Market Anxiety Heightened by Prospect of Reduced Liquidity
We think last week's focus on the Fed's intentions calls into question just how much of the recent rally has been due to improving underlying fundamentals.
The credit market was generally trendless last week, as volume was muted and we were unable to discern any change in investment themes. Dealers tightened their bid/ask spreads in an attempt to generate trades with the most liquid names such as Apple (AAPL) (AA-, narrow moat) tightening to a 1-basis-point bid/ask spread. The Morningstar Corporate Bond Index ended last week at +138, widening 2 basis points in a holiday-shortened session Friday in sympathy with the decline in the equity market. Those managers with cash were seen waiting for new issues to put money to work, as opposed to chasing bonds in the secondary market. The remaining market participants seemed content to sit on their existing positions, close out early for the week, and head home for the long weekend.
U.S. economic data released last week were generally positive, but completely overshadowed by Fed chairman Ben Bernanke's testimony to the Joint Economic Committee and by several members of the Federal Reserve who gave speeches throughout the week. It's disconcerting to see how much of the market's attention has been focused on the Fed's intentions as to the timing and pace of reducing asset purchases. We think this overreliance on easy-money policy calls into question just how much of the recent rally has been due to improving underlying fundamentals versus the monetary steroids provided by nearly daily asset purchases by the Fed. Considering the yield on 10-year Treasury bonds has historically averaged about 200 basis points over inflation, once the Fed begins to discontinue its purchase program, we think long-term interest rates will quickly increase. Even at the low rate of inflation of 1.1% year over year during March, the 10-year rate needs to increase more than 100 basis points to return to historical averages.
Doves Vs. Hawks, Round 1
Bernanke began the session with the Joint Economic Committee with his typical outlook: cautious optimism tempered by fiscal and global economic headwinds and testimony that future monetary policy would be driven by economic data as it unfolds. However, in response to questioning, he said the Federal Open Market Committee could begin reducing asset purchases as soon as a few meetings from now. Soon thereafter, the FOMC released the minutes from the April 30-May 1 meetings, which highlighted that a number of members believe the current asset-purchase program should be decreased as early as the June meeting (with one participant recommending beginning decreasing purchases immediately). The consensus of the FOMC members remains that the current asset-purchase program should continue, but with inflation as measured by personal consumption expenditures edging down in March and rising only 1% year over year, several members have indicated that they may favor actually increasing asset purchases. In fact, one participant even recommended adding more monetary easing at the meeting.
Based on the minutes and recent speeches by several Federal Reserve Bank branch presidents, it appears to us that the FOMC is becoming increasingly polarized between the doves and the hawks. Bernanke will have an increasingly difficult job trying to attain consensus as the divergence of opinions appears to be increasing. For example, last Monday, Chicago FRB president Charles Evans opined that the asset-purchase program should continue at least through the summer to make sure that the momentum in job recovery and the economy is self-sustainable. He believes GDP growth this year will be about 2.5% and will increase to escape velocity in 2014, hitting 3%-4%. Last Tuesday, New York FRB president William Dudley concurred with that assessment and thought the FOMC would need at least three to four more months of data to discern how the economy is progressing in light of this year's tax increases and federal spending cuts before considering reducing asset purchases. Dudley also said his outlook is currently so uncertain that he was not sure whether the next Fed move would be to decrease or increase monetary stimulus.
On the other side of the argument, Dallas FRB president Richard Fisher has been one of the earliest advocates of reducing the asset-purchase program and has recently been joined by two others. Philadelphia FRB president Charles Plosser has called for the Fed to begin reducing asset purchases after the June FOMC meeting, and Richmond FRB president Jeffrey Lacker has recommended discontinuing the purchase of mortgage-backed securities. As the hawks and doves battle over the future of monetary policy, this could be anything but a quiet summer for the corporate bond market.
New Issue Notes
Concho Resources to Tap 5.5% Notes Due 2023 to Fund Bond Tender; Bonds Look Cheap (May 20)
Concho Resources (CXO) (BB+, narrow moat) announced Monday that it plans to offer an additional $500 million of its 5.50% senior unsecured notes due 2023. We put fair value on the 2023 notes around a yield to worst of 4.50%. Following the new issuance, the total amount of the 2023 notes outstanding will be $1.2 billion. The use of proceeds will be to tender for any and all of the company's $300 million 8.625% notes due 2017 at a price of $106.922. Concho is tendering early for the 2017 notes which become callable in October 2013 at a price of $104.313. Proceeds from today's issuance will also be used to repay a portion of the company's outstanding secured credit facility. As of March 31, there was $467 million outstanding under Concho's $2.5 billion credit facility.
Concho Resources is a play on oil, the Permian Basin, and the firm's ability to successfully integrate a growing roster of acquisitions. In 2012, long-term debt increased by approximately $1 billion, primarily as a result of two acquisitions in the Permian Basin: PDC and Three Rivers. We recently initiated credit coverage on Concho with an issuer credit rating of BB+. Our rating reflects the company's narrow economic moat, its relatively low leverage and its high reserve life, offset by its high ratio of total debt/proved reserves and relatively small size. As a low-cost operator, we project that Concho will self-fund its capital expenditure budget, which will drive leverage and debt/proved reserves lower as the company increases production and reserves without increasing debt.
Concho's 5.50% notes due 2023 recently traded at a YTW of 4.73%. For comparison, Range Resources' (RRC) (BBB-, narrow moat) 5.00% notes due 2023 are quoted at a YTW of 4.30%, which we view as slightly rich. Both Concho's and Range's bonds are in a junior position to each company's secured credit facility. On a trailing 12-months basis, Concho's gross leverage is 2.2 times and its total debt/proved reserves is $1.22 per thousand cubic feet equivalent. Range has higher leverage at 3.3 times, although its debt/proved reserves is much lower at $0.45 per mcfe due to Range's substantial acreage positions. Unlike Concho, we project that Range will need to borrow to funding its drilling program, which will restrain improvement in its credit metrics. Based on our assumption that Concho self-funds its drilling program, we project that Concho's credit metrics will improve over our forecast period with gross leverage declining to 1.0 times and debt/proved reserves declining to $0.65 per mcfe by 2016. Based on our assumption of improving credit metrics as the company integrates its recent acquisitions, we peg fair value on Concho's 5.50% notes at a YTW of 4.50%.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.