As Pace of New Issuance Slows, Credit Spreads Should Begin to Recover

Even including the $8 billion Alibaba (BABA) (rating: NR, wide moat) transaction, the pace and volume of new issues slowed last week from the prior two weeks. Although the pace slowed, it was still greater than the average weekly volume this year. As evidenced by widening credit spreads over the past few weeks, the new issue volume has eclipsed market demand. The average spread of the Morningstar Corporate Bond Index widened 2 basis points to +132 (its widest level this year), and in the high-yield market, the Bank of America Merrill Lynch High Yield Master II Index widened 11 basis points to +454.

Investor demand has been pressured from the top down, as global economic growth has generally shown signs of cooling, and from the bottom up, as shareholder activism has reduced the credit quality of a number of issuers over the past few months. Further damaging sentiment, the 7-year and 10-year tranches of Alibaba deal performed poorly in the secondary market. At the close Friday, the midmarket quotes for the 7- and 10-year bonds were 2 and 4 basis points wide of their new issue spreads. The order book for Alibaba bonds was reportedly 5 times the size of the deal, but the underwriters ended up pricing the bonds significantly tighter than price talk, and many large investors, especially insurance companies, dropped out.

There were rumblings that Medtronic (MDT) (rating: A, wide moat) may come to market this week to fund a significant portion of the $16 billion it needs in cash consideration for its planned acquisition of Covidien (rating: A, wide moat). If the transaction is not brought to market this week, it will need to be priced soon as the acquisition is expected to close in early January. The new issue market in December will be abridged by the holidays and year-end portfolio window dressing. If Medtronic does try to tap the market this week, the poor reception in the secondary market for the Alibaba bonds may prompt Medtronic to pay a healthy new issue concession to entice investors. Otherwise, while there may be a few one-off issuers that hit the market, it should be a relatively quiet week.

As the pace of new issues begins to slow and trading in the secondary markets decelerates, we expect that credit spreads will grind tighter for the remainder of the year. Even though the Fed has wound down its asset-purchase program, we expect positive economic momentum will continue through the fourth quarter and forecast GDP growth of 2.0%-2.5% in 2015. While this growth rate is nothing to write home about, it should be enough to keep default rates near the low single digits in the coming year. In addition, investment-grade and high-yield spreads have some room to run, as both are still well wide of their tights from earlier this year. The tightest level our investment-grade bond index reached earlier this year was +101 on June 24, and the tightest the high-yield index reached was +335 on June 23.

New Issue From Scripps Brings New Bond to Our Best Ideas List
While there were a number of bonds priced in the new issue market last week that appear cheap, the most attractive issue to us on a risk-adjusted basis was issued by Scripps Networks (rating: A-, narrow moat). The company issued 10-year notes at +165 basis points over Treasuries, which quickly traded to +148. We think there is still significant upside as we see fair value for the bonds at +115. Comparatively, the A- tranche of the Morningstar Industrial Corporate Bond Index is +116. Within the sector, we rate Scripps one notch higher than media peer Time Warner (rating: BBB+, wide moat) and think the Scripps bonds should trade about 15 basis points tighter than our fair value estimate of +130 for Time Warner's 2024s. Among the other new issues, the next most attractive issue we saw was Fluor's (FLR) (rating: A, no moat) 10-year bonds, which priced at +130; we view fair value at +115.

China Cuts Interest Rates and ECB Pledges to Ramp Up Its Stimulus Programs
In a move that seems to confirm our opinion that China's economy is slowing more quickly than its official GDP indicates, China cut its short-term interest rates in an effort to boost economic activity. The HSBC Flash China Manufacturing PMI report declined to 50.0, which is the demarcation line between an expanding and contracting economy.

Last Friday, in what appears to be an attempt to signal that additional stimulus is coming soon, European Central Bank president Mario Draghi said the ECB needs to increase inflation and inflation expectations as quickly as possible. In his keynote speech at the Frankfurt European Banking Congress, Draghi said, "We will do what we must to raise inflation and inflation expectations as fast as possible, as our price stability mandate requires of us. If on its current trajectory our policy is not effective enough to achieve this, or further risks to the inflation outlook materialize, we would step up the pressure and broaden even more the channels through which we intervene, by altering accordingly the size, pace, and composition of our purchases."

Bonds investors took Draghi's remarks to heart and sent Spanish and Italian bonds higher in the expectation that the ECB will expand its asset-purchase program into the sovereign debt market. The 10-year bond of each country declined 9 basis points to their lowest ever yields of 2.01% and 2.21%, respectively. Spain and Italy are rated Baa2/BBB by the rating agencies, and the credit spread on those bonds are now +124 and +144 basis points. Compared with where equivalent-rated European corporate bonds are currently trading, there may be further upside as the option-adjusted spread of the BBB tranche of the Morningstar Eurobond Corporate Index is +102 basis points. However, if the ECB does not come through with a program to expand its asset-purchase program into sovereign bonds, then we could quickly see these bonds widen dramatically. It was just one year ago that both of these bonds were trading at levels about double their current yield.

It remains to be seen if the ECB will embark upon an expanded stimulus plan in the near term. Earlier this month, Eurostat released its flash estimate for third-quarter GDP, which revealed that the economic growth rate picked up slightly from the second quarter. Seasonally adjusted GDP rose 0.2% in the euro area during the third quarter as compared with a 0.1% growth rate in the second quarter. On the inflation front, while one month does not make a trend, the annual inflation rate increased to 0.4% in October, the first sequential uptick since April. While the pace of GDP and inflation picked up, it must have been slower than the ECB's projections as the ECB reduced its forecasts for GDP growth to 0.8%, 1.1%, and 1.7% for 2014, 2015, and 2016, respectively. In addition, inflation is expected to remain well below the ECB's 2% target at 0.5% in 2014 and 0.8% in 2015.