The average credit spread in the Morningstar Corporate Bond Index tightened 3 basis points last week to +144. Since the beginning of June, credit spreads have steadily tightened about 4 basis points a week, with very little variability.
Last week, after lagging the tightening in the financial sector, the industrial sector finally outpaced the financials and tightened 4 basis points compared with the financials, which were largely unchanged.
However, year to date the key to outperformance has been to be overweight the financial sector, as the spread between financials and industrials has tightened 120 basis points to a 27-basis-point differential compared with its widest level of 148 basis points last December.
Otherwise, the story remains the same. Portfolio managers continue to receive inflows from investors, meaning that cash needs to be put to work. With little new issuance and low dealer inventories, traders are scrounging to source bonds. Any dips in the corporate bond market have become increasingly shallow and shorter-lived.
These technicals have continued to rule the market, irrespective of the concerns looming on the horizon. Across the board, clients we met with last week all complained about the lack of supply in the market and their inability to size up positions. However, while they fret about sitting on cash, these same clients are worried about the impending US fiscal cliff, the debt ceiling, recession in Europe, and a slowing Chinese economy. The dire headlines stemming from the EU crisis have died down since the end of August, but the structural and systemic issues in the European Union continue to simmer in the back of many investors' minds. Third-quarter earnings reports will consume most of investors' attention for the next few weeks, but we expect that these systemic issues will return to the forefront after the US presidential election.
Spain Downgraded by S&P
Standard & Poor's lowered its rating on the Kingdom of Spain to BBB-, the lowest rating before migrating into the high-yield, or junk, category. Contrary to the typical market reaction after a downgrade, Spain's 10-year bonds actually traded up, as the yield declined 14 basis points to 5.63%. Investors speculated that the lower rating would push the country to request bailout funding from the EU and International Monetary Fund, triggering the European Central Bank to purchase the country's debt in the secondary market. However, the decline in yields following the downgrade actually has the perverse effect of reducing the country's need to request bailout funding, as it is now easier for the country to finance its deficit and roll over maturing debt.
To learn more about Spain's current debt crisis, read "Spain's Dangerous Waiting Game".
The market continues to await the results of Moody's re-evaluation of its Baa3 rating on Spain. Moody's has warned that it may downgrade the country below investment grade. Initially, Moody's had reported it would finalise its analysis by the end of September, but recently announced that it would not wrap up until later this month.
While Morningstar does not rate sovereign debt, it seems intuitively incorrect to believe that an issuer could earn an investment-grade rating when it has had to request a bailout of its banking system, may be on the verge of requesting a formal sovereign bailout programme, and required the ECB to create a new programme, Outright Monetary Transactions, to provide investors enough comfort to purchase its bonds. The economic fundamentals in the country continue to deteriorate and the structural issues that have led it to this position have not been alleviated.
It seems to us that a speculative-grade rating that is implied within the trading levels of Spain's debt is more appropriate. Currently, the actions of politicians and the support of policymakers are driving Spain's liquidity position. Ultimately, the country will have to resolve its own structural issues in order to provide sound footing for economic fundamentals to improve. Until then, Spain's fate is tied to the political state of affairs of the other EU members. The winds of political change can be abrupt, and if the political will to keep the EU intact in the current design were to dissipate, Spain could quickly find itself in a position in which it no longer has capital market access.
New Issuance Slows, But May Ramp Up Post-Earnings Season
As we expected, new issuance volume was slow last week as preparations and quiet periods before earnings kept issuers on the sidelines. We expect this week will be on the slow side as well. The new issue market will probably pick up as companies report earnings and look to tap the markets before the US presidential election and before the market's attention turns to the looming US fiscal cliff.
New Issue Notes
Reed Elsevier Printing a New Bond Deal (Oct. 9)
Reed Elsevier (REL) is coming to market with a $250 million 10-year bond deal. The firm recently repaid $450 million in debt and has another $550 million due in early 2014. Despite the fact that this is a "no grow" offering, we think the deal could be upsized as other no-grow deals recently have--for example, Kohl's (KSS)--given the need for additional refinancing capital.
Given its heavy exposure to print publishing and the difficulty that business services companies are facing in the tepid economic recovery, Reed Elsevier's bonds trade wide of where we would expect them to. The firm's 8.625% notes due 2019 trade 268 basis points above US Treasuries.
While Reed Elsevier took on £1.5 billion of debt in 2008 in connection with its acquisition of ChoicePoint, it repaid the debt in less than three years, thanks to copious free cash flow and an £800 million equity issuance. Pro forma leverage had spiked to nearly four times but now is well below three times. We expect it will remain at this level, as management's target net debt/EBITDA is 2-3 times. Despite a Cash Flow Cushion of less than 1 times our base-case expense and obligation forecast, we think the company can comfortably cover its debt obligations with ample access to liquidity, thanks to its credit facility and ample cash balance.
The original version of this article first appeared on Morningstar.com.
