One of the themes we have highlighted this year is that management teams are concentrating their efforts on increasing shareholder value. Considering that top-line growth is stagnant as the economy muddles along, and increased productivity is increasingly harder to generate, management teams are turning to acquisitions to expand their businesses.
Several deals were announced last week that affect bondholders in different ways. On the positive side, Petrohawk (ticker: HK, rating: Suspended), which we had rated BB before the deal, announced that it had accepted an offer to be acquired by BHP Billion (BLT). The Petrohawk bonds traded up significantly on the news as BHP is one of the world's largest miners and has investment-grade-type credit metrics. Similarly, Nalco (ticker: NLC, rating: Suspended), which we previously rated BB+, agreed to be acquired by Ecolab (ECL). Nalco bonds traded up significantly on the news, as Ecolab also has investment-grade-type credit metrics. To the downside, Express Scripts (ESRX), which we previously rated A-, announced its intention to acquire Medco Health Solutions (ticker: MHS, rating: Under Review), which we had previously rated A-. The bonds for both issuers traded down on the news as investors became concerned about the amount of debt leverage the combined entity would employ to consummate the merger.
In our recommendations, we are always cognizant of the upside/downside dynamics that potential merger and acquisition deals can have on bondholders, and we take those risks into consideration in our opinion.
A Bailout to End All Bailouts?
The sovereign debt crisis finally came to a crescendo last week. Eurozone members structured a new financing plan to bail out Greece and "voluntarily" require the banks holding Greek debt to take a haircut and restructure their exposure. Credit spreads peaked at the beginning of last week and then began to tighten as information about the financing plan was leaked. The Morningstar Corporate Bond Index ended the week at +159, 2 basis points wider than last week, but we think the underlying pricing in the index may have lagged the rally toward the end of the week, and most bonds were probably unchanged for the week.
Once the financing plan was announced, Greek 10-year bonds moved up 9 points and Irish and Portuguese bonds gapped up 6-7 points. Their respective credit default swaps tightened even further than the bonds would indicate, as traders are now questioning the value of sovereign credit default swaps. When politicians specifically structure bailout financing with the intent to not trigger a credit event and pledge not to let any other countries default on their debt, the value of the credit default swap becomes questionable at best.
The most recent eurozone agreement to bail out Greece has the potential to cause significant trading dislocations in the sovereign debt market and will weigh on price discovery for the near future. While European officials went to great lengths to say that Greece was its own special case, and that this plan is intended for Greece alone, the market will undoubtedly look at this plan as the precedent for dealing with Portugal and Ireland and, if needed, Spain and Italy. We are also concerned that the European Financial Stability Facility will now have the ability to intervene in the secondary markets and purchase sovereign debt when it deems the capital markets are not correctly pricing a country's debt. Granted, we don't know how much dry powder the EFSF has to purchase such securities, when it would deem it appropriate to enter the market, or how it will be required to account for losses if it enters the market too early.
The bailout plan significantly reduces the interest rate Greece will pay on new financing and lengthens the debt maturity schedule, providing the country with plenty of runway to execute the arduous task of restructuring its economy. However, the plan does not appear to initially make much of a dent in the amount of outstanding debt. While the country will pay lower interest expense, and short-term debt will be termed out into long-dated debt, if Greece is not able to quickly reduce its deficit to below the rate of nominal GDP growth, its total indebtedness as measured by debt/GDP will continue to grow.
In the Eleventh Hour, Can Congress Beat the Clock?
So what will we face this week? More headline risk.
U.S. politicians continue to be at loggerheads as to how to get our own house in order and time is running short. We don't believe the United States will allow a default on the payment of either principal or interest if the debt ceiling is not raised before Aug. 2. However, all the rating agencies have put the government on alert that they will look to downgrade the U.S. (and are probably looking for an excuse to do so) if a realistic plan is not agreed to, at least in principle, by Aug. 2.
We think at least one of the agencies would pull the trigger on a downgrade. What does this mean for corporate bonds? We're not sure. There may be some short-term volatility, but corporate bonds will continue to trade at a spread to Treasuries, even if Treasuries are no longer the risk-free rate. Underlying dynamics of corporate credit risk will be unchanged. The repo market may require a slightly higher margin or haircut, but should still be viable. Hopefully, we won't have to see what the unintended consequences of a AA rating on Treasury debt would be.
Dave Sekera, CFA, is a senior securities analyst with Morningstar.
