David Sekera, CFA, is managing director of corporate bond ratings and research for Morningstar Credit Ratings, LLC.
Activity in the U.S. Treasury bond market was a mixed bag last week as short-term rates rose and long-term rates fell. The yield on the 2-year Treasury bond rose 2 basis points to 1.61%, its highest level since October 2008, whereas the yield on the 10-year Treasury bond declined 8 basis points to 2.33%. The Federal Reserve did not raise the federal funds rate following its November monetary policy meeting and left the language in its meeting statement mostly unchanged from the prior month. With the economy on solid footing and corporations generally reporting solid earnings, the market is pricing in essentially a 100% probability that the Fed will hike interest rates following its December meeting.
The yield on the 2-year bond has been trending steadily higher for several years and is now the highest since October 2008; conversely, long-term rates have generally been trading in a relatively narrow trading range, resulting in a flattening yield curve. At the end of last week, the spread between the 2-year and the 10-year (2s10s) had flattened to its tightest level since October 2007. However, at that time, the trends were reversed. The yield curve of the 2s10s was rising instead of falling because short-term rates were quickly declining as the Fed was cutting the federal funds rate in an attempt to bolster the economy.
Historically, a flattening yield curve is a leading indicator of a potential weakening economy, although this time the signal may be distorted by global central bank actions. The short end of the curve is being directly influenced by the Federal Reserve, which is hiking short-term rates, while the long end of the curve may be influenced by the ongoing quantitative easing programs of the European Central Bank and Bank of Japan. Even though the 10-year U.S. Treasury is yielding only 2.33%, that yield is attractive to global bond investors as the yield on Germany's 10-year bond is 0.36%, and the yield on Japan's 10-year bond is barely positive at 0.05%. From an economic perspective, growth in the short term appears to be healthy. GDP growth was reported to be a relatively strong 3.0% in the third quarter, and the Federal Reserve Bank of Atlanta's GDPNow model forecast for real GDP growth in the fourth quarter is 3.3%.
This flattening trend may have further room to run. While the Fed held off on raising short-term interest rates this past week, the futures market for the federal funds rate has priced in an interest rate hike following the December Federal Open Market Committee meeting as fait accompli. Based on CME Group's FedWatch Tool, the market is pricing in a 100% probability of a rate hike in December.
The European Central Bank announced that it would not begin to taper its asset-purchase program until next year. Even then, the ECB will continue to continue to purchase EUR 30 billion per month until September 2018, and it noted that the purchases could be extended if warranted. While this places the ECB on the path toward a more normalized monetary policy late next year, these purchases will still infuse the eurozone with an additional EUR 270 billion of new money that will need to find a home somewhere, and the ECB's main financing rate remains at 0%.
After Short Hiatus, Mergers and Acquisitions Ramping Back Up
According to data from PitchBook, after a record-setting 2016, the dollar value of M&A activity in North America and Europe has declined 19% year to date compared with the same period a year ago. In PitchBook's view, the possibility of major tax and healthcare reform this year has led management teams to take a wait-and-see approach to M&A.
Although the amount of M&A has declined thus far this year compared with last year, prices have increased in conjunction with the rising stock market. For example, PitchBook estimates that the median enterprise value/EBITDA multiple for transactions has increased to 10.6 times. This represents the highest multiple recorded by PitchBook. The credit market has played a hand in supporting such high multiples, as the amount of debt used to fund transactions has increased to 5.9 times EBITDA, which is also the highest debt leverage multiple in PitchBook's records.
This wait-and-see attitude may be coming to an end as the number and value of M&A transactions appear to be surging. The largest of the proposed acquisitions is Broadcom's (NR) offer to acquire Qualcomm (NR) in a $100 billion takeover bid. Emerson Electric (A+, negative) was recently rumored to have made a $27 billion acquisition overture to Rockwell Automation (A, stable). According to Basili Alukos, the Morningstar Credit Ratings analyst who covers these companies, the motive behind Emerson's offer was to incorporate Rockwell Automation's leading discrete automation franchise into Emerson's process automation offerings. In addition, CVS Health (BBB+, stable) reportedly made an offer to purchase Aetna (BBB+, stable).
While some firms are looking to grow through acquisitions, several other firms are evaluating the sale of business lines. For example, Kroger (BBB, stable) is reportedly evaluating selling its convenience store operations, Pfizer (AA-, stable) is reviewing strategic options for its consumer business, and Eli Lilly (AA, stable) is weighing strategic options for Elanco, its animal health segment.
High-Yield Fund Flows
Open-end high-yield mutual funds and high-yield exchange-traded funds registered a small $0.4 billion outflow for the week ended Nov. 1. While there were inflows of $0.3 billion into high-yield open-end mutual funds, that inflow was overwhelmed by $0.6 billion of redemptions among the high-yield ETFs. Typically, the ETFs are considered a proxy for institutional investors, which are more sensitive to small changes in the corporate credit spread, whereas the open-end funds are considered a proxy for individual investors.
Morningstar Credit Ratings, LLC is a credit rating agency registered with the Securities and Exchange Commission as a nationally recognized statistical rating organization ("NRSRO"). Under its NRSRO registration, Morningstar Credit Ratings issues credit ratings on financial institutions (e.g., banks), corporate issuers, and asset-backed securities. While Morningstar Credit Ratings issues credit ratings on insurance companies, those ratings are not issued under its NRSRO registration. All Morningstar credit ratings and related analysis contained herein are solely statements of opinion and not statements of fact or recommendations to purchase, hold, or sell any securities or make any other investment decisions. Morningstar credit ratings and related analysis should not be considered without an understanding and review of our methodologies, disclaimers, disclosures, and other important information found at https://ratingagency.morningstar.com.