The Song Remains the Same

The average credit spread in the Morningstar Corporate Bond Index tightened 3 basis points last week to +144. Since the beginning of June, credit spreads have steadily tightened about 4 basis points a week, with very little variability.

Last week, after lagging the tightening in the financial sector, the industrial sector finally outpaced the financials and tightened 4 basis points compared with the financials, which were largely unchanged.

However, year to date the key to outperformance has been to be overweight the financial sector, as the spread between financials and industrials has tightened 120 basis points to a 27-basis-point differential compared with its widest level of 148 basis points last December.

Otherwise, the story remains the same. Portfolio managers continue to receive inflows from investors, meaning that cash needs to be put to work. With little new issuance and low dealer inventories, traders are scrounging to source bonds. Any dips in the corporate bond market have become increasingly shallow and shorter-lived.

These technicals have continued to rule the market, irrespective of the concerns looming on the horizon. Across the board, clients we met with last week all complained about the lack of supply in the market and their inability to size up positions. However, while they fret about sitting on cash, these same clients are worried about the impending fiscal cliff, the debt ceiling, recession in Europe, and a slowing Chinese economy. The dire headlines stemming from the EU crisis have died down since the end of August, but the structural and systemic issues in the European Union continue to simmer in the back of many investors' minds. Third-quarter earnings reports will consume most of investors' attention of the next few weeks, but we expect that these systemic issues will return to the forefront after the presidential election.

Spain Downgraded to Lowest Investment-Grade Rating by S&P
Standard & Poor's lowered its rating on the Kingdom of Spain to BBB-, the lowest rating before migrating into the high-yield, or junk, category. Contrary to the typical market reaction after a downgrade, Spain's 10-year bonds actually traded up, as the yield declined 14 basis points to 5.63%. Investors speculated that the lower rating would push the country to request bailout funding from the EU and International Monetary Fund, triggering the European Central Bank to purchase the country's debt in the secondary market. However, the decline in yields following the downgrade actually has the perverse effect of reducing the country's need to request bailout funding, as it is now easier for the country to finance its deficit and roll over maturing debt.

The market continues to await the results of Moody's re-evaluation of its Baa3 rating on Spain. Moody's has warned that it may downgrade the country below investment grade. Initially, Moody's had reported it would finalize its analysis by the end of September, but recently announced that it would not wrap up until later this month.

While we do not rate sovereign debt, it seems intuitively incorrect to believe that an issuer could earn an investment-grade rating when it has had to request a bailout of its banking system, may be on the verge of requesting a formal sovereign bailout program, and required the ECB to create a new program, Outright Monetary Transactions, to provide investors enough comfort to purchase its bonds. The economic fundamentals in the country continue to deteriorate and the structural issues that have led it to this position have not been alleviated.

It seems to us that a speculative-grade rating that is implied within the trading levels of Spain's debt is more appropriate. Currently, the actions of politicians and the support of policymakers are driving Spain's liquidity position. Ultimately, the country will have to resolve its own structural issues in order to provide sound footing for economic fundamentals to improve. Until then, Spain's fate is tied to the political state of affairs of the other EU members. The winds of political change can be abrupt, and if the political will to keep the EU intact in the current design were to dissipate, Spain could quickly find itself in a position in which it no longer has capital market access.

New Issuance Slows, But Will Probably Ramp Up After Earnings Reports
As we expected, new issuance volume was slow last week as preparations and quiet periods before earnings kept issuers on the sidelines. We expect this week will be on the slow side as well. The new issue market will probably pick up as companies report earnings and look to tap the markets before the presidential election and before the market's attention turns to the looming fiscal cliff.

Click to see our summary of recent movements among credit risk indicators.

Upcoming Pension Regulations to Have Substantial Impact on Government Balance Sheets and Pension Funding Levels
Contributed by Rachel Barkley, Municipal Credit Analyst
The Governmental Accounting Standards Board, which establishes government accounting standards, approved new accounting and reporting standards for state and local government pension plans in June under GASB Statements 67 and 68 with the goal of improving the accounting and financial reporting for affected plans.

GASB standards are nonbinding, but compliance is required for governments to receive a clean audit. The new pension standards become effective for state and local pension plans in fiscal years beginning after June 15, 2013, and for employers in fiscal years beginning after June 15, 2014. While it will be a few years until all applicable governments fully incorporate these standards, some areas will probably move toward early adoption and compliance.

Overall, the new standards aim to focus pension disclosure on liabilities as opposed to the annual required contribution.(1) For defined benefit plans, disclosure of the ARC will no longer be required. Instead, annual change in the net pension liabilit(2) will serve as the primary pension expense reported. Analysts will need to judge movement of the NPL to determine if an entity is making adequate contributions to the plan.

Defined benefit plans(3) will be required to report on their balance sheets a net pension liability. This will in many cases cause a drastic change in the balance sheet presentation, particularly in terms of total liabilities. This number is expected to be relatively volatile, as asset smoothing will not be allowed for accounting purposes. The NPL will be measured at market value with annual changes immediately recognized. Despite its expected volatility, the implementation of the NPL will allow for investors and constituents to gain a clearer picture of actual projected liabilities, as this data is currently only disclosed in the financial notes section of a government's audit. Cost-sharing multi-employer plans(4) will record a liability and expense equal to their proportionate share of the total plan liability and expenses, allowing analysts to accurately incorporate pension liabilities into analysis of credits that participate in a CSME plan.

Additionally, some changes are being made to allowable accounting methods. Smoothing will no longer be allowable for accounting measurements, but it will still be allowed for funding purposes. Actuarial cost methods will be limited solely to the entry age normal method. Additionally, liabilities will be required to be allocated as a level percentage of payroll and will no longer be able to be allocated as a level dollar amount. The discount rate of liabilities will change for accounting purposes, but will remain unchanged for funding calculations. For accounting purposes, the allowable assumed discount rate will depend on whether the plan's net position is projected to be sufficient to pay benefits of current employees and retirees. If that condition is met, the regular discount rate is able to be used. An index rate on tax-exempt 20-year AA or higher rated municipal bonds will be used to the extent that projected assets are not anticipated to meet projected liabilities. Overall, these accounting changes will cause a disconnect between pension funding and accounting while leading to greater levels of volatility for pension accounting measures.

In aggregate, the funded level of pension plans is expected to decrease due to the accounting changes. A recent report by the Center for Retirement Research at Boston College indicated the aggregate funded level for 126 large pension plans it sampled would decline from 76% based on fiscal 2010 levels to a low 57%(5). This decline in funding coupled with the emphasis on the NPL will probably increase the level of debate regarding pension benefits and their impact on governments.

New Issue Notes

Reed Elsevier Printing a New Bond Deal (Oct. 9)
 Reed Elsevier (RUK, BBB) is coming to market with a $250 million 10-year bond deal. The firm recently repaid $450 million in debt and has another $550 million due in early 2014. Despite the fact that this is a "no grow" offering, we think the deal could be upsized as other no-grow deals recently have--for example,  Kohl's (KSS, A+)--given the need for additional refinancing capital.

We believe Reed Elsevier merits a narrow economic moat despite being in the challenging publishing and information services industries. The LexisNexis segment (42% of sales) enjoys competitive advantages in the legal information business. The firm faces a formidable rival in  Thomson Reuters (TRI, A-), but these two companies enjoy a combined 78% of the U.S. legal information market. Elsevier (the publishing unit, 34% of sales) has a roughly 25% share in the niche science, technology, and medical publishing industry and is about 3 times larger than its closest competitor.

Given its heavy exposure to print publishing and the difficulty that business services companies are facing in the tepid economic recovery, Reed Elsevier's bonds trade wide of where we would expect them to for the rating. The firm's 8.625% notes due 2019 trade 268 basis points above Treasuries, or around 80 basis points wider than our BBB index. Peer Thomson Reuters has 10-year bonds that also trade outside its respective index at around 153 basis points over Treasuries. Another publisher,  Pearson (PSO, A-) has 10-year bonds that trade at 163 basis points over Treasuries. Based on where these two comparable bonds are trading, and given their two-notch-higher ratings, we believe fair value for Reed Elsevier's new 10-year would be around 60 basis points wider (the differential between 10-year A- and BBB credits in Morningstar's Industrials Index), so 215-220 basis points over Treasuries. Initial price talk of 162.5 basis points over Treasuries is way too tight, in our view, and we would rather own Thomson Reuters or Pearson at this level, given their stronger credit qualities.

While Reed Elsevier took on GBP 1.5 billion of debt in 2008 in connection with its acquisition of ChoicePoint, it repaid the debt in less than three years, thanks to copious free cash flow and a GBP 800 million equity issuance. Pro forma leverage had spiked to nearly 4 times but now is well below 3 times, which we deem appropriate for the rating. We expect it will remain at this level, as management's target net debt/EBITDA is 2-3 times. Despite a Cash Flow Cushion of less than 1 times our base-case expense and obligation forecast, we think the company can comfortably cover its debt obligations with ample access to liquidity, thanks to its credit facility and ample cash balance.

John Deere Capital Back in Market With Benchmark-Size 2- and 7-Year Notes (Oct. 9)
John Deere Capital (A) is expected to be back in the market with a benchmark-size offering of 7-year fixed and 2-year floating-rate notes. The company continues to take advantage of low interest rates and strong investor demand to raise cash for refinancing needs and lower its overall borrowing costs.

Our credit rating on Deere Capital is directly linked to our rating of  Deere & Co. (DE, A) based on the strong interrelationships between the two entities. Deere dominates the North American agricultural equipment market with a share near 50%. Although we think competitors' products have narrowed the quality gap somewhat during the past several years, customer loyalty and Deere's solid dealership network have preserved share and helped the company generate impressive economic profitability, carving a narrow economic moat.

In April, Deere Capital issued 7-year notes that we recently saw quoted around a spread of 60 basis points over Treasuries, which we view as fairly valued within the sector. Caterpillar Finance, which we rate one notch lower at A- and maintain an underweight weighting on the bonds, is the obvious comp for Deere Capital. Both companies have bonds in the 10-year part of the curve that generally trade on top of each other, around 80 basis points over Treasuries. Given our one-notch-higher rating on Deere Capital, we prefer its bonds over Cat Finance and maintain a market weight recommendation. We're hearing initial price talk on the new Deere Capital 7-year in the area of 75 basis points over Treasuries, which sounds attractive based on existing levels. We expect final pricing to tighten but would buy the bonds down to existing levels of 60 basis points over Treasuries.

Click here to see more new bond issuance for the week ended Oct. 12, 2012.

Endnotes

1. The annual required contribution is determined by the actuary during the valuation of the plan and equals the amount that would need to be paid during the current fiscal year to fund benefits earned in that year (the normal cost) plus a portion of any unfunded liability from past years.

2. The net pension liability is the total pension liability (actuarially determined present value of future benefits that are due to work already completed by plan participants) less the plan net position (plan assets set aside in a trust or restricted for benefit payments).

3. For defined benefit plans, pension payments operate as an annuity with each employee entitled to a specific annual payment based on a benefit formula. These formulas generally incorporate years of service, salary and a multiplier variable. Specific benefit formulas vary between plans and often within plans dependent on an employee's start date and/or employee classification (public safety, general, management, etc.). Defined benefit payments can either be constant for the life of the payment, adjusted annually for cost of living, or adjusted occasionally for cost of living increases as seen fit by the overseeing party. The government is responsible for funding this liability no matter what return it achieves on its investments.

4. In CSME plans, the participating employers pool their obligations and assets. Assets of the plan can be used to pay pension obligations of any participating employer.

5. Munnell, Alicia et al. How Would GASB Proposals Affect State and Local Pension Reporting? Center for Retirement Research at Boston College. November 2011.