Markets Rally, but Implied Volatility Curve Steepens
Although the fiscal cliff was averted, once the debt-ceiling battle heats up in earnest, access to the new issue market could quickly become impaired.
Credit spreads rallied after the agreement was announced that would forestall the fiscal cliff. The volume traded in the bond market was subdued, but in the more liquid derivatives market, credit spreads quickly tightened 10 basis points. Trading volume of corporate bonds picked up Thursday as several issuers priced multi-billion-dollar deals and short-end buyers came out of the woodwork, lifting offers in the 4- to 5-year maturity range. For the week, the average spread in Morningstar's Corporate Bond Index tightened 5 basis points to +135, near its tightest level since November 2011. Credit spreads in the financial sector tightened 6 basis points, slightly outperforming the industrial sector, which tightened 4 basis points. In our First Quarter 2013 Outlook, we opined that the financial sector would outperform the industrial sector this quarter, and we continue to hold that view.
While markets shot up Wednesday in response to the agreement to temporarily resolve the fiscal cliff, the markets have also begun to price in the next battle in Washington. Implied volatility in the equity market has declined substantially since the agreement was announced; however, 31- to 90-day volatility has not declined to nearly the same degree as 30-day volatility. This indicates that the market is viewing little downside risk for the next month, but pricing in greater downside risk as we approach the end of February/beginning of March. That's when we expect the political battles will heat up in the headlines as the government runs up against the end of the sequestration period and the Treasury runs out of accounting tricks to circumvent the government's need to issue new debt, as the United States reached its debt ceiling at the end of 2012.
We suspect that this week will be busy in the new issue market. While the current agreement in Washington has resolved the tax increases and forestalled the spending cuts under the sequestration, it has addressed neither the fact that the U.S. has already reached its current debt ceiling nor the longer-term issues of spending cuts and entitlement reform. If CFOs are thinking about issuing debt during the first quarter of this year, they would be well advised to tap the capital markets while the new issue window is open, rather than risk trying to come to market after these issues return to the forefront. Once the next political battle heats up in earnest, access to the new issue market could quickly become impaired.
Among the issuers that priced bonds last week, Ford Motor Company (F) (BBB-) priced a $2 billion, 30-year bond at +180. Rick Tauber, Morningstar's director of corporate bond research, wrote that fair value for this bond issue should be roughly +200 basis points over Treasuries. Investors who heeded his advice were well served, as the new issue quickly traded wide of the new issue spread, widening to almost +190 before ending the week wrapped around +184.
The domestic markets were not the only risk assets that have priced in a benign short-term political environment. Sovereign debt in the peripheral eurozone is acting as though the sovereign debt crisis has been resolved. For example, Italian bond yields reached their lowest levels since October 2010 and Spanish bonds have reached levels similar to where they were trading last March, before the runup in their yields as the sovereign debt crisis began. Credit spreads in Morningstar's Eurobond Corporate Index have continued to tighten and are now at the same level as Morningstar's U.S. Corporate Bond Index. The average credit spread in our European Corporate Bond Index had traded as much as 81 basis points wider than our U.S. Corporate Bond Index in November 2011. We continue to be leery of the economic conditions in Europe and don't think the sovereign debt crisis has been fully resolved. As such, we recommend investors concentrate on issuers with high exposure to U.S. markets, where we anticipate continued modest economic growth.
New Issue Notes
GE Capital Tapping the Market; Initial Price Talk Sounds Attractive (Jan. 3)
General Electric Capital Corporation (A) is kicking off the 2013 new issue calendar, looking to raise money across several tranches, potentially including 3-year fixed and floating as well as 10-year fixed. Proceeds are likely to be used to repay some maturing debt. Our rating on GECC is influenced by our rating on parent General Electric (GE) (AA-, wide moat) and the financial support provided through an income maintenance agreement. However, given that the support agreement does not constitute a guarantee of GECC's debt and the majority of GECC's profits are derived from businesses unrelated to GE, we do not believe there is an inextricable link between the two entities. As such, the foundation for our GECC rating is its stand-alone rating, which falls in the A- category, subsequently adjusted upward for the GE support.
We're hearing initial price talk for the 10-year tranche in the area of 125 basis points over Treasuries, which sounds attractive to us relative to existing GECC bonds as well as other financial comps. GECC's existing 10-year, the 3.15% due 2022, recently traded around a spread of 105 basis points over Treasuries, which seems fair to us and is in line with J.P. Morgan Chase's (JPM) (A) 2022 bonds, which we also view as fairly valued. Although final pricing will probably ratchet in from the initial talk, we would be comfortable buying the new 10-year down to existing levels of +105. We would place fair value for a new GECC 3-year about 50 basis points tighter, or +55, which is generally in line with its existing 1.625% due 2015.
New Issue Concession Should Make Citigroup's 3-Year Attractive (Jan. 3)
Citigroup (C) (A-) announced today that it plans to issue new benchmark 3-year notes. Initial price talk is a spread in the area of 100 basis points above the Treasury curve. We recently took Citigroup off our investment-grade Best Ideas list as we view its bonds as fairly valued across the credit curve. Given that Citigroup's current 3-year trades in the area of 85 basis points above the Treasury curve, we think the initial price talk on these new notes is attractive and would recommend them all the way down to a spread of 85 basis points. From a credit perspective, we continue to like the positive momentum Citigroup has shown. During the past two years, Citigroup has raised its Tier 1 common ratio more than 200 basis points to 12.7% on a Basel I basis. The company also has been able to reduce its nonperforming assets to less than 1% of total assets. Citigroup has reserves for loan losses of more than $25 billion, which represents approximately 4% of total loans and well over 200% of nonaccrual loans. The company has estimated that its Tier 1 common ratio is 8.6% on a Basel III basis.
American Tower's 10-Year Issuance Looks Fair (Jan. 3)
American Tower (AMT) (BBB) plans to issue new 10-year notes, with initial price talk at a spread of 185 basis points above Treasuries. This level would provide a decent concession to the firm's existing bonds--its 4.7% notes due in 2022 currently trade at about +170 basis above Treasuries--and provide a reasonable value given our rating. The typical BBB rated issuer in the Morningstar Industrials Index trades at about +172 basis points. Finding a good comparable firm for American Tower is difficult, however. The firm is significantly stronger financially than its major wireless tower peers but it was also the first of the group to convert to a real estate investment trust. Given the size and stability of the business, we believe an investment-grade rating is clearly warranted for American Tower. As such, we believe current trading levels are fair. However, we would prefer to see the firm trade near the weak end of the investment-grade world--north of +220 basis points in the current environment--before getting really excited about its bonds.
Balancing out a capital-allocation plan that leaves no room for debt reduction, American Tower generates very predictable cash flow and management has a well-articulated balance sheet strategy. The firm targets leverage at 3-5 times EBITDA, but prefers to keep this ratio between 3.5 and 4.0 times under normal circumstances with a clear path back to this range when leverage moves higher. Leverage is currently around the 4.0 times mark. In addition to distributions to shareholders, American Tower is also spending aggressively on expansion, such as the recently announced EUR 393 million acquisition of towers in Germany, another new market for the firm. Management is also spending to buy back stock.
Ford Motor Company in the Market With a Rare Offering; We Like the Story (Jan. 3)
Ford Motor Company (F) (BBB-) is making a somewhat rare appearance in the investment-grade market with a benchmark 30-year offering. Proceeds are targeted for the reduction of higher-cost outstanding debt and to accelerate contributions to its pension plans. Ford has a number of small, longer-dated, high-coupon bonds outstanding and appears to be taking advantage of good market conditions to clean some of that up. The firm recently reiterated its goal of reducing manufacturing debt to $10 billion by middecade and had a bit over $14 billion of debt outstanding as of the third quarter. We believe this goal is achievable and in line with our view that the credit continues to improve on the back of strength in the North American auto market.
Ford's 7.45% bond due in 2031 recently traded at an interpolated spread of +250 basis points over Treasuries while Ford Credit's (BBB-) latest 10-year bond traded at a spread of +175 basis points over Treasuries. We believe trading levels should be similar between Ford and Ford Credit, given the inextricable linkage between the two. Given positive ratings trajectory and the potential for an upgrade, we view the latter as fairly valued after a sharp rally since issuance in September, as this is in line with BBB levels. We would place fair value on the new 30-year at roughly +200 basis points over Treasuries.
In comparison, Daimler's (DAI) (BBB+) finance subsidiary has a 2021 maturity issue indicated at a spread of around +130, and Johnson Controls' (JCI) (BBB+) 2021s are indicated at +147. We view both as fairly valued. As an additional reference, the Morningstar Industrials BBB index is currently at a spread of 171 basis points above Treasuries.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.