Banking & Capital Markets

Low Yields + High Spread = Prime Funding Situation

Here are the current yields and spreads for each rung of the debt ladder.
Ed ZwirnApril 2, 2001

It’s no wonder that firms continue to borrow money in the bond market at the record pace they established at the beginning of the year.

As has been stated many times over, the first quarter of 2001 has constituted the largest corporate borrowing spree ever in the first three months of a year.

The reasons for this are few and simple, and likely to continue to remain valid for some time.

  • The stock market’s woes are frightening investors and causing massive shifts into most grades of bonds. At the same time, equity funding for business is being constricted by this same factor.
  • The Fed has shaved 150 basis points from rates since the beginning of the year and is still in a loosening mode. As a result of this and the “flight to quality” toward Treasuries and higher-grade corporate bonds, absolute yields are down in almost every category of debt, except that of firms teetering on the edge of default.
  • At the same time rates in general are coming down, spreads between corporate bonds and Treasuries — still the most common “benchmark” used is assessing bond investments and whether they make sense, according to the Capital Asset Pricing Model (CAPM) — continue to be wide. For CFOs and other corporate brass deciding whether to hit the debt markets, this is good news because it lures investors seeking opportunity to obtain the maximum yield over the risk-free rate of return.
  • Finally, incentives for mergers and acquisitions are also increasing, particularly now that FASB is expected as soon as July 1 to lift the requirement that goodwill resulting from mergers be amortized.

The need to pay for acquisitions has been a conspicuous reason for entry into debt markets, the most recent prominent example being the $4.6 billion offering priced by Kellogg, which was used to finance the company’s acquisition of Keebler (and then some). This was the first bond issued by the firm in two years and its largest ever.

And these observations hold throughout most of the credit spectrum.

According to figures compiled for by Merrill Lynch, the spread of every grade of corporate bond from triple-A to single-C is significantly wider than it was one year ago.

But at the same time, yields are also significantly lower on bonds of every quality ranking through double-B. Starting with single-B, yields are higher, presumably because general economic jitters are prompting increasing reluctance to loan money to firms for which default is a real possibility.

In investment grade, spreads are out in general by about 40 points. The current level is 176 as of March versus 137 one year ago. But the typical “effective yield,”–that is the yield figure applicable after taking into account any “optionality” incurred by call provisions and other features–is 6.726 percent, versus the 7.794 percent of one year ago.

More specifically by grade:

  • AAA-rated bonds typically yield 90 basis points over Treasuries, versus 88 one year ago. The yield is 5.773 percent, versus 7.297 percent.
  • AA: Spread: 112, versus 108. Yield: 6.01 percent, versus 7.493 percent.
  • A: Spread: 158, versus 122. Yield: 6.529 percent, versus 7.647 percent.
  • BBB: Spread 259, versus 175. Yield: 7.425 percent, versus 8.151 percent.

Below these ratings, high-yield debt is indicated at a spread of 784 basis points over Treasuries. While the average yield, 12.757 percent, is up versus the 11.866 percent of one year ago, this is due to the “dragging” effect of the lowest tiers.

High-yield debt, inhabiting the lowest rungs of the credit ladder, has fared specifically as follows:

  • BB: Spread: 784, versus 542. Yield: 8.954 percent, versus 9.959 percent.
  • B: Spread: 828, versus 534. Yield: 13.207 percent, versus 11.785 percent.
  • C: Spread: 1,731, versus 1,358. Yield: 22.216 percent, versus 20.029 percent.

Some Recent Pricings

And more current indications are that the trends indicated by these figures are continuing.

While the actual pricing of debt has slowed down tremendously during the past week, trading levels have held their own and the bonds that have been issued have met with good receptions.

The exceptions were driven by concerns specific to the companies themselves.

American Home Products barely made it out of the gate with last week’s $3 billion multi-tranche deal, which had been downsized from $3.5 billion. It was forced to offer significant spread concessions and “step-up coupon” assurances after investors became concerned over the roughly $12 billion in charges expected to be incurred by the firm as a result of diet drug litigation.

Avista, a Washington state electricity provider, was forced to pay an astonishing 495 basis points over Treasuries to issue $400 million of seven-year bonds rated Baa2 by Moody’s Investors Service and BBB by Standard & Poor’s.

“It’s sort of a mini-California situation with this one,” says one market professional who refuses to be identified. “There are unsecured fuel costs, a possibility of hydroelectric problems if the summer is dry, and an uncertain regulatory environment,” he adds. “It looks like the ratings agencies have really failed to keep up on this company.”

But the week was marked mainly by borrowing success stories. For example:

Transocean Sedco Forex priced a $1.2 billion two-tranche (Baa2/A- ) offering via the private 144a market. Both the $700 million 10-year segment, which priced at 170 over Treasuries, and the 30-year, which weighed in at +195, were priced at the tight end of forecasts.

Apogent Technologies priced $325 million of 10-year Baa3/BBB- rated notes, also via the 144a market, to yield 8.067 percent, or 315 points over Treasuries, in a deal that had been increased from $300 million.

Looking Ahead

Companies seeking funding through either investment-grade or high-yield debt above the lowest levels can continue to expect decent investor receptions going forward.

Investment-grade paper continues to hold in general to outperform Treasuries, at least at the higher levels.

According to David Finklestein of Williams Capital Group, the yield on the typical 10-year A-minus bond is about 30 basis points lower than it had been at year-end 2000.

About 17 basis points of this improvement is due directly to the huge rally which occurred after the “surprise” Fed rate cut at the beginning of January. The remainder is due to the corporate bond sector’s tracking of the reduction of yields in the underlying benchmark Treasuries.

In addition to the overall reduction of absolute yields, Finklestein points out that the incentive for investors to move away from short- term borrowing such as money markets, which are based upon spreads over the London Interbank Overnight Rate (Libor), to intermediate-term bonds such as five-years is “very attractive.”

The only possible fly in the ointment is of course the economy.

And here, assuming continued economic weakening, the question of whether a possible slowdown in demand for corporate bonds will be neatly offset by a “lessening of need by corporate borrowers,” is “impossible to answer” at this point, Finklestein admits.

But the short-term trend is more clear-cut.

“My feeling is that there are a lot of accounts out there with money to place now that the [first] quarter is over,” he says.

In junk, the trends are similar. While a slowdown in issuance is occurring, trading levels of the securities themselves are holding their own.

High-yield bond funds raked in $1.783 billion during February, the last complete month for which figures were available, according to the Investment Company Institute.

For the week ending March 28, according to AMG Data, $72.9 million, just 0.14 percent of assets, left the funds that report this data weekly.

“Not only market timers, but also mom-and-pop investors, yanked money out of high yield,” says Martin Fridson, Merrill Lynch’s chief high- yield strategist.

Issues to Expect

Investment Grade

  • Delhaize America, a supermarket holding company, plans a private sale of $2 billion of (Baa3/BBB-) bonds via Deutsche Bank Alex. Brown and J.P. Morgan Chase.
  • PSEG Power, a unit of Public Service Enterprise Group, plans $1.6 billion of three-, five-, 10- and 20-year maturity (Baa1/BBB) bonds via Morgan Stanley Dean Witter.

In junk:

  • Chesapeake Energy, a natural gas exploration company, plans a private sale of $800 million of (B2/B+) 10-year notes, to be used to repay existing debt.
  • Davita, which makes kidney-dialysis machines, plans to sell bonds and a loan some time in April to raise a total $625 million. Investor meetings are scheduled to continue through April 5. The proposed notes are rated A2 by Moody’s.
  • After investor meetings conclude April 10, Fibermark, a maker of specialty fiber-based materials, is expected to sell $225 million of (B1/BB-) 10-year senior notes.