Heavy New Issue Volume Pressures Corporate Bond Market

While credit spreads held in fairly well two weeks ago despite the record-breaking amount of weekly new issue volume, they were unable to hold their ground last week. New issue volume slowed from its torrid pace the prior week, but among the issuers we rate, still another healthy $24 billion worth of volume was priced last week. Between the volume, interest rates backing up, and weakness in the equity markets, the average spread of the Morningstar Corporate Bond Index widened 2 basis points to +110.

In the high-yield space, fund flows turned negative after four consecutive weeks of inflows. Among high-yield mutual funds and exchange-traded mutual funds, investors pulled $0.9 billion out of the asset class, reversing the prior two weeks' worth of inflows. The credit spread of the Bank of America Merrill Lynch High Yield Master II Index widened 11 basis points to +403 basis points.

Interest rates also rose last week as the yield on the 10-year Treasury rose 15 basis points to 2.61%. Considering the 10-year started the year at 3%, this move by itself is not that meaningful, but may be the beginning of a trend higher. Many investors believe the Federal Reserve's Federal Open Market Committee, which meets this Tuesday and Wednesday, will revise its language regarding how long it intends to hold the federal funds rate near 0%. Currently, the FOMC says "It likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset-purchase program ends, especially if projected inflation continues to run below the committee's 2% longer-run goal, and provided that longer-term inflation expectations remain well anchored."

The time may be right to make this change. The Fed will assuredly announce that it will wind down its asset-purchase program, economic indicators continue to indicate the economy is expanding at its current pace, and inflation is running much closer toward the Fed's target. In conjunction with its statement, the Fed will release its updated summary of economic projections and the Fed chair will host a press conference that will allow her to provide greater clarity regarding the Fed's actions. If the Fed resists changing its language at this meeting, we expect any change to be delayed until the December meeting, the next time the Fed will release updated projections and host a press conference. That will allow enough time for the more hawkish governors to persuade other governors that the emergency monetary accommodation of 0% interest rates is no longer required.

As the Fed winds down its asset-purchase program and the economy continues to expand at a moderate pace, we think interest rates will rise toward normalized levels more in line with historical averages as compared with economic growth, inflation, inflation expectations, and the shape of the yield curve. In our view, the 10-year could rise to as high as 3.50%-4% to reach a normalized level. With interest rates poised to rise further and credit spreads near their tightest levels since the end of the 2008-09 credit crisis, we expect rising rates will offset a significant amount of the yield that investment-grade corporate bonds currently offer. Since the high-yield segment has a much lower correlation to underlying interest rates and we expect moderate economic growth in the United States (which will hold down default rates), we would expect high-yield bonds to hold their value better in a rising rate environment than investment-grade bonds.

Overweight Owens & Minor's New Issue; Pass on AK Steel
Coming off a record-breaking week, the new issue market still priced a healthy amount of new issues. Based on our view of the credit risk, Owens & Minor (OMI) (rating: BBB+, no moat) provides the best value and upside potential among the issues priced. Our issuer rating is several notches higher than that of the rating agencies, which is Ba1/BBB/BBB-. The company priced $275 million 3.875% senior notes due 2021 at +175 basis points over Treasuries and $275 million 4.375% senior notes due 2024 at +187. We think these spread levels are attractive as we estimate fair value at +115 and +130, respectively. We do not believe Moody's below-investment-grade rating is appropriate; Owens & Minor's credit profile appears much stronger than even a borderline credit. Our BBB+ credit rating reflects the firm's solid cash flow prospects and manageable leverage. The firm operates in the mature, slow-growing medical and surgical supply market, where it distributes health-care products such as disposable gloves, syringes, sterile procedure trays, and surgical gowns. We think it will remain an integral part of the hospital supply chain for the foreseeable future because of its scale advantages.

To the downside, we think AK Steel's (rating: B-/UR, no moat) 7.625% senior notes due 2021 are overvalued. The notes were priced at a discount to yield 7.75%, but we think investors should be paid over 8% to be properly compensated for the credit risk. The company is using a combination of new debt and equity to fund its acquisition of a large flat-rolled steel manufacturing facility in Dearborn, Michigan, from Russia-based Severstal for $700 million. We had placed AK Steel under review following the announcement of the deal, which at the time did not include specific financing terms. Although management indicated during its July announcement that any financing plan would be credit-enhancing, the proposed package does little to meaningfully reduce leverage, which remains among the highest in our coverage universe. When factoring in management's adjusted EBITDA estimate for the new blast furnace facility, we estimate total leverage will still be a very high 8.5 times.

Scottish Independence Referendum Could Strengthen Other Separatist Groups
On Thursday, Scotland will hold a referendum to decide if it will separate from the United Kingdom. If the Scots do decide to exit the U.K., it is unlikely to have much of an impact on global financial markets; however, it could spur on other separatist movements. If these other movements gain traction, especially in Spain's Catalonia region, that would probably have an impact on global financial markets. Catalonia accounts for a significant percentage of Spain's GDP and provides a disproportionate amount of tax revenue to the Spanish government compared with the amount it gets back. If this region were to secede from the national government, this would spark worries about Spain's ability to service its debt. Considering that the Spanish banking system holds a significant amount of assets in Spanish bonds, concerns regarding Spain's ability to service its debt would quickly spiral into another round of the sovereign debt and banking crisis. In addition, while it's a different concept, a vote to extricate Scotland from the U.K. could also bolster groups that advocate leaving the eurozone.