Other Credit Trends
In the first half of the year, companies used newly issued debt primarily to refinance short-term debt or bank credit facilities. In the third quarter, we saw a big shift in how this new capital was deployed, as issuers have been taking advantage of strong demand for bonds and low interest rates to raise money to fund large capital expenditure programmes, strategic mergers and acquisitions, share buybacks, and special shareholder dividends. For instance, Brazilian iron ore giant Vale (VALE: Morningstar Credit Rating: BBB+) came to market in September with a $1.75 billion transaction whose proceeds will be used to fund the firm's massive capital expenditure activities in the coming years.
While the banks generally have been reluctant to rent out their balance sheets to provide commitment letters to support private equity LBO transactions, the bond market has been happy to provide financing for strategic mergers and acquisitions by investment-grade issuers. For example, Cliffs Natural Resources (CLF: BBB) issued bonds to fund the acquisitions of INR Energy and Spider Resources.
In the consumer products sector, Wal-Mart (WMT: AA) and McDonald's (MCD: AA-) both issued debt to fund large share repurchase programmes. The health-care sector has been especially active issuing debt to fund stock buyback programmes. Large, highly rated issuers in this sector such as Gilead GILD and Baxter (BAX: AA-) have been happy to add additional leverage at cheap rates to fund their share repurchase programmes.
Companies in the technology sector, which have historically kept very low levels of leverage and significant cash balances, are being pressured by their shareholders to increase dividends. With the threat of increasing tax rates on dividends next year and equity valuations constrained by the burgeoning cash balances, we expect to see an increase in special dividends through the end of this year. However, a significant amount of cash is often domiciled in foreign subsidiaries. Rather than realising the tax bite to repatriate this cash to pay dividends, CFOs are eyeing the low absolute interest rates available in the debt markets to fund dividends and effectively evade paying taxes. For example, Microsoft (MSFT:AAA), is rumoured to be contemplating a large bond issue to fund a one-time special dividend rather than pay the tax on repatriating cash from foreign subsidiaries.
Banks
We expect continued improvement in bank credit quality in the fourth quarter, though reported results are likely to remain weak by historic standards. The pace at which both credit losses and new delinquencies are occurring appears to have stabilised, if not peaked, for the time being.
With lending standards tight and loan demand weak, bank balance sheets are likely to continue shrinking as deleveraging continues. Furthermore, banks are shifting funds into less risky assets, such as government securities. Finally, some of the stronger banks have returned to profitability, and those that have are likely to remain profitable for the remainder of the year.
All of these factors have increased the capital levels of high-quality banks substantially over recent quarters, providing additional safety to debtholders. Though most banks we cover already meet the newly proposed Basel III capital standards, we expect banks to establish a comfortable cushion over minimum levels before aggressively pursuing dividend increases or share repurchases, further providing support for creditors.
On the other hand, we don't expect major improvement in credit quality or loan growth to occur for some time. Thus, banks that are currently experiencing losses could continue to see declines in capital levels as long as loan losses remain elevated. It's conceivable that further bifurcation of the bank credit universe could occur if the economic recovery continues at an anaemic pace, with high-quality bank spreads tightening while the financials of low-quality banks deteriorate.
Basic Materials
Credit metrics continue to improve in most pockets of the basic materials sector, particularly for industries with direct exposure to emerging-markets growth rates, such as mining. Strong prices for commodities like copper and coal have afforded a significant lift to miners' cash flows, enabling firms that had taken on too much leverage heading into the downturn to reduce their debt load--e.g., Teck (TCK: BBB-) and Xstrata (XTA: BBB-)--and facilitating major growth spending, both organic and inorganic, at firms with balance sheets that had weathered the downturn rather well--e.g., BHP Billiton (BLT) and Vale.
Credit markets remain open for mining companies, many of which have been able to issue 30-year bonds at very little spread premium to their shorter-dated issues. As long as yields remain at present levels, we expect the mining industry will be avid issuers as they seek the funding required to embark on ambitious capacity expansions.
Concerns regarding the sustainability of Chinese growth rates and the associated appetite for raw materials will dominate the credit outlook for the mining industry in the fourth quarter. Recent declines in Chinese crude steel output in July (-1.9% year over year) and August (-1.1% YoY) could be a cause for concern. That said, considered in the context of still-strong industrial output (+16.6 YTD August) and fixed asset investment (+24.8% YTD August) data, we'd caution against viewing the negative numbers as a sign of mounting end-demand weakness in China.
In contrast to the improving credit metrics we've seen from companies tied to China and other emerging markets, firms heavily dependent on OECD construction spending haven't fared well. In particular, balance sheets of cement and aggregates firms lacking material emerging-markets exposure are still stressed and are likely to remain so as long as construction spending in the US and Europe continues at a fraction of pre-slump levels.
