Bond Market Mostly Ignores China Corporate Defaults, Ukraine Tensions
The market seems to believe that any potential contagion from the situation in the Ukraine or economic weakness in China will be extremely limited in the United States.
Corporate credit spreads widened last week as the first defaults in China's domestic public bond market and the ongoing political tension in the Ukraine weighed on investor sentiment. With to the flight to safety, Treasury bonds recouped their prior weeks' losses, driving the interest rate on the 10-year Treasury down 14 basis points, back to 2.65%.
As some investors decided to take a little risk off the table and lock in gains from earlier this year, the average spread in the Morningstar Corporate Bond Index widened 5 basis points to +120. However, this sell-off is very mild compared with the index's trading range over the past year. For example, at its current level, the index is still tighter than where spreads backed off to when the turmoil in the Ukraine pressured risk assets in late January. In addition, corporate credit spreads are still significantly tighter than last summer, when the corporate bond market sold off in sympathy with the rise in Treasury rates. Considering credit spreads are at their tightest levels since before the 2008-09 credit crisis, the takeaway from the current market action is that investors are confident that any potential contagion from the situation in the Ukraine or economic weakness in China will be extremely limited in the United States.
In fact, on a longer-term basis, the amount of spread widening from either the Ukrainian political crisis or the Chinese company defaults is almost imperceptible.
Based on a long-term fundamental perspective, we continue to believe corporate credit spreads are fairly valued—albeit at the tight end of the range that we view as fairly valued. 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 mergers and acquisitions, increased shareholder activism, and so on). However, considering that spreads are already at the tight end of where we think fair value lies, we think there is risk in the near term that spreads could quickly widen out if the slowdown in China quickens or contagion from the political turmoil in the Ukraine begins to spread into other former Soviet states or Eastern Europe.
Closer to home, other than retail sales, there were very few economic indicators of importance released last week. Retail sales rebounded 0.3% in February after declining in January. However, Robert Johnson, Morningstar's director of economic analysis, cautioned that while the monthly increase appeared to be strong, a deeper analysis of the data shows a sustained weakness in consumer spending of retail goods on a year-over-year basis. In addition, revisions to previous months suggest that the third revision to fourth-quarter GDP is more likely to be down than up.
Although the flight to safety pushed interest rates down last week, as the Fed tapers its asset-purchase program over the remainder of the year, we still think that interest rates will rise toward normalized historical metrics as compared with inflation, inflation expectations, and the steepness of the Treasury curve. We think that at a more normalized level, the yield on the 10-year Treasury could increase to 3.20%-3.70% to reach historical norms.
New Issue Market Cools; Quest Diagnostics Most Attractive Deal Last Week
After three blistering weeks in the new issue market, the pace of deals cooled off as a result of widening credit spreads and decreasing risk appetite. In our view, the cheapest bond priced last week was Quest Diagnostics' (DGX) (rating: BBB+, narrow moat) 10-year note. The company issued $300 million 5-year notes at +113 and $300 million 10-year notes at +158. Based on her view of credit risk and compared with the company's peers, Julie Stralow, our health-care analyst, maintained her overweight recommendation on Quest as she sees fair value on these issues at 100 and 140 basis points over Treasuries, respectively. Her fair value assessment is close to the current trading levels on notes outstanding from diagnostic lab peer LabCorp (LH) (rating: BBB+, narrow moat). LabCorp's recently issued 2018s and 2023s are indicated around 95 and 140 basis points over the nearest Treasury, respectively, and we continue to recommend the bonds at market weight. Both companies have dug narrow economic moats around their respective diagnostic lab businesses. As a duopoly, Quest and LabCorp so thoroughly dominate the independent diagnostic market in the U.S. that it would be very difficult for a new entrant to compete as a national network of labs and facilities in a cost-effective manner. High barriers to success in the industry and their ongoing willingness to purchase diagnostic upstarts make us believe Quest and LabCorp will dominate the U.S. diagnostic business with rational pricing dynamics for the foreseeable future. Also, the firms typically operate with similar debt leverage. For example, at the end of December, debt/EBITDA stood at 2.5 times for Quest and 2.4 times for LabCorp, making their financial risks similar as well. Given their similar credit profiles, we believe notes for Quest and LabCorp should be valued similarly by investors. Therefore, if higher bond compensation remains available for Quest, we would continue to overweight the notes relative to its peer. After this new issuance, we plan to remove Quest from our Potential New Issue Supply list, as its need for external financing will probably decline.
Economic Growth in China Shows Further Signs of Slowing
In addition to China's recently suffering its first onshore public corporate bond default, economic metrics are indicating that economic growth is slowing. For example, China's exports unexpectedly fell more than 18% in February compared with last year, although much of the blame was apportioned to the shift in timing of the Lunar New Year holiday. Multiple other recently released economic indicators continue to indicate rapid growth, yet the growth rates are rising at some of their slowest paces in years. Fixed asset investment, which measures the infrastructure spending that has been China's economic backbone, increased 17.9% during the first two months of 2014. While this rate of growth would be remarkable in developed markets, this rate was actually the slowest increase in China since 2002. In addition, industrial output increased 8.6% in January and February compared with last year, but this growth rate was the lowest rate since April 2009. Similarly, retail sales increased 11.8% over the same period, but was the lowest rate of increase since February 2011.
Slowing growth in China is having an adverse impact in the commodities markets. For example, copper (also known as "Doctor Copper" for its historical ability to diagnose economic health or sickness) has dropped precipitously since the beginning of the month. The price per pound has fallen below $3 as compared with $3.20 at the end of February and more than $3.50 at this time last year. In addition to China's being the largest consumer of copper, the metal has reportedly been used as collateral in the country's shadow banking system.
China's policy makers appear to be beginning to publicly admit that growth may be slower than the country's official goals for 2014. For example, China's finance minister was recently quoted as stating that GDP growth of 7.2% in 2014 would be "about" the 7.5% growth rate that officials had publicly targeted earlier. Similar to the goals of other policy makers across the globe, he has taken the position that the government's focus is on employment, as opposed to economic growth alone. This wording suggests to us that the government will allow slower-than-desired growth so long as the labor markets are not too adversely affected by the reduced pace.
While the size of the current bond defaults are de minimis relative to the overall size of the Chinese financial system, it's not the size of the defaults that is concerning, but what they might indicate. The worry is that this is a harbinger of many more defaults and in greater principal amounts. Previously, the Chinese banks and government have supported the bond and loan market by rolling over or extending maturing debt of those firms that were not able to otherwise repay or refinance. It now appears that the Chinese government is going to allow at least some amount of issuers to default. We suspect the Chinese government will endeavor to allow small deals to default that can be written off by the banking system, but will continue to support those issuers whose deals are large enough to potentially cause systemic financial issues. If the government successfully allows some debt to default but restrain the default rate from rising too far or too quickly, it should help brake the rapid rise in corporate debt. Total corporate debt outstanding has grown substantially faster than GDP in China over the past five years and is reportedly 125% of GDP, up from 92% of GDP in 2008.
While we will be keeping an eye on the default rate of China's domestic public corporate bonds, we are more concerned about the wealth management products that have supported the country's shadow financing system. Many of these products are structured investment vehicles that use short-term debt to finance long-term loans, often of dubious value. There is reportedly about $2 trillion of these products outstanding, with about 60% having a maturity of less than one year. Many of the investors in these vehicles do not realize that they are incurring liquidity and principal risk, as the products are often sold to them through the retail banking system. If investors for whatever reason decide that they want to cash out their existing loans, new investors are required to roll over the loans. However, if there are not enough new investors to provide liquidity, and investors are not able to pull their investment out, it may begin a domino effect in which other investors attempt to cash out and refuse to roll over their investments. In this scenario, we could see an event similar to the U.S. auction-rate securities market, which froze during the credit crisis.
New Issue Notes
Quest Issuing New Debt; Maintain Overweight Recommendation (March 12)
Quest Diagnostics (rating: BBB+, narrow moat) is in the market issuing about $600 million in new 5- and 10-year notes. Initial price talk of 140 and 180 basis points over Treasuries, respectively, looks relatively attractive to us, and we are maintaining our overweight recommendation. We see fair value on these issues around 100 and 140 basis points over Treasuries, respectively. Our fair value is close to spreads on notes from key diagnostic lab peer LabCorp (rating: BBB+, narrow moat). LabCorp's recently issued 2018s and 2023s are indicated around 95 and 140 basis points over the nearest Treasury, respectively, and we continue to recommend LabCorp's bonds at market weight. Given their similar credit profiles, we believe notes for Quest and LabCorp should be valued similarly by investors. Therefore, if higher bond compensation remains available for Quest, we would continue to overweight the notes relative to its key peer.
We believe Quest and LabCorp operate with similar credit profiles. Both have dug narrow economic moats around their respective diagnostic lab businesses. As a duopoly, Quest and LabCorp so thoroughly dominate the independent diagnostic market in the U.S. that it would be very difficult for a new entrant to compete as a national network of labs and facilities in a cost-effective manner. High barriers to success in the industry and their ongoing willingness to purchase diagnostic upstarts make us believe Quest and LabCorp will continue to dominate the U.S. diagnostic business with rational pricing dynamics for the foreseeable future. Also, the firms typically operate with similar debt leverage. For example at the end of December, debt/EBITDA stood at 2.5 times for Quest and 2.4 times for LabCorp, making their financial risks similar as well.
The proceeds from Quest's new issuance will be used to help repay borrowings on its credit facilities, which had $660 million outstanding. Quest recently tapped those facilities to fund the Solstas acquisition ($570 million); the firm also may have used its facilities to fund a portion of its share-repurchase program, which had $828 million authorized at the end of December. Additionally, $200 million in debt comes due later this month. After this new issuance, we plan to remove Quest from our Potential New Issue Supply list, as its need for external financing will probably decline.
CenterPoint Energy's Houston Electric to Issue 30-Year General Mortgage Bonds (March 12)
CenterPoint Energy's (CNP) (rating: BBB+, narrow moat) regulated electric utility subsidiary, Houston Electric, announced today that it will issue $400 million of 30-year general mortgage bonds. Initial price talk is in the +95 area. We peg fair value on Houston Electric's new issue at +75-80 basis points. While we do not formally assign an issuer rating to Houston Electric, we view this entity to be of similar, albeit slightly weaker, credit risk to PPL's (PPL) (rating: BBB, narrow moat) regulated utility Kentucky Utilities. Houston Electric's existing 3.55% general mortgage bonds due 2042 currently trade at +73 bps over the nearest Treasury, which we view as slightly rich. Kentucky Utilities' 4.65% first mortgage bonds due 2043 trade at 76 basis points over the nearest Treasury, which we view as fair. Thus, we place fair value on Houston Electric's 30-year new issue is in the range of +75-80.
Houston Electric's credit characteristics include a relatively average allowed return on equity of roughly 10.0%, an average Southern regulatory environment, and average regulatory lag mechanisms, enhanced by above-average management performance. We believe Kentucky Utilities ranks slightly better than Houston Electric based on its average allowed ROE of roughly 10.25%, an average Southern regulatory environment, above-average regulatory lag mechanisms, and average management performance. Compared with our coverage universe of regulated utility operating companies, we view Houston Electric and Kentucky Utilities as slightly less risky credits.
On a consolidated basis, CenterPoint Energy reported weak 2013 adjusted EBITDA of $2.2 billion, down 8.1% year over year. However, full-year results are not comparable as CenterPoint's Midstream business was reclassified as an equity investment in May 2013. As such, CenterPoint reports Midstream results as equity in earnings of unconsolidated affiliates versus operating income. We have adjusted 2013 EBITDA to include $173 million of pretax Midstream equity earnings; CenterPoint's 2013 EBITDA probably would be higher had it not reclassified its Midstream interests. Strong natural gas distribution results had a favorable impact on 2013 EBITDA, although more normal weather at the electric utility partially offset this.
Verizon Notes Will Probably Price Moderately Cheap; AT&T Still Looks More Attractive (March 10)
Verizon (VZ) (rating: BBB, narrow moat) has announced a tender offer for eight series of its notes this morning, financed with a five-part bond issuance that includes 7-, 10-, and 20-year maturities. Initial price talk looks attractive. However, given that recent new issues have priced 10-15 basis points tight of initial talk, we would expect the new Verizon notes to price around fair value and slightly rich relative to AT&T (T) (rating: A-, narrow moat). We believe Verizon should trade about 30 basis points wide of AT&T, based on our view of the differential between the firms' current financial positions. We believe AT&T already has metrics worthy of an A- rating, while we expect Verizon will need three years or more to bring its leverage back into the range typical for an A- issuer.
AT&T priced a new 10-year bond last week at +125 basis points (versus initial talk of +135-140 basis points), indicating a relative fair value for Verizon's new 10-year of +155 basis points. However, we would place fair value on AT&T's 10-year notes in line with the A- portion of the Morningstar Industrials Index, which stands at +97 basis points. Thus, in absolute terms, we believe the new Verizon 10-year should price at about +130 basis points. Initial talk on the new Verizon 10-year is in the mid- to high 150s, and we would expect that it will price around +140-145 basis points. As such, we believe the Verizon notes will offer good absolute value. However, we would continue to overweight AT&T in relative terms.
Initial Price Talk on BNP's New Issue 3- and 5-Year Is Attractive (March 10)
BNP Paribas (BNP) (rating: A, narrow moat) is in the market with a benchmark-size offering of 3-year fixed- and floating-rate notes and 5-year fixed-rate senior notes. Initial price talk on the 3-year notes is 70 basis points over Treasuries while the price talk on the 5-year is in the low +90s, both of which we view as attractive. Price talk on both tranches would provide an attractive new issue premium to existing 3-year and 5-year issues. BNP's current 3-year, the 1.25% due in 2016, is indicated at 50 basis points over the nearest Treasury, which we view as fair, while the firm's 2.4% notes due in 2018 are indicated at 80 over the nearest Treasury, which we also consider fair. Price talk is also attractive relative to lower-rated European peers. For example, French banking peer Societe Generale's (GLE) (rating: A-, narrow moat) 2.625% notes due in 2018 are indicated at 94 basis points over the nearest Treasury, which we consider roughly fair. Other European peers Deutsche Bank (DB) (rating: A-, narrow moat) and Barclays (BCS) (rating: A-, no moat) are both indicated at 89 to the nearest Treasury in the 5-year area, which we consider fair. Assuming a modest new issuance concession, we see fair value on BNP's new 5-year note at +85.
Although BNP reported modest results in 2013, we still consider it one of the better European banks. While pretax income dropped 21% on the year, the bank still managed to produce a return on equity of more than 6%. Results were marred by a EUR 798 million ($1.1 billion) provision related to the bank's investigation into U.S. dollar payments made through its networks into countries covered by U.S. sanctions, which may be illegal under U.S. law. They also included EUR 432 million of restructuring costs (full-year restructuring charges were EUR 669 million). We see these items as transitory and do not foresee a lasting impact to BNP's earnings capacity. The bank managed to increase capital during the year. On a Basel III basis, common equity Tier 1 finished the year at 10.3%, ahead of most European peers.
Entergy Arkansas to Issue 10-year First Mortgage Notes at Very Cheap Initial Levels (March 10)
Entergy's (ETR) (rating: BBB+, narrow moat) regulated electric utility subsidiary, Entergy Arkansas, announced today that it will issue $375 million of 10-year first mortgage backed notes. Initial price talk is in the +105 area. We believe Entergy Arkansas' 10-year new issue appears about 35-40 basis points cheap. While we do not formally assign an issuer rating to Entergy Arkansas, we view this entity to be of similar credit risk to CMS Energy's (CMS) (rating: BBB-, narrow moat) regulated utility Consumers Energy and Xcel's (XEL) (rating: BBB+, narrow moat) regulated utility Public Service Company of Colorado. Entergy Arkansas' 3.75% first mortgage bonds due 2021 traded at 87 basis points over the nearest Treasury, which we view as cheap. Furthermore, Consumers Energy's 3.375% first mortgage bonds due 2023 trade at 69 basis points over the nearest Treasury and Public Service Company of Colorado's 2.5% first mortgage bonds due 2023 trade at 65 basis points over the nearest Treasury. Thus, we believe fair value on Entergy Arkansas' 10-year new issue is in the neighborhood of 65-70 basis points over Treasuries.
Entergy Arkansas' credit qualities include a relatively average allowed ROE of roughly 10.2%, an average Southern regulatory environment, average regulatory lag mechanisms, and average management performance. We believe Consumers Energy ranks similarly, with an average allowed ROE of roughly 10.3%, an average Midwestern regulatory environment, average regulatory lag mechanisms, and slightly above-average management performance. Public Service Company of Colorado also ranks similarly, with an average allowed ROE of roughly 10.0%, an average regulatory environment in Colorado, average regulatory lag mechanisms, and average management performance. Thus, we rank Entergy Arkansas, Consumers Energy, and Public Service Company of Colorado, in terms of credit risk, as relatively average regulated utility operating companies under our coverage.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.