Historically Low Interest Rates in Europe Prompt Demand for Higher-Yielding U.S. Dollar-Denominated Debt
Corporations finding cheaper financing in Europe.
Demand for U.S. corporate bonds continued to be very strong last week; however, the amount of new issuance brought to market was enough to satiate demand. Credit spreads were largely unchanged in the investment-grade space and only slightly stronger in the high-yield market. Over the course of the week in the investment-grade market, the average spread of the Morningstar Corporate Bond Index was unchanged at +133. High-yield bonds performed slightly better, as the average spread of the Bank of America Merrill Lynch High Yield Master Index tightened 10 basis points to +443. The demand for U.S. dollar-denominated fixed-income securities was not limited to the corporate bond market. Investors bid up prices on Treasury bonds as well, sending the yield on both the 10-year and 30-year Treasury bonds down 13 basis points to end the week at 2.00% and 2.60%, respectively.
Across the eurozone, sovereign yields bumped along their lowest ever yields. The yield on the 10-year German bund ended the week at 0.33%, the French 10-year OAT at 0.60%, Italian 10-year at 1.33%, and Spanish 10-year at 1.26%. In Asia, the 10-year Japanese government bonds declined to 0.34%. Among shorter-dated bonds, many developed markets bonds are trading at a negative yield. For example, Germany sold 5-year bunds at a yield of negative 0.08%. While the German 5-year has traded in the secondary market at a negative yield before, this was the first time it was sold at the time of offering at a negative yield. This means that investors are locking in a guaranteed loss if they hold the bonds until maturity. Fundamentally, the only instances in which this would make economic sense is if an investor expects a significant deflationary event that would decimate other asset values across the world. Otherwise, the only way for an investor to make money on these bonds is to sell them to another investor at a price that locks in an even greater loss. In this case, speculators are expecting that they will be able to sell the bonds to the European Central Bank, which has said it would consider buying debt trading at a negative yield.
Much of the recent demand has been attributed to foreign investors in developed markets looking to pick up the higher all-in yield U.S. corporate bonds offer, as well as invest in the safety of the strengthening dollar. As the ECB begins its quantitative easing program this month and the Bank of Japan continues to weaken the yen with its own asset-purchase plan, we expect global fixed-income investors with the ability to invest wherever they choose will continue to reallocate increasing amounts of their portfolios into U.S. dollar-denominated corporate bonds. As such, based on this demand, corporate credit spreads should continue to strengthen over the near term.
New funds continued to pour into the high-yield asset class last week, although the pace of new money has continued to slow. Last week, $0.9 billion of new funds were invested in high-yield mutual funds and exchange-traded funds. This brings the cumulative amount of money flowing into the sector over the past five weeks to $11.4 billion. Since the 2008-09 credit crisis, this is the greatest amount of funds over a consecutive five-week period that has been invested into the high-yield market.
A number of weeks ago, we noted that oil prices appeared to bottom out in the mid- to high $40s, and subsequently, prices have ranged within a few dollars around $50 per barrel. Corporate bonds in the energy sector have similarly rebounded off the lows. Since the end of January, the average credit spread in the energy sector of our investment-grade index tightened 38 basis points to +226, and in the high-yield index, the energy sector tightened 138 basis points to +672.
Corporations Finding Cheaper Financing in Europe
New corporate bond issuance rose dramatically last week. Among the issuers we cover, the amount of new issuance brought to both the U.S. and European markets was the greatest weekly amount raised since the Verizon megadeal in September 2013. Several domestic issuers took advantage of the record-low underlying yields in Europe and issued bonds denominated in euros. For example, Coca-Cola (KO) (rating: AA-, wide moat) issued a total of EUR 8.5 billion across several tranches ranging from 2 to 20 years. As an indication of how low interest rates are in Europe, the coupon on Coke's new 10-year bond is 0.75%. According to The Wall Street Journal, this was the largest euro-denominated transaction by an American firm and the second-largest transaction by any issuer. Among other companies that issued in Europe last week, Mondelez (MDLZ) (rating: BBB, wide moat) issued bonds in both euros and British pounds, AT&T (T) (rating: BBB, narrow moat) issued EUR 2.5 billion, Priceline (PCLN) (rating: A, narrow moat) issued EUR 1 billion, and TE Connectivity (TEL) (rating: BBB+, no moat) issued EUR 500 million.
Corporations that issued in the U.S. new issue market last week benefited from the high demand for dollar-denominated corporate bonds as credit spreads on many new issue bonds were much tighter than we thought represented fair value. For example, Agrium (AGU) (rating: BBB, no moat) issued 10- and 20-year bonds at spreads of +142 and +162, respectively. Proceeds will be used to refinance outstanding commercial paper, previously drawn to fund capital spending projects in 2015. Relative to competitors and the company's credit risk, we thought fair value for the new 10-year notes was +160, about 18 basis points wider than where the bonds priced.
Among other new issues last week, Arrow Electronics (ARW) (rating: BBB, narrow moat) issued 7- and 10-year bonds as spreads of +175 and +205, respectively. In our view, fair value on the bonds is +205 and +225, respectively. The primary use of the proceeds of the notes will be to repay the company's notes maturing in November 2015. In our valuation, we considered the lower Business Risk score of Arrow compared with key competitor Avnet (AVT) (rating: BBB+, narrow moat) as well as Arrow's persistently higher leverage relative to Avnet. We also considered Arrow's more aggressive shareholder payout ratio, which averaged 55% in 2014. Over the past five years, share repurchases have averaged about 75% of Arrow's free cash flow, compared with 47% for Avnet. Avnet's 4.875% notes due 2022 were indicated at +188 bps over the nearest Treasury.
Similarly, Juniper Networks (JNPR) (rating: A+/UR-, narrow moat) issued 5- and 10-year bonds at spreads of +185 and +245, respectively. In our view, fair value on the bonds is some 20 bps wider at +205 and +260, respectively. Our credit rating is under review with negative implications as we anticipate reducing it by at least two to three notches. We are considering the impact of additional leverage on Juniper's credit pillars, its cash flow prospects, and the effect of its current financial policy on its longer-term financial resiliency. The lack of clarity on longer-term leverage targets and potential corporate actions remains a key source of uncertainty and concern. To this point, the proposed notes offer no additional protections over existing notes, such as a downgrade-triggered coupon step-up, which would merit a tighter fair value. The stated use of proceeds for the new notes will be to fund share repurchases and dividends, which are keeping domestic cash reserves under pressure.
While most deals were either fully or overvalued, we did see some upside in a few. Bombardier (BBD.B) (rating: BB-/UR-, narrow moat) issued 3- and 10-year bonds at coupons of 5.50% and 7.50%. In our view, fair value on the 10-years is 7.25%. While our credit rating is under review with negative implications and we expect it to come out in line with the rating agencies at high single B, we believe investors should receive compensation closer to weak single B levels given ongoing program execution challenges and the firm's recent history of missing launch date and cash flow targets. Royal Bank of Canada (RY) (rating: AA-, narrow moat) issued 5-year notes at a spread of +67 basis points over Treasuries, which we think is attractive compared with our fair value estimate on these notes of +53. RBC was a consistent performer throughout the financial crisis due in part to its solid foothold in Canadian banking, where it derives about 50% of net income. Returns on equity in the Canadian banking segment have been above 40% during the past two years, and for the company as a whole, return on equity for the fiscal year ending in October was an impressive 19%, among the highest globally of any bank under our coverage. Credit quality remained strong, with impaired loans representing less than 0.5% of total loans. During 2014, net charge-offs represented just 0.24% of average loans, a rate that compares favorably with strong-performing Canadian peers. The bank also keeps operating costs low, as evidenced by its 52% efficiency ratio recorded during the year. RBC's solid capital is another hallmark of its credit quality. Common equity Tier 1 finished the year at 9.9% and Tier 1 at 11.4%, both on a fully phased basis.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.