Credit Spreads Return to Where They Started
The impact from the emerging-markets disruption barely dented the corporate bond market.
Corporate credit markets recaptured the spread widening that occurred at the end of January and beginning of February when the markets sold off as a result of turmoil in the emerging markets. At the end of last week, the average spread in the Morningstar Corporate Bond Index returned to +119, which is where spreads were in the middle of January and the end of 2013.
The impact from the emerging-markets disruption barely dented the corporate bond market, and on a longer-term chart, the pullback is only a minor blip. We continue to believe that from a fundamental, long-term perspective, corporate credit spreads are fairly valued based on our outlook for gross domestic product to rise between 2.0% and 2.5% this year. Across our coverage universe, our credit analysts generally have a balanced view that corporate credit risk will either remain stable or improve slightly, but that the tightening in credit spreads on those names will probably be offset by an increase in idiosyncratic risk (debt-funded M&A, increased shareholder activism, and so on). While the flight to safety has recently pushed the yield down on the 10-year Treasury to 2.75% from 3% at the end of 2013, we still expect interest rates will rise over the long term as the Fed tapers its asset-purchase program. With less market intervention from the Fed, interest rates should normalize towards historical averages compared with inflation, inflation expectations, and the steepness of the yield curve. As such, while the Morningstar Corporate Bond Index has risen 1.98% thus far this year, we think the corporate bond market will struggle to return much higher over the remainder of the year.
New Issuance Concentrated in Medium-Duration Notes
The new issue market was relatively subdued last week. Of note, among the companies we rate that issued bonds last week, 7-year bonds were the longest maturities that were priced, and the average maturity was 4 years. Among U.S. dollar-denominated bonds, the longest maturity was 5 years. Other than the weeks in which no new issues were priced, this is the first time over the past few years that we can remember that there were no 10-year or longer-dated bonds priced in the new issue market. It appears that the market is betting that rates will be heading higher soon and longer-duration bonds have quickly gone out of fashion.
The only issue of note to us last week was that of BT Group's (rating: BBB, narrow moat) subsidiary, British Telecom, which priced 3- and 5-year bonds at +60 and +85, respectively. British Telecom's notes priced at a level that Mike Hodel, our telecom analyst, thought was fair value. However, he thinks the pricing on British Telecom's 5-year bonds highlights the relative attractiveness of ORANGE's (ORAN) (rating: BBB+, narrow moat) 5.375% senior notes due 2019, which were recently indicated at 108 basis points over the nearest Treasury.
Don't Rock the Boat; Monetary and Fiscal Policy to Proceed on Course
In her first testimony before the House Committee on Financial Services as chair of the Board of Governors of the Federal Reserve System, Janet Yellen said she expected to keep monetary policy consistent with the Fed's current approach. This came as no surprise to us. We have previously written that we think the Fed will continue to taper its asset-purchase program and it would take a severe economic pullback for the Fed to change its current course. We also expect that the Fed will continue to downplay the unemployment rate as a trigger to begin raising the federal funds rate. In the past, the Fed has said it would consider raising short-term rates once unemployment reached 6.5%. However, as the unemployment rate has dropped closer to that benchmark, the Fed has revised its language. In its December statement, the Federal Open Market Committee began to hedge its bets, including language stating that the committee anticipates it will be appropriate to keep the federal funds rate near zero well past the time that unemployment declines below 6.5%. In her testimony, Yellen pointed at other employment indicators that will dictate the Fed's course of action. We continue to think that the Fed will not begin to raise rates until well into 2015. The other takeaway from her testimony is that the Fed currently does not view the late January/early February turmoil in the emerging markets as having a material impact on the U.S. economy.
In addition to the continuity in monetary policy, fiscal policy will continue unabated. Both the House and Senate passed a "clean" debt limit resolution that does not contain any conditions on raising the debt ceiling until March 2015. This effectively removes the threat of default and the risk of brinksmanship that has been played out in Washington over the past few years as the country bumped up against its borrowing capacity.
European Banks Preparing for Next Round of Stress Tests
Fourth-quarter results have generally been disappointing among European banks. One of the reasons that earnings have been lackluster is that many banks have been taking extra provisioning in an attempt to shore up their balance sheets before the next round of stress tests, to be conducted this spring. As part of the stress tests, regulators are currently reassessing the risk factors and weightings they will use to stress loan portfolios. Included in this reassessment, regulators are debating whether to increase the risk weighting of sovereign bonds. If the regulators were to require banks to increase capital levels for holding sovereign debt, we think the Spanish and Italian banks would be affected the most, potentially leading those banks to sell significant portions of their sovereign debt portfolios. We think the banks most at risk of performing poorly in this round of stress tests will be those with sizable portfolios of hard-to-value and impaired assets like shipbuilding loans, such as Commerzbank (CBK) (rating: BBB+, no moat) or underwater Irish mortgages, such as Royal Bank of Scotland Group (RBS) (rating: BBB+, no moat).
Stagnant Eurozone Economy Showing Very Modest Trend Improvement
The eurozone's economy grew very modestly in the fourth quarter as GDP rose 0.3% sequentially and 0.5% compared with the same quarter of the previous year. Germany, the largest economy in the European Union, grew 0.4% sequentially, and France, the second-largest economy, grew 0.3%. Italian GDP rose 0.1%, the first time the country's economy has expanded since the second quarter of 2011. Spanish GDP rose 0.3%, which is the first time since the third quarter of 2011 that Spain has posted two consecutive quarters of economic expansion. While the trend is positive and we hope will continue, the absolute level of economic growth is still below that which is needed to halt the increase in--and then begin to reduce--debt/GDP ratios for the peripheral countries. The most recent data shows that Italy's debt/GDP has risen to 132.9% as of the third quarter of 2013 as compared with 127.0% at the end of 2012 and Spain's debt/GDP has risen to 93.4% from 84.2% at the end of 2012. We also suspect that with economic growth in Europe essentially stagnant, nonperforming loans in the beleaguered southern peripheral countries will continue to rise and pressure the banking system.
Italian and Spanish Bonds Holding Their Gains; at Their Lowest Yields in Years
Neither the turmoil in the emerging markets, the stagnant growth in Europe, nor political upheaval in Italy has derailed investors' willingness to accept greater credit risk in their search for yield. Spanish and Italian 10-year bonds continued to rally last month, pushing yields down to levels not seen since 2005 and compressing spreads to pre-credit-crisis levels. At the end of last week, the yield on Spanish 10-year bonds was 3.60% and its spread over German bonds was +190 basis points. Likewise, the yield on Italian 10-year bonds dropped to 3.69% and its spread over German bonds was +201 basis points. With these bonds trading at the lowest yields and tightest spreads of the past five years, we caution that if contagion from the capital flight in the emerging markets begins to spread into the developed markets, we expect these two bonds would be among the first to be hit by a wave of selling pressure and their prices would fall further and faster than those of other European sovereign or corporate bonds.
New Issue Notes
Guidance on Bank of America's New 3-Year Is Expensive (Feb. 11)
Bank of America (BAC) (rating: BBB, narrow moat) is in the market with 3-year senior bank notes offering both fixed- and floating-rate tranches. Initial price talk on the 3-year fixed notes is 60 basis points over Treasuries, which we view as expensive. Our rating focuses on the holding company, as opposed to the bank operating subsidiary. We believe the holding company notes should be priced at +75 basis points to the nearest Treasury. We would expect bank-level debt to trade roughly 5 basis points tighter due to its senior position in an orderly liquidation, placing fair value on the new issue notes around +70. B of A's most recent 3-year bank note, the 1.125% due in November 2016, is indicated at 60 basis points over the nearest Treasury, which we also view as expensive. B of A's closest peer, Citigroup (C) (rating: A-, narrow moat) has current 3-year holding company notes, the 1.3% due November 2016, indicated at +67 basis points to the nearest Treasury, which we view as fair. JPMorgan Chase's (JPM) (rating: A, narrow moat) 3-year note, the 1.125% due in 2016, is indicated at 66 basis points over the nearest Treasury, which we also view as fair. As a result, we see better value in both JPMorgan and Citi than in Bank of America's notes.
B of A's posted solid results in 2013, with net income of $11.4 billion more than double the level in 2012. The bank was successful increasing net interest income--up nearly 4% on the year--while decreasing noninterest expense by a similar amount. Although BAC recorded litigation expenses of $2.3 billion in fourth-quarter 2013 for mortgage-backed securities, we believe that the largest legal expenses are behind the bank. B of A's balance sheet is now in fairly good shape, with a Basel III Tier 1 common ratio of 9.96%. We expect the company to exceed 10% in early 2014. Net charge-offs decreased to 0.68% in the fourth quarter of 2013 from 1.40% in the year-earlier period. Nonperforming loans have also shown improvement, ending the year at 1.93% of loans compared with 2.62% in the year earlier, while loan loss coverage has decreased slightly but still remains at healthy levels near 100%. Although these and other measures are clearly moving in the right direction, the bank has room for further improvement. As such, we see better value in other global banks.
BT Bond Offering Looks Fair, Though We Prefer Orange Among European Telecom Issuers (Feb. 11)
BT Group subsidiary British Telecom is in the market with benchmark-size 3- and 5-year U.S. dollar note offerings. Current price talk is around 65 and 90 basis points over Treasuries, respectively, which we believe sits near fair value. However, we prefer Orange among European telecom issuers.
BT has done a great job of reducing leverage over the past several years, with net debt declining to GBP 7.6 billion (about 1.3 times EBITDA) at the end of the third quarter of fiscal 2014 from GBP 11.4 billion (2.0 times) four years ago. Our concern with BT remains the size and funding of its pension obligations, however. BT has made sizable pension contributions in recent years, but it still faces a GBP 5.8 billion deficit, net of tax. More critically, the absolute size of the pension obligation (currently estimated at about GBP 45 billion) relative to the size of BT's business is our primary concern. Relatively small changes in assumptions significantly affect the value of pension assets and liabilities as well as the firm's voluntary although regular contributions.
At 90 basis points over Treasuries, the new BT 5-year notes would price attractively relative to Deutsche Telekom (DTEGY) (rating: BBB-, no moat), whose 6% U.S. dollar notes due in 2019 were recently indicated at a spread of 87 basis points over the nearest Treasury. We believe the BT 5-year would also price fairly relative to Verizon Communications's (VZ) (rating: BBB, narrow moat) 3.65% notes due 2018, which have traded recently at about 80 basis points over the nearest Treasury. While we have equivalent ratings on BT and Verizon, we see greater room for rating improvement over the near term at Verizon. However, among European telecom issuers, we prefer Orange's 5.375% U.S. dollar notes due 2019, were recently indicated at 108 basis points over the nearest Treasury.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.