. Our A- rating is in line to a notch higher than the rating agencies. The markets were a little choppy, so we expected to see a slight new issue concession from where we last saw Kellogg's existing 2016 notes trade, which was 89 basis points above Treasuries. Based on where existing bonds and comparables are quoted, we expected Kellogg's new five-year notes to price around 100 basis points above Treasuries, which is right where the new issue priced. We consider that area to be fair. Dr Pepper, which we rate one notch lower than Kellogg, priced five-year notes at 120 basis points above Treasuries the prior week and the five-year notes of similarly rated food and beverage issuers, such as Heinz, trade in the upper 80s.

 L-3 Communications (ticker: LLL, rating: BBB-) priced $500 million of five-year senior unsecured notes at a spread of T+325. The notes appeared to tighten 10 basis points in secondary trading. We view the pricing as attractive and see this as a solid core holding. The proceeds, along with cash, will be used to call the firm's $1 billion of 6.375% senior subordinated notes due 2015 at 102.125. L-3 had $538 million of cash at the end of the third quarter, so cash will be depleted after this deal. We would note, however, that the firm typically generates strong free cash flow in the fourth quarter (typical of defense firms) and also has an undrawn $1 billion credit facility. With total debt being reduced by $500 million as a result of the deal, the firm's pro forma debt/EBITDA ratio declines about 0.3 to around 2.2 times. L-3 continues to have almost $700 million of senior subordinated convertible debt below the bondholders in the capital structure. This is the next maturing debt, putable in early 2016. The firm is planning to spin off its Engility government services business in 2012, representing about $2 billion in sales and almost $200 million in EBITDA. L-3 is expected to receive a dividend of $500 million-$650 million, which will be another source to replenish its coffers.

While L-3 is at the forefront of the Defense Department's proposed spending cuts given its shorter-cycle contracts, we view its rating as very stable at weak-investment grade. All three rating agencies maintain the same rating as do we. Management has been very vocal about maintaining these ratings, and we believe it will manage its strong cash flow in a way to retain those ratings. As such, we view some of the other higher-quality defense firms as having greater rating risk than L-3, and we are comfortable trading down in credit quality to pick up yield. For example, we highlight A rated  Raytheon (ticker: RTN, rating: A) and the new Rockwell Collins 10-year notes at about +110 as representing fair value. In the lower-tier investment-grade category,  Textron's (ticker: TXT, rating: BBB-) recently issued five-year bonds are at about +310, in line with L-3.

 Norfolk Southern (ticker: NSC, rating: BBB+) issued $500 million of 10-year notes with proceeds expected to be used for general corporate purposes. With their existing 5.90% due 2019 trading around 120 basis points over Treasuries before the new deal, we opined that the new issue should come around 125 basis points over Treasuries. The new 10-year ended up pricing at 128 basis points over Treasuries and remained around that level thus far in secondary trading. We maintain our underweight view on Norfolk's bonds as we see better value within the sector. We still prefer  CSX (ticker: CSX, rating: BBB+). The two have similar leverage profiles and operating ratios in the low 70s, supporting our BBB+ rating on both names. However, with the CSX 4.25% due 2021 recently trading around 155 basis points over Treasuries, we continue to see more value in CSX bonds. We also prefer  Union Pacific (ticker: UNP, rating: A-) to Norfolk Southern. Our one-notch-higher rating on Union Pacific is driven by its slightly better credit metrics and larger top line, and with its 4.0% due 2021 trading around 125 basis points over Treasuries, roughly on top of lower-rated Norfolk Southern, we also see more value in Union Pacific relative to Norfolk Southern.

 Rockwell Collins (ticker: COL; rating: A), a rare but high-quality corporate bond issuer, sold $250 million of 10-year notes at T+110, which we view as fair value. We view Rockwell Collins as a very well-run company with a focus on avionics and communications and navigation systems. The firm supplies both the commercial market, including sales to the aircraft original-equipment manufacturers and aftermarket sales and service, and the defense market. We view this balance, and the integration of the two business units to share technologies, as very favorable from a credit standpoint as the firm has established a narrow economic moat with positions on long-term programs. While the defense side represents almost 60% of sales and is under pressure from Defense Department cutbacks, the commercial side is growing and has a solid outlook. Net, we expect modest top-line sales and EBITDA growth over our forecast horizon. Even with an additional $250 million of debt, Rockwell Collins ended fiscal 2011 with pro forma debt/EBITDA of about 0.8 times and nearly no net debt.

There are a number of aerospace/defense and diversified industrial comps to establish fair value on the new bonds. On the rich end, we have underweight ratings on the 10-year bonds of  General Dynamics (ticker: GD, rating: A+) at 90 basis points above Treasuries,  Honeywell (ticker: HON, rating: A) at +85, and  Boeing (ticker: BA, rating: A-) at +100. On the cheap end, we have overweight ratings on  Lockheed Martin (ticker: LMT, rating: A+) at 135 basis points above Treasuries and  Northrop Grumman (ticker: NOC, rating: A) at +145. We also view Raytheon as fairly valued at +112. Rockwell Collins has a 2019 maturity bond indicated at 150 basis points above Treasuries, which we view as very attractive. Given the comps, we would view fair value for Rockwell Collins' 10-years at about 110 basis points above Treasuries. We note that this deal is likely to get put away, but this is a solid core holding. We also note that the deal appears to offer traditional change-of-control language, which we view as necessary since we think Rockwell Collins fits the mold as a strong strategic target for another aerospace/defense firm or diversified industrial company.

 Stanley Black & Decker (ticker: SWK, rating: A-) issued $400 million of 10-year notes with proceeds expected to be used for general corporate purposes, which could include the repayment of short-term debt. Stanley's 2010 merger with Black & Decker created a global leader in hand and power tools, and management has been very successful in harvesting cost and revenue synergies since the deal closed. We expect the company to remain acquisitive, as evidenced by the recently completed acquisition of European security firm Niscayah for $1.2 billion. However, given the company's strong cash-flow-generating ability, we expect leverage to remain at or around 2.0 times, consistent with our rating.

As we wrote in our new issue note, initial price talk in the area of 150 basis points over Treasuries sounded modestly attractive to us, and the deal ended up pricing at a spread of 145 basis points over Treasuries. Across diversified industrials, there is a wide spread gap between the solid A rated names and BBB rated names. For example, Honeywell, which we rate underweight, has 2021 bonds that trade around 85 basis points over Treasuries.  Ingersoll-Rand (ticker: IR, rating: BBB+), which we rate market weight, has a higher-coupon 2018 bond that was quoted around 180 basis points over Treasuries. Given our A- rating on Stanley, we think its bonds should trade between these two names and would put fair value in the area of 130-140 basis points over Treasuries; thus far in secondary trading, the new Stanley 2021s have traded in to roughly 135 basis points over Treasuries.

Click here to see more new bond issuance for the week ended Nov. 18, 2011.

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