US Credit Market
The credit market continued to rally last week as the combination of strong economic indicators and inflows into taxable bond funds more than offset headwinds from the recent financial and environmental calamities. The Morningstar Corporate Bond Index tightened 3 basis points to +139, with financials leading the way.
Since the sovereign credit crisis last summer that pushed the Morningstar Credit Index 60 basis points wider, we have opined that credit spreads would tighten as improving economic fundamentals would lead to stronger credit metrics. We continue to expect credit spreads will generally tighten, although we caution investors that there will be an increase in issuer-specific credit widening as management teams instigate shareholder-friendly catalysts to boost their stock prices at the expense of increasing credit risk. Credit spreads, though, are beginning to close in on their tightest levels since last April, before the sovereign credit crisis. As such, the pace of tightening we have experienced over the past few months will dramatically slow. Outperformance in the credit market for the remainder of this year will be driven by specific catalysts and by avoiding issuers that inflict these self-induced credit wounds. As we approach credit spreads that mirror the same levels as mid-2007 when the credit market began to widen out in earnest at the beginning of the credit crisis, we expect to shift to a more neutral view on any further tightening.
Europe Credit Market
European credit spreads held steady during the week, but tightened Friday. On Thursday night, Ireland reported the results of its recent round of bank stress tests. While the amount of capital required was within market expectations, the positive news was that Ireland will reportedly contribute capital to the banks to cover the shortfalls if the banks are unable to independently raise the capital. In addition, Ireland will not haircut the existing senior bondholders, which some government officials had threatened. Once that threat was off the table, European financials rallied and credit spreads in the sector tightened about 10 basis points.
News flow out of Europe has been dominated by the sovereign debt crisis, and we expect that news surrounding Portugal's ability to finance its impending debt maturity schedule will continue to lead the headlines. Standard & Poor's sovereign credit group had a busy week. After downgrading Portugal's credit rating two notches to BBB on March 24, it followed with another notch downgrade to BBB- last week. It also downgraded Ireland one notch to BBB+ and downgraded Greece two notches to BB-.
Emerging Trends
Of particular note last week, Unilever (ULVR) issued its first renminbi-denominated bond. The notes were issued in Hong Kong for institutional investors. This appears to be a emerging trend, as McDonald's (MCD, rating: AA-) issued CNY 200 million 3% senior notes 2013 last August and several international banks such as Barclays (BARC), HSBC (HSBA), and UBS (UBSN) have issued renminbi-denominated bonds over the past few months. There is a voracious demand for bonds issued in Chinese currency in Hong Kong, and we suspect additional firms are evaluating, and will issue, renminbi-denominated bonds. For corporations with a significant amount of business in China, issuing bonds denominated in renminbi will provide a natural foreign exchange hedge to their income statement and better balance firms' asset/liability match in the same currency as the location of property, plant, and equipment. We think firms such as Colgate-Palmolive (CL, rating: AA), Yum Brands (YUM, rating: BBB+), and Procter & Gamble (PG, rating: AA) are likely candidates.
New Issue Market
New issue activity rebounded sharply last week. Issuers priced several transactions to fund acquisitions, dividends/share buybacks, and term out short-term debt.
European luxury goods manufacturer and retailer LVMH (MC) took on EUR1 billion in debt, which we expect to help finance the EUR 3.7 billion acquisition of Bulgari, announced last month. We continue to believe the acquisition will not materially hurt the firm's capital structure. The transaction was split evenly in two tranches: 3.375% senior notes 2015 priced at +106 and 4.00% senior notes 2018 priced at +104. Both issuances have tightened 5-10 basis points after issuance, but given LVMH's A- credit rating, which reflects the firm's strong free cash flows and moderate capital structure, we believe the bonds are still slightly undervalued. We believe they could tighten by another 20 basis points as the firm uses its free cash flow to pay down debt as it matures.
