Summer is over, the window to the new issue market has been thrown wide open, and the credit market is on fire. Portfolio managers continue to report receiving a flood of new money as funds flow into the fixed-income sector. Even with more than $17 billion of investment-grade bonds issued last week, fund investors still seem to have plenty of cash that needs to be put to work.
Credit spreads tightened 6 basis points in the Morningstar Corporate Bond Index as the average spread declined to +167 last week with the preponderance of tightening occurring after the European Central Bank (ECB) announced its new Outright Monetary Transactions programme on Thursday. Credit spreads have returned to their tightest levels since August 2011 and are slightly tighter than the average credit spread over the past 12 years.
Telefonica Takes the Lead
No firm was a bigger beneficiary of the frenzied demand for paper and growing optimism in the European sovereign market last week than 
Telefonica SA (TEF). On Wednesday, the firm issued €750 million 5.811% senior notes due 2017 at a spread of +485 over mid-swaps. Two days later, it returned to the market and added another €250 million to the same bond deal and priced those bonds at mid-swaps +390, almost 100 basis points tighter.
On July 26, we had identified Telefonica's bonds as trading at relatively attractive levels--too cheap to ignore, but too tied to sovereign risk to sharply overweight. At that time, the 3.992% notes due 2016 were trading at +650 and have subsequently tightened to +420.
As can be seen in the following chart, Telefonica debt remains closely intertwined with Spanish debt, and optimism surrounding the ECB's actions last week has clearly played a role in the firm's ability to upsize its earlier offering at very favourable rates. At current spreads, we'd be wary of Telefonica bonds in absolute terms, but we continue to view the firm much more favourably than Telecom Italia (TIT).
Attractive New Issues?
We had heard from syndicate desks to expect a deluge of new issues in the first two days of this week, totaling between $25 billion and $30 billion. It will probably quiet down thereafter as investment bankers will be recommending to clients to access the markets before the German Constitutional Court rules on Wednesday and the US Federal Reserve releases its decision from the September Federal Open Market Committee meeting on Thursday. Considering the near-insatiable demand for paper, we expect the new issues will easily be digested by the market. We hope that with such a large calendar, the new issues will offer attractive new issue concessions to existing trading levels.
In a bull market like we are experiencing now, any issuer that comes to market will probably find a warm reception, regardless of its credit quality. Remember when fundamentals used to matter? While the market is focused on monetary policy, FedEx (FDX) and Intel (INTC) have reduced guidance for the third quarter. In the past, announcements by such bellwethers would have put the markets into a tailspin; however, there was so much upward momentum in the markets caused by monetary largesse that this news barely registered in the broader markets.
Even the nonfarm payrolls report was analysed not for the insight it might provide into the outlook for the economy, but for whether it will provide ample cover to the Fed to institute another round of monetary steroids after the FOMC meeting. While the market as a whole appears to be driven by monetary policy as opposed to individual fundamental analysis, we advise investors to be cautious in selecting which bond offerings they participate in, lest they be plagued by buyer's remorse if the market takes a turn for the worse.
ECB Seeks to Enhance Monetary Policy Transmission
With its new OMT programme, it appears that the ECB has begun to morph from a secured lender of last resort to the banking system into an unsecured lender of last resort to sovereign nations. As long as a country formally requests assistance and accepts the conditions attached to a European Financial Stability Facility or European Stability Mechanism, this new plan effectively eliminates sovereign default risk in the near term. This plan will not purchase debt directly from individual countries, but will purchase bonds of up to three-year maturities to reduce interest rates to levels that the ECB deems appropriate. The EFSF or ESM programmes would be used to intervene in the primary markets as needed.
Spain is scheduled to auction bonds several times through the end of October as it needs to raise enough money to fund its deficit and a few large bond maturities. While Spanish bond prices have ripped higher and yields have plunged, it remains to be seen if instituting this new programme will entice investors to purchase the volume of new bonds that the country needs to issue, or if Spain will have to formally request aid under this programme. We expect that Spain will delay until the last minute requesting assistance under this programme in order to negotiate as much leeway under the conditionality provisions as possible. This new programme places the European Union/ECB and Spain in difficult negotiating positions as it appears that failure of either party to reach an agreement will bring about an implosion in the eurozone, a form of mutually assured financial destruction.
While the ECB has announced that bond purchases made under the OMT will be pari passu with other existing bondholders, we have doubts. If push comes to shove, we think the ECB would still be treated differently than other creditors. As we've seen in past examples, when governments are involved in restructurings and defaults (think General Motors (GM) and Chrysler), not all creditors are necessarily treated equally.
One final concern about this programme was that the ECB's decision was not unanimous. Germany's Bundesbank president Jens Weidmann voted against the bond-buying programme, with a press release stating, "He regards such purchases as being tantamount to financing governments by printing banknotes." He also argued that this programme could take the pressure off struggling countries to institute necessary but painful reforms in the near term as well as transferring credit risk of those nations onto the taxpayers of the other EU member countries. If this programme is insufficient to halt the sovereign debt crisis in Europe, this discord may be indicative of the first real cracks evolving among the eurozone members that could lead to further disunity.
One piece of news that has been overshadowed by the OMT programme is that the ECB has reduced its forecasts for real GDP growth in the eurozone for 2012 to a decline of 0.2% - 0.6% and lowered the midpoint of its 2013 forecast to 0.5% from 1.0%. The ECB also raised its forecasts for inflation by 0.1% to a range of 2.4% - 2.6%. As eurozone economies deteriorate, it will place added pressures upon sovereign credit metrics and lead to higher losses among the banks that are already struggling with rapidly increasing non-performing loans.
Headlines on the Horizon: German Constitutional Court and the Fed
The German Constitutional Court is expected to rule on Wednesday whether it will implement an injunction to prohibit Germany from ratifying the ESM. If the constitutional court inhibits ratifying or rejects the ESM, it would take the eurozone back to square one in figuring out a way to finance the deficits and maturing debt of the peripheral countries. On Thursday, the FOMC will release its statement following the September meeting and announce any plans to implement further monetary easing.
Assuming the ESM is constitutional under German law, the market will focus on the plan and structure to bail out the Spanish banks, which continue to increase their borrowings from the ECB as they are essentially shut out of the public capital markets. It's still unclear as to the structure of the bailout offered to the Spanish banks and whether this debt will have to be guaranteed by the Spanish government, which would increase the country's debt/GDP ratio. In conjunction with uncertainty around the impact of a Spanish bank bailout on Spain's credit quality, Moody's may conclude its rating evaluation of Spain. Moody's had placed its Baa3 rating under review for possible downgrade in June, and we are approaching the three-month window in which Moody's usually concludes its rating reviews. Also, the ongoing negotiations with Greece to allow the next installment of bailout funds should be concluded in September.
