Markets Diverge, So We Look For Credit-Supported Breakouts
Comment of the Day

September 12 2012

Commentary by Eoin Treacy

Markets Diverge, So We Look For Credit-Supported Breakouts

Thanks to a subscriber for this report by Brian Reynolds for Rosenblatt Securities highlighting the arbitrage between the bonds and equities of a number of companies. Here is a section:
While this pace can't be maintained, we continue to believe that we are at the beginning of a wave of pension flows into credit reminiscent of those which followed the panics of 2010 and 2012. Over the summer pension after pension voted to put more money into credit and many of those votes have yet to be implemented.

Our first chart illustrates the intensity of this wave, showing new corporate bond issuance for the first 10 calendar days of each September of this credit boom. This September blows away all the others. We would further highlight that August saw record inflows, and that yields have dropped despite the new supply!

This process is putting waves of cash onto corporate balance sheets, much of which will be used on things such as buybacks to try to boost stock prices. And yet, just as happened at the end of panics of 2010 and 2011, stocks are lagging credit as equity investors seem reluctant to push stocks higher. We would cite as evidence yesterday's late day selloff in stocks, even as credit was improving.

Eoin Treacy's view Despite a recent rally in government bond yields, corporate bond yields have continued to decline. For example the Bloomberg Fair Value US$ 10-year BB Composite Index remains in a consistent downtrend and a sustained move above 5.7% would be required to question the consistency of the almost four-year downtrend. Such has been the demand for credit that the spread over Treasuries has compressed from a peak last September of 489 basis points to yesterday's 356 basis points.

While BB bonds represent the junk side of the credit spectrum, A-rated credits represent some of the companies with the strongest balance sheets. The BFV A Index remains in a relatively consistent downtrend and at 2.96% opens up the opportunity not only for corporates to borrow at record low rates but also to engage in balance sheet optimisation.

For example Siemens recently announced a bond issuance to help fund its share buyback program which fulfilled the dual purpose of supporting the stock price and improving the weighted average cost of capital. This was achieved because it was able to borrow in the credit markets for less than what its equities are currently yielding. (Also see Comment of the Day on August 3rd).

Wells Fargo is another interesting example. The share has an indicated yield of 2.57% while the 2.625% bond maturing in 2022 yields 2.688%. From an investors perspective is it better to bet on a further compression of bond yields or the equity yield for such companies? Put another way, if they are so eager to borrow should we be so eager to lend?

The credit markets are presented with the supply of bonds multiplying while the equity markets see supply contracting. Against a background where investors are likely to put an increasing premium on yield, the shares of well capitalised globally oriented corporates are ripe for yield compression.

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