The US Debt Market
Investors in the credit markets stepped aside last week and tried to make head or tail out of the extreme volatility in the commodities markets. The turmoil in commodities and foreign exchange was quite a show for those of us not involved in those markets. Over the course of last week, oil declined 14%, agricultural commodities slumped 7%, silver plummeted 27%, copper dropped 5%, and the euro fell 3%. The S&P 500 fell as much as 2.5% intraweek, but regained some ground Friday thanks to the strength in the jobs report and ended the week down 1.7%.
In all this chaos, the credit market was relatively steady as the Morningstar Corporate Bond Index was only off 1 basis point to +136 and credit spreads held their own and digested a relatively full plate of new issues.
Even with some mixed economic indicators earlier last week and volatility in the commodities market, we continue to believe that corporate credit spreads will tighten over the course of the year. Issuers have generally posted strong quarterly earnings and robust credit metrics, fixed-income mutual funds continue to receive a steady stream of inflows as investors demand income, and default rates continue to subside as there is an abundance of liquidity for the riskiest of high-yield credits.
As a testament of the strength in the corporate bond market and investors' willingness to stretch for yield by taking on greater credit risk, the highlight in the US credit market last week was the unusual news of a deal for newspaper conglomerate Lee Enterprises (LEE) that couldn't get done. Considering that even the most highly leveraged buyouts of 2006 and 2007 have been able to refinance and extend maturities at lower rates and payment-in-kind toggle notes have resurfaced, it surprised many market participants to see a failed offering. From our point of view, it's encouraging to see investors push back on a transaction that did not warrant investment regardless of the yield.
Supporting our theme that most of the risk in the US credit market this year will come from either merger and acquisition activity or self-inflicted credit deterioration, ConAgra (ticker: CAG, rating: A-) made an unsolicited bid for Ralcorp (ticker: RAH, rating: BBB+). ConAgra's $4.9 billion cash bid values Ralcorp at about 7 times EBITDA. If ConAgra is successful with its bid, we think its debt leverage pro forma for the acquisition will place the combined entity on the precipice between investment grade and high yield. Last we saw, ConAgra's 7% senior notes 2019 were trading at +180. On a probability-weighted basis that ConAgra is successful and weighting the potential for ConAgra's rating to slip below investment grade, we think the spread is too tight at these levels and could widen a further 25-50 basis points.
Europe
Similar to the US markets, corporate credit spreads in Europe stepped to the side last week to wait for more clarity before making a meaningful move in either direction. Although European credit spreads will tighten or widen based on the same fundamentals as the United States, there continues to be a considerable overhang from the ongoing sovereign debt crisis. As we have opined previously, how and when the sovereign crisis works itself out could cause significant short-term volatility for all credit instruments in Europe. If a sovereign debt crisis does erupt in Europe and drags corporate credit spreads wider, we would view that as an opportunity to increase corporate exposure. We are more comfortable investing in corporate bonds relative to sovereigns as the transparency to analyse the underlying fundamentals and credit risk of corporate issuers is vastly greater than that of sovereigns.
After a month of negotiating, Portugal finally finalised its bailout with the European Central Bank and is awaiting the European Union's approval of the plan. The bailout calls for Portugal to reduce its deficit from 9.1% to 3% by 2013. Considering that the yield and credit spread on Spain's bonds has been held to a relatively tight trading range since the beginning of the year, the sovereign credit market is pricing in a high probability that the sovereign contagion has been halted and the line has been drawn in the sand with Portugal. It was almost a year ago that we first said that the eurozone would need to draw the line before Spain and that failure of Greece or Portugal could cause short-term chaos, but that a Spanish default would have dire consequences across the financial system in Europe.
Greek, Portuguese, and Irish bonds, which have been making continuous new lows since the middle of March, appear to have finally found some support.
-- Greece's 6.25% notes 2020 bounced 2 points to 56.75, resulting in a 15.36% yield, which is +1,227 basis points above German bonds.
-- Portugal's 4.80% notes 2020 held steady at 70.25, resulting in a 9.91% yield, which is +680 basis points above Bunds.
-- Ireland's 4.50% notes 2020 moved up more than a point to 69, resulting in a 9.88% yield, which is +683 basis points over Bunds.
There is increasingly more news on a possible restructuring of Greek debt, including an extension of maturities. Last Friday, there was a rumour floating around (and quickly refuted by the Greek government) that Greece was threatening to leave the eurozone. Then over the weekend and earlier this week, there were speculations that Greece is to receive a EUR60 billion bailout, which was denied by the authorities in Athens on Tuesday. While we quickly disregarded these rumours as noise, based on the pace of more reputable news flow, we suspect that the authorities are closer to figuring out how to alleviate Greece's debt problems. However, the news is neither specific enough nor is its pace quick enough to lead us to believe this is a near-term event. Whatever action the authorities end up taking, it will probably become a blueprint for addressing Portugal's and Ireland's balance sheets as well and will provide a guide for how it will affect the European banks and the credit markets. Depending on those outcomes, the blueprint can be adapted to alleviate unwarranted volatility.
If a restructuring of Greece's debt does come to fruition, it appears that an extension of the debt maturities is more likely than a principal haircut. Currently, the 4.60% notes 2013 are trading at 71, resulting in a 23.82% yield. As an example of how a maturity extension may play out, if these notes were extended to 10 years and the coupon was left unchanged, the yield on the bonds would need to drop to 9.05% to break even from current trading levels. Considering that corporate credit spreads have generally been tightening across the board in Europe, including the banking sector, it appears that the European credit market is becoming increasingly comfortable with the idea that the eurozone and its banks would survive restructuring among Greek, Irish, and Portuguese bonds.
