Proud Mary

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Corporate bond supply has trailed off to almost nothing. This week we had just $6 billion in new issue, about a quarter of which was from Credit Suisse, as the banks come back into the market post earnings. Credit Suisse reopened two existing bonds, selling an additional $750mm each of the 2.3% 5/28/19 and the 1.375% 5/26/17 at spreads of +70 and +47, respectively. There was just $65 billion in corporate bonds issued all month, and this week’s supply came to an abrupt halt with the equity market sell-off on the last day of the month.

Spreads overall were weaker, backing up 2-5 basis points. Banks and higher risk sectors bore the brunt of it, but weakness was pretty widespread. For the month of July, spreads ended up close to unchanged, and total returns were pretty close to zero – a far cry from the 5.7% for the first 6 months of the year.

We are keeping a close eye on Supply / demand trends in credit right now. We have watched the high yield market suffer significant outflows for most of July, creating selling pressure and driving total returns to -1.33% for the month. We have not seen the same selling pressure in high grade markets, where money continues to come in, but we are wary. The risk-on tone which blanketed the markets through June has given way under the weight of geopolitical pressures, economic uncertainty, and the expectation that higher interest rates are finally right around the corner.

We can’t help but feel that the river of liquidity that has been carrying us all downriver is about to dump us into the Gulf of Mexico. Being carried out to sea on a riverboat would be a vastly different end to the credit cycle than anything we’ve seen before. Everyone is so busy waiting for the river to dry up – the more typical end to the cycle – that perhaps they are missing the bigger risk. As the Fed ends QE, and moves into rate hikes, maybe we will find that shutting off the tap is harder than they thought.

Back to the Basics

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John Boylan, CFA

Lately you can’t open up any financial publication or website without seeing some investor prognosticate about what companies or industries are most ripe for this business strategy or that. Right now tax inversions are the craze. Just before the financial crisis it was private equity buy-outs. And divining potential stock buybacks never, ever goes out of style.

We wrote a little bit about inversions in the past. Is it a good business strategy? Perhaps. Lots can be said for lowering a tax bill and plowing cash back into new growth strategies such as new equipment, etc. or just plain giving the cash back to investors.

But is identifying potential investment candidates that might benefit from a change in business strategies like an inversion a bankable investment strategy? Not if that is your only goal in my view. However, in a strange way, I think looking at companies in that light is a healthy thing for the investment industry as a whole because it does get investors to get back to the basics.

How? The cynic in me sometimes thinks that we investors strive to make the due diligence process as complex and opaque as possible sometimes to justify our existence. Instead, I have always thought that the due diligence process was actually quite elegant—the vast majority of time we compare and contrast business models and structures. Period. And in reality, the differences in successful business models and structures are usually observable and repeatable across business sectors.

Often in my observation successful investments are based on answering a number of basic questions. These questions include but are not limited to: Does the model work over time? Is it differentiated? Is it defensible? Is it diversified? Do they have a solid business structure as measured by cash flows and healthy balance sheets to not only maintain but grow the model? Can a company change its capital structure to optimize those cash flows?

Ironically when I look at companies and think about if they are ripe for a tax inversion, I often start with those questions. Then I realize what I am really looking for is a well-run company that has a defensible business model that is difficult to replicate anywhere in the world, has the smarts to be fully knowledgeable of their business options, and has financial flexibility to endeavor those strategies. In other words, what I am looking for is a good, solid company that has a lot of solid options for its business. Tax inversion or not, that’s what we all strive to find as investors.

Firework

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As we headed into July 4th, 2013, Investment Grade Corporate Credit did not have a lot of friends. The fear of higher interest rates created all the fireworks, and spurred the market into a flurry of what today looks like a bout of panic selling, which ignited some rather unpleasant spread widening. IG Corps felt a little like a house of cards, one blow from caving in.

We find ourselves in a very different spot today. Spreads are about 50 basis points tighter than a year ago. With the threat of taper now behind us, and the reality of rate hikes somewhere in the future, volatility has remained low and risk-taking has been rewarded. Corporate credit has been one of the market’s star performers, with both spreads and rates rallying, pushing the benchmark up YTD by 5.7%. For us, it was the best July 4th in recent memory, since this was the first June since 2007 that spreads did not widen going into month-end.

The corporate bond market celebrated by taking most of the week off. There was about $18 billion in total new issue, and software provider Oracle was responsible for more than half of the volume, coming to market on the last day of the quarter with a $10 billion transaction spread across 6 tranches. The company will use the proceeds to pre-fund its $4.6 billion acquisition of Micros Systems, a provider of integrated software and hardware solutions for the hospitality and retail industries, as well as for share buybacks and general corporate purposes. Given the size of the transaction, ORCL pricing was attractive across the curve. The ORCL transaction again highlights current market trends around M&A. While we have not seen a significant pick-up in LBO activity, companies are increasingly turning to M&A to boost shareholder returns while taking advantage of attractive levels in the corporate bond market.

IG Corporate performance has so far won out over interest rate fears, M&A risk, slow economic growth – you name it. The sector has shown us all just what it’s worth. While it’s hard to imagine another six months as good as the last, for a brief moment we will just sit back and admire recent history with an ahh…ahh…ahh…

World’s Cup Runneth Over

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Once again, one of the world’s central bankers was in charge of the game. On Wednesday, the FOMC released its much anticipated statement, confirming as expected that the Fed would continue to taper its bond purchase program. Its 2014 growth outlook was slightly lower, but not very negative. If there was any surprise, it came during Yellen’s press conference, when she spooked a few corners of the bond market by dismissing recent inflation figures as noise. This led to a steepening of the yield curve which persisted into Thursday. It seemed to be exacerbated by the 30-year TIPS (treasury inflation protected securities) auction, which didn’t go quite as well as dealers were expecting. Nominal 30 year levels recovered sharply on Friday – but still ended the week higher by about 4 basis points. It seems that the bond market is struggling to figure out the FOMC’s next step. It may be that the FOMC is struggling to figure out its next step.

There was no uncertainty, however, on the part of credit markets, which once again took its cues from a Dovish central bank. Not worried about any increase in inflation, 10 year bank spreads rallied by 5 basis points or so, and higher vol sectors like materials have also had a good week. Utilities felt like they lagged a bit, so data all around showed support for the central bank-induced risk-on trade. The World Cup of liquidity continues to flow.

The new issue market, on the other hand, slowed down this week. Most issuers tried to get in ahead of the Fed, so Monday and Tuesday were the big days, with about 80% of the week’s volume. Total supply this week was just over $20 billion, so a pretty slow week overall. The week had more than its share of energy companies, as Cameron, ERP Operating, and Hess all brought deals to market. The interesting trade of the week was our local friend Target – the company had to widen the price from initial talk in order to get its deal done, which we haven’t seen in a while. The company brought $2 billion total, $1 billion of a 5 year at +60, and $1 billion of a 10 year at +90. These bonds ended up among the better performers on the week, so the initial guidance wasn’t that far off, but the market demanded a concession given the noise around the company’s story recently.

So in the end, we think it was a pretty solid week for credit. Should we be worried about liquidity driven bubbles? Maybe, but I think we’ll just focus on soccer for now. Gooooooooaaaaaal!

Inversion Layer

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John Boylan, CFA

The recent popularity of tax inversion strategies got me to thinking about what might be the toughest thing to do when analyzing a company. Namely determining what its optimal capital and tax structure could be. Most of the time, I tend to rely more on free cash flow analysis than trying to forecast capital structure or determine optimal tax considerations. I figure if I develop a reasonable and attainable cash flow forecast it would be easier to determine what the use of that cash might be. Even then I tended to be off in my cash use prediction because of the Curse of the Financial Analyst—we think tend to think every business decision is a financial decision. More often than not many other business and management considerations are of equal, if not higher, importance. We as analysts often forget that.

For example, why don’t more companies take advantage of tax inversion strategies? Management might feel uncomfortable having essentially two headquarters, one for executive management and one for day to day operations—some managements may feel uncomfortable managing crucial functions remotely. Some might feel that tax advantages and loopholes can shift over time for a variety of reasons, meaning a company may have to move its headquarters more than once to keep their tax saving strategy intact (e.g. Accenture moved to Ireland from Bermuda due to changes in tax considerations). Additionally some companies might see longer term opportunities for that cash that could offer a better return, even after taxes. This might include investments in research and development, marketing and distribution, new capacity, acquisitions, and the like. It also depends on where the cash resides and the opportunities, or lack thereof, there might be in that market.

Still as shareholders we often want as much cash returned to us from our investments as quickly as possible, and managements need to respect the will of its owners when it makes sense to do so over the long run. It really comes down in my view where the management and investors believe the company is in its growth cycle. If it is early on in the cycle I would rather see cash spent on growth, which also lowers a company’s tax bill without adding more managerial complexity to the organization. If the company is in a more mature industry I would rather see the company managed for cash flow and see that money returned to investors. Therefore in reality, I think that we need to take as close of a look at the personality and management style of its executive team and determine if their longer term goals match where we think the company is in its growth cycle as much as we do trying to determine what companies may be best suited for a change in capital or tax structure on a pure numbers basis.