In addition to the sentiment effect from the equity selloff, the corporate bond market is also focused on the building calendar. Although the blockbuster deals are out of the way, absolute yields are low (even if spreads have widened) and corporate Treasurers may look to access the market before increased volatility or another down leg in prices restricts the primary market to only the largest benchmark borrowers. Whether corporates can withstand a more vigorous new issue calendar is not clear. On the positive side, investment grade debt continues to benefit from flows into fixed income and also from the reversal of the high yield convergence trade that dominated the first six weeks of 2001. Issuance continued at an anemic level for the week with only $8 billion in debt brought to market. Average credit quality at BBB remained low and average deal size was under $500 million for the second week in a row.
Risk of Bankruptcy rises to 75% for So Cal Ed and Pac Gas
We raised our bankruptcy probability for Southern California Edison and Pacific Gas & Electric to 75% from 50% on March 17 when one QF power supplier in Nevada got court permission to attach So Cal Ed assets in that state. In-state QF generators have had to shut down production because they lack cash to buy natural gas to operate while the California ISO blacked out millions for lack of power. The QFs are a class of creditor that may be better off with a bankruptcy, and they are circulating an involuntary petition while hoping for a solution from the PUC and the Legislature. We're not optimistic at this point.
Brokerage Results: Bear Market Not in the Numbers Yet
While a few quarters of results do not mark a major trend, the securities firms are starting to get worried and will be weighing more aggressive cost-cutting measures. Although there are no major threats showing up in the numbers yet, the results paled in comparison to the top of the market a year ago. The relative surprise this week was Morgan Stanley's poor performance versus Goldman. Similarly, Lehman looks to have turned in a superior performance relative to the Bear. From a sector standpoint, we believe bondholders will be quite comfortable with the slowing of revenues. The biggest risks to the brokerage sector are always the off-balance-sheet ones and the risk of stress and illiquidity in the financial system.
Tobacco: If the Suit FitsÉ
Five state Attorney Generals filed suit against RJR alleging violations of the 1998 Master Settlement Agreement (MSA). The suits are essentially an attempt by the AGs to gain a "cease and desist" order (no damages are requested), thereby inducing RJR to change its marketing policies. While these suits are not as threatening as the backlog of Class Actions coming down the pike, the legal action does have broader implications for RJR.
De la Rua Raises the Stakes in Argentina yet Again
President de la Rua has pulled out all of the stops to try to salvage the deteriorating situation. The flip side of this is that the stakes have been raised to the point where failure of this team would raise the odds of a debt rescheduling/devaluation substantially. Political uncertainty is the dominant variable. Argentina now has an embarrassment of riches, with effectively two presidents-Cavallo and de la Rua. Although Argentina doesn't matter much in the global economy, financial linkages are enormous. International banks have more exposure to Argentina ($68.5 billion) than to any other country in Latin America with Spanish banks ($17.7 billion) and U.S. institutions ($11.1 billion).
All Alone Again: Northeast Utilities Faces Future without Con Edison
Northeast Utilities is facing an uncertain future now that Con Edison has scuttled their proposed merger. Credit and event risk is rising at NU and ratings have plateaued for now. Small cap companies like NU with unmatched supply/demand risk cannot sustain the kinds of losses that are possible in these situations without credit implications. On March 8 we recommended reducing exposure to NU.
Trucks On Steep Grade, Cycle Has Weak Brakes
While the news cannot be described as a major surprise, more of the commercial vehicle manufacturers and truck-exposed component companies have started to introduce clear evidence of the weakness that the market has been expecting for some time. The shortfall in truck demand is translating into more warnings from truck manufacturers and these warnings mirror the ongoing credit and operational pressure on the truck-buying segments of the market. From our standpoint, the cap goods sector is in a recession and the truck market, the most volatile sub-segment of that universe, is clearly taking the worst of it. The only hope right now for the sector is if the more optimistic macro-prognosticators are correct in their view that the sharp declines are part of a rapid inventory correction and not a protracted slide in capex.
Kraft IPO: MO Money, MO Alternatives
The Kraft IPO and the follow-on activity should focus bondholders on how much asset support MO has to support its litigation settlements as well as to deal with its massive short-term and intermediate term debt maturity schedule. The potential for more dramatic restructurings and shareholder enhancements via a spin-off or accretive M&A deals will also go a long way towards sustaining MO's stock price after this major run-up versus the market. The longer term trick for the unsecured bondholders at MO will be to monitor how their own risk profile changes with the steady structural subordination of their interests to future lenders at the Kraft unit, and how MO's evolving capital structure and relative mix of financings leaves the unsecured bondholder at MO positioned against the always-present risk of a class action cataclysm.
FCC Walks the Deregulatory Talk
In a flurry of regulatory moves, the FCC under Michael Powell has continued to walk the deregulatory talk that has been coming out of the new FCC head. One notable decision was to lift the deadline on AT&T's required asset sales. Even though the 30% cap was thrown out by the Appeals Court, AT&T still has a binding agreement with the FCC, so this relief was crucial to avoiding a fire sale. Whether a spin-off of Liberty Media or a sale of the 25.5% stake in TWE was the means of compliance, the time pressure was influencing the decision-making process in a manner that was not in the best interests of AT&T's securities holders. With the FCC's enforcement of the divestiture deadline suspended, AT&T is likely to achieve more debt reduction by taking more time and pursuing its asset sales/debt reduction program against what hopefully will be a better market backdrop.
BHP and Billiton Show Their Metal
The announcement that BHP and Billiton will merge under a dual listed company structure, which wedges BHP Billiton into a group of mega-metal operators such as Alcoa and Anglo American, underscores the steady stream of mergers and asset purchases within the metals sector in recent years that shows no signs of abating. We expect that the metals and mining operators will continue to strive for diversification across commodity types, geographic exposure, currencies, and end markets. The key goal in all of these mergers has been to take unit costs down and maintain some reasonable degree of balance sheet strength as an offset to commodity price volatility. This transaction combines BHP's strength in coal, iron ore, copper, and oil and gas with Billiton's in such areas as aluminum and nickel. We expect that the headline impact of this merger will also lead to the next exercise, which is usually to ask the question "who's next?" The most logical speculation will revolve around WMC and Inco.
Lucent: Fear and Loathing on the IPO Trail
The day of reckoning had come at Lucent for the Agere IPO, and a strange mix of communication came out of the company. Obviously there must have been some tense moments in-house at LU. The revised terms detailed in the most recent S-1 leaves unsecured bondholders in a tenuous position. The details have been splattered all over the screen, but as the deal is structured now, the deal price has been cut to $6 to $7, the number of shares has risen to 600 million, and the Morgan Stanley debt-equity component will likely be scuttled, even though they have left some room for debgt reduction (90 million shares) if the deal is oversubscribed. We will obviously see pressure on the debt unless a major league cash bid for the fiber optics unit materializes, but then our concern is that the proceeds take the banks out and bondholders see the two best businesses (Agere and fiber) disappear. This would be a very difficult scenario for bondholders since it would most likely put LU below investment grade, increase the stakes of the next round or transaction risk, and seriously impair the flexibility of the company to fund its operations. The banks would be in the driver's seat and it would be a buyer's market for assets, with the best assets being sold and the banks getting taken down in their exposure while unsecured bondholders pray for a rebound.
