The Rumors Were True: Eurogroup Agrees to Provide Loans to Recapitalize Spanish Banks
We continue to favor U.S. corporate bonds over European corporate bonds.
This time the rumors were actually true. On Saturday, the Eurogroup released a statement that it would provide as much as EUR 100 billion in financial assistance to Spain in order to recapitalize the country's banks. The move is predicated on the Spanish government formally requesting the loan later this month. The final amount of financial assistance will be based on the recommendations of the external evaluators hired by the Spanish government to analyze and value the loans held by Spanish banks. The loan will be extended to the Fund for Orderly Bank Restructuring, Spain's existing bank bailout fund; however, it will be an obligation of the Spanish government and will increase the country's debt/GDP ratio.
Monetary Authorities Holding Policy Steady to Force Politicians to Act
For the week, the Morningstar Corporate Bond Index and the Morningstar Eurozone Bond Index both tightened 7 basis points to +217 and +240, respectively. In addition, the yield on the 10-year Treasury bond rose 17 basis points off its historic low to 1.64% as the flight-to-safety trade abated. Credit markets started the week on a rough note, but began to recover Wednesday morning and continued to strengthen throughout the rest of the week.
On Wednesday, the European Central Bank announced that it was not making any changes to its policy, which we initially thought would pressure risk assets. Around the same time as the ECB announcement, reports emerged that some sort of negotiations were going on behind the scenes to construct a deal in which the European Union would agree to recapitalize Spain's banks. The market grabbed on to these reports and ran up prices on risk assets across the board.
The timing of these news leaks and positive market response appears to us to place additional pressure on Germany to reach an agreement in the near term. On Thursday, the news flow was a little more mixed as Fed chairman Ben Bernanke testified before the Joint Economic Committee, but he did not give any hints as to possible additional easing at the next Federal Open Market Committee meeting. However, the Chinese government did announce that it was reducing its short-term rates by 25 basis points, the first cut since 2008. This provided some hope that monetary policy in China would help to ease the pace of the country's economic slowdown.
The action in the new issue market continues to indicate that irrespective of the potential systemic risk emanating from Europe, there is still a strong and deep bid for U.S. corporate bonds. For example, Time Warner (ticker: TWX, rating: BBB+) issued $1 billion of new notes consisting of 10-year and 30-year bonds. We were not all that enthusiastic about the bonds based on the price guidance and the lack of new issue concession. The notes rallied strongly in the secondary markets, and both issues ended the day about 8 basis points tighter. Considering there was no meaningful new issue concession on the new notes, the price action on the break indicates to us that investors have a significant amount of cash to put to work and are willing to bid up bonds when there is enough liquidity available to be able to establish meaningful positions in their portfolios.
FRBSF Research Supports Our Recommendation for U.S. Over European Corporate Bonds
Since May 2010, we have recommended that investors stick with U.S. corporate bonds over European corporate bonds. Over that period, the Morningstar Corporate Bond Index has risen a total of 16.9% as compared with Morningstar's Eurobond Corporate Bond Index, which has risen 2.5%.
Supporting our recommendation, the Federal Reserve Bank of San Francisco released a study last week, Are U.S. Corporate Bonds Exposed to Europe? The authors found that "...shocks to the European corporate bond market are readily transmitted to the U.S. corporate bond market. However, the rate of transmission is less than one to one."
The report quantifies the effects of the sovereign debt crisis from 2009 through 2011 on the U.S. corporate bond market. It found that a 1% increase in euro area credit spreads correlated to a 0.68% increase in U.S. credit spreads. Digging a little deeper, the researchers disaggregated credit spread movements between weeks in which there were negative news announcements and weeks in which rating agencies downgraded sovereign debt ratings. The correlation between the U.S. and European corporate debt markets was higher for European news weeks (0.67%) as opposed to downgrade weeks (0.44%). As we do not think the situation in Europe has been resolved--and this research supports our position--we continue to recommend investors favor U.S. corporate bonds over European corporate bonds for long-term investors.
Spanish Debt Auctions Reminiscent of Greek Auctions Before Losing Market Access
Spain returned to the public markets Thursday and issued EUR 2.1 billion consisting of EUR 638 million 2-year, EUR 825 million 4-year, and EUR 611 million of 10-year debt.
The market's focus was mainly on the strength of the 10-year auction. Spain sold the new 10-year bonds at a yield of 6.04%, which was 10 basis points tighter than where the existing 10-year bonds were trading. The bonds quickly sold off after the auction and ended the week at 6.22%, resulting in a quick loss for those investors whose positions must be marked to market.
While many market observers commented on the strength of the auction as an indicator of the market's receptiveness to fund Spain's debt, we are not as reassured. To us, the decreasing size of the auctions and the trading action surrounding the auction are reminiscent of Greece's sovereign bond auctions before the country finally lost access to the public debt markets. For example, in the final death throes of the Greek auctions, many times we saw the bonds rally and yields drop going into the auction. The yield on the newly auctioned bonds was oftentimes significantly tighter than where the existing comparable bonds were trading in the secondary market. Then once the newly auctioned bonds were free to trade in the secondary market, the price immediately dropped to levels at or even lower than prevailing prices in the secondary market.
This indicates to us that the bulk of the buyers of the bonds are either investors who are not subject to mark to market, investors who are trading the basis spread between the bonds and credit default swaps, or traders who were probably short the bonds at lower prices and used the opportunity to cover their positions. Either way, this does not appear to be a healthy market. We would be much more comfortable with the auction results if buyers appeared to be long-term investors subject to mark to market who bought the bonds based on their view that the credit spread adequately compensated for the risk.
While we did not gain any comfort from the dynamics of the bond auction, we do take comfort that the 2/10s curve steepened to +194 from +153 the prior week as the yield on the 2-year Spanish bond dropped 72 basis points to 4.28%. This indicates that the market is pricing in significantly lower jump-to-default risk. While we await news as to the form and structure of any capital injections into Spain's banks, we continue to favor U.S. corporate bonds over European corporate bonds. Before we change our opinion, we would need to see enough capital injected into the Spanish banking system to absorb the real estate losses that need to be recognized as well as meaningful advances made to address the structural imbalances across the EU's labor and regulatory regimes.
Headlines on the Horizon
We will be watching a number of events over the next few weeks that have the potential to significantly move markets.
Italy is scheduled to issue bonds June 14. This will probably be a non-event, but a weak or failed auction could raise concerns about Italy's ability to finance its deficit and heighten concerns about this heavily indebted country's solvency.
Greeks go back to the polls June 17 for national elections. Some surveys show a rise in support for the Syriza party, which is advocating against austerity and rejecting bailout measures, which in turn could jeopardize the country's access to further financing. It's also quite possible that this election will once again fail to reach a coalition, which could call into question the government's ability to negotiate further bailout financing with the EU and force the country into default as the country's cash reserves are quickly dwindling.
The G-20 meets June 18-19 and is likely to focus on the EU's ability to capitalize failing European banks. The FOMC will meet June 19-20. This meeting could prove to be a contentious debate between the hawks and doves as economic metrics in the United States have been weakening, but may not have deteriorated enough to warrant additional monetary policy adjustments.
Later in June, two independent audits commissioned by the Spanish government will be released that will detail the amount of additional capital required to adequately capitalize the country's banks. In addition, we are still waiting for Moody's to release the reassessment of its ratings for U.S. banks, which could come at anytime.
New Issue Commentary
New Time Warner Notes Look Rich (June 8)
Time Warner (ticker: TWX, rating: BBB+) plans to issue $1 billion of 10- and 30-year bonds. Its existing 4.0% 2022 notes, issued last fall, currently trade at about 170 basis points over Treasuries, closer to the A- bucket in the Morningstar Corporate Bond Index (+155) than the BBB+ group (+206). The firm's 4.75% 2021 notes have been trading a bit wider, around 188 basis points over Treasuries, but still tight to the index.
We're hearing that the new 10-year notes will price in the neighborhood of 185 basis points over Treasuries, which we believe is rich. Media names often trade tighter than our index would suggest. For example, Disney's (ticker: DIS, rating: A+) 2.55% 2022 bonds trade near 90 basis points over Treasuries versus 105 basis points over Treasuries for the A+ bucket in the index. CBS (ticker: CBS, rating: BBB-) 3.375% 2022s trade around 186 basis points over Treasuries versus 306 basis points over Treasuries for the index. There are exceptions, though. In particular, we believe Viacom's (ticker: VIA, rating: A-) 3.875% 2021 notes, trading around 158 basis points over Treasuries, are attractive for those looking for exposure to the media industry.
Time Warner has performed well of late on the strength of its cable networks and solid results from its film and television studio. However, a big reason we'd hesitate to chase Time Warner here--in addition to generally tight spreads--is that the firm has placed a heavy emphasis on shareholder returns, especially recently. The firm repurchased $4.6 billion of its shares in 2011, pushing leverage up to 2.9 times EBITDA from 2.6 times during the year. Another $4 billion repurchase plan has been authorized for 2012, with $725 million repurchased in the first quarter. Combined with the firm's $1 billion annual dividend payout, shareholder returns currently far exceed free cash flow generation.
Ford Motor Credit Taps Investment-Grade Market With 5-Year Benchmark Offering (June 7)
Ford Motor Credit (rating: BBB-) is back in the market with a five-year benchmark-size offering, but this time as an investment-grade issuer. Moody's upgrade to Baa3 on May 23 pushed Ford into investment-grade indexes. The firm sold $1 billion of 4.25% due 2017 on Jan. 31 into the high-yield market at a spread of 353 basis points over Treasuries. These bonds are indicated at spreads of about 235 currently, providing a yield of around 3.0%. In comparison, Daimler's (ticker: DAI, rating: BBB+) finance subsidiary priced 5-year 144a bonds in April at 138 basis points above Treasuries, and these were recently indicated at about 158. Volkswagen's (ticker: VOW, rating: A-) finance subsidiary priced 5-year bonds in March at 135, which are now trading around 130 basis points over Treasuries. We view all of these existing spread relationships as largely appropriate, given our current credit views and the ongoing positive momentum in the Ford story. We would look to buy the new Ford Motor Credit deal on any spread concessions to existing levels.
Cintas' New Offering Should Look Attractive (June 5)
Cintas (ticker: CTAS, rating: A) is expected to issue $250 million of 10-year notes. We're hearing that the deal size will not grow and that proceeds will be used to repay commercial paper and fund share repurchases. The company had a $225 million senior note mature June 1 that we think was partly refinanced with commercial paper, so a portion of the new notes is effectively being used to refinance that debt.
Our credit rating reflects Cintas' solid operating profile and reasonable capital structure. The firm's dense and efficient uniform services distribution network results in a narrow economic moat that should continue to drive sound returns on invested capital. For the 12 months ended Feb. 29, TD/EBITDA was 1.8 times, slightly high for our rating. We expect leverage to gradually decline over time; however, if management were to undertake a significant debt-financed share-repurchase program, our rating could be pressured.
Cintas has an existing 2021 note that we recently saw quoted around a spread of 160 basis points above Treasuries, which looks attractive relative to the A bucket of the Morningstar corporate index, which currently stands at 132 basis points above Treasuries. Assuming the new notes offer a premium to existing notes, we think they will look attractive, although the small size of the offering will probably hamper liquidity, making them better suited for buy-and-hold accounts.
In looking at other comps across the corporate market, we think the waste management companies are relevant benchmarks. Although we view them as less cyclical in nature than Cintas, their diverse customer bases, recurring revenue streams, and difficult-to-replicate networks present some commonality across the names. Both Waste Management (ticker: WM, rating: BBB+) and Republic Services (ticker: RSG, rating: BBB+) have 2021 bonds that recently were quoted around 185 and 193 basis points above Treasuries, respectively, which we view as fairly valued. Given that the spread differential between the A and BBB+ buckets of the Morningstar industrial index is currently about 80 basis points, we would prefer the Cintas bonds.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.