Corporate Credit Spreads Hold Steady While Equity Markets Slip
European banks downgraded; Kraft and Heinz to merge.
We previously highlighted the recent divergence of the performances of the equity market and corporate bond market. While equity prices rose after the Federal Open Market Committee released its meeting statement and updated economic projections March 18, corporate credit spreads in the Morningstar Corporate Bond Index widened. This divergence corrected last week as equity prices fell but credit spreads were largely unchanged. The S&P 500 fell 2.2% (to slightly below where the index was before the FOMC statement) while the average corporate credit spread of our index was unchanged at +138. In the high-yield market, the Bank of America Merrill Lynch High Yield Master Index tightened a modest 5 basis points to +476.
While credit spreads have widened over the past few weeks, we think much of the widening occurred as the market had to digest an unusually large amount of new issuance. Over the next few months, we continue to expect that corporate bonds will remain well bid. As the European Central Bank's asset-purchase program prints new money to purchase sovereign bonds and asset-backed securities, the path of least resistance will be to reinvest those proceeds in corporate bonds. Much of the recent demand in the U.S. corporate bond market has been attributed to foreign investors in developed markets looking to pick up the higher all-in yield that U.S. corporate bonds offer and invest in the safety of the strengthening dollar. As we suspected the prior week, fund flows in the junk bond market turned around after two weeks of outflows, as the net amount of inflows rose to $900 million last week for open- and closed-end funds.
Considering the all-in yield on European corporate bonds is currently less than half of that in the United States and investors expect that the U.S. dollar will continue to strengthen versus the euro, global investors have been reallocating principal to the U.S. market. In addition, the Bank of Japan continues to weaken the yen with its own asset-purchase plan, which has prompted some Japanese fixed-income investors to also reallocate their asset mix to the U.S. corporate bond market.
European Bank Downgrades
Last week, we downgraded our credit ratings of HSBC (HSBC) (rating: A, narrow moat) to A from A+, Standard Chartered (STAN) (rating: A-, narrow moat) to A- from A+, and Royal Bank of Scotland (RBS) (rating: BBB-, no moat) to BBB- from BBB+.
Our rationale for downgrading HSBC and Standard Chartered (both U.K. banks that derive most of their income from Asia and other developing regions) involved lower profitability resulting in lower Solvency Scores in our bank model. During the past year, the slowdown in China's GDP growth rate has led to slower growth rates across the region, damping commodity-related activity, which is an important source of income for both banks' trading and lending operations. In the case of Standard Chartered, these influences have also led to higher loan-loss provisions, which detract from earnings.
Another factor influencing profits and the Solvency Score is legal and regulatory expenses. All three banks have suffered to varying degrees from settlements regarding interest rate hedging, misselling payment protection insurance, foreign exchange trading, or mortgage-backed securities. In addition to these "one-off" expenses, the banks have also reported material restructuring changes. No bank has been more affected by charges than RBS. Outsize charges have culminated in annual losses for the bank every year since the beginning of the financial crisis in 2007.
Another factor involved in lowering RBS' credit rating was removing the rating uplift from U.K. government ownership. We previously considered the 80% government ownership of the bank to be a positive factor in our rating assessment. However, the European Union's recently enacted Bank Recovery and Resolution Directive and emerging total loss-absorbing capacity regulation mandate that bank holding company debt act as a buffer to support and recapitalize bank operating units. As a result, we no longer assign a rating uplift from our baseline credit assessment due to the bank's government ownership. This contributed to the lower credit assessment of the bank.
Mergers and Acquisitions: Kraft Foods to Merge With Heinz
Mergers and acquisitions continue to be the greatest idiosyncratic threat to bondholders. Last week, we placed our rating of Kraft Foods Group (rating: BBB+/UR-, narrow moat) under review with negative implications because of the firm's announced merger with Heinz. Instead of being taken private, the merged entity will continue to be a publicly traded company. Kraft shareholders will receive stock of the combined entity and a special dividend payment that an equity investment from Warren Buffett's Berkshire Hathaway and Brazilian private equity fund 3G Capital will fund. Subsequent to the merger, Kraft shareholders will own 49% of the combined firm and shareholders of Heinz (which is currently privately held) will own 51%. Even though the firm is not planning to issue debt to fund the merger, debt leverage will rise because of the combination of Heinz's high debt leverage (estimated at 4.8 times) with Kraft's debt leverage (approximately 2.8 times). Management said it is strongly committed to being rated investment grade when the transaction closes. As such, it expects to be able to refinance Heinz's existing secured high-yield debt and preferred equity with cheaper investment-grade debt. The company is targeting debt reduction of $2 billion within two years and a net debt leverage metric of under 3.0 times in the medium term. In addition, management expects to be able to realize $1.5 billion of synergies by 2017.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.