Bond rally hits stumbling block as CenturyLink deal falters

Tue Oct 2, 2012 4:19pm EDT

Oct 2 (IFR) - The wild rally in the investment-grade corporate bond market hit its first stumbling block this week, as investors rejected a deal from CenturyLink despite the prospect of generous yields.

CenturyLink (Baa3/BB/BBB-) on Monday postponed plans to raise about US$1bn of 10- and 30-year bonds as investors headed for the hills on rumors the telecoms provider might consider another acquisition - which implied the threat of a downgrade.

Even a yield of more than 7% on the 30-year wasn't enough to entice investors, which may be a signal that the market's mad grab for yield might be coming to an end.

"This is the first crack in the investment grade market's recent rally," said Scott Kimball, senior portfolio manager at Taplin, Canida & Habacht, part of the BMO Global Asset Management stable.

"The market is now at an inflection point, where it is no longer an all-out rush for anything with yield," Kimball said. "That window has closed."

Over the last two years investors have packed themselves with both duration risk and credit risk, sometimes even turning a blind eye to the issuer's credit story.

While that worked when high-grade spreads were somewhat wider, they have tightened so much in recent months that there is no longer enough cushion to absorb the negative effects of a back-up in rates, especially in longer maturities.

This so-called duration risk, coupled with the fact that high-grade portfolios have significantly increased exposure to lower-rated companies, could explain why investors rejected the CenturyLink deal even though, just two months ago, they snapped up US$1bn of 5-year bonds at just 4.75% from General Motors, which has a much more complicated credit story.

Books opened early in the market with initial price thoughts at 337.5bp over Treasuries on CenturyLink's 10-year and 450bp area on the 30 year. After failing to get enough interest in the 30-year, bookrunners turned it into a new 10-year and a tap of an existing 30-year.

There was talk that the company had considered a step-up coupon or a bigger new-issue concession, but CenturyLink finally decided to postpone the deal due to what it called "market conditions".

DOING DAMAGE

CenturyLink's outstanding bonds gapped out on the news, with its 7.65% 2042s quoting around 445bp on Monday afternoon, from a Friday close of around 425bp mid level. The 10-years got hit even harder, as the 5.8% 2022s traded 30bp wider at 335bp.

Trying to get a 30-year done in a market saturated with duration risk could have been CenturyLink's problem, some investors say.

"Spreads have tightened so much that investors are not getting compensated for the duration risk inherent in their 30-year bonds," said Kimball.

"This is how we gauge when we are at a saturated point. And when it gets to it, you see investors being more cognizant of the credit itself and less focused on the yield."

A negative outlook on its Moody's rating, and rumors of another acquisition that could drag it back into high-yield, also had an effect.

"You'll find that the high-grade guys will like these cuspy credits when they think there's a chance of an upgrade, but they won't go anywhere near them if there's a risk of a downgrade," said one portfolio manager.

High-yield investors tend to stick to deals that are the standard 10 non-call five or seven non-call four structures. If a 30-year bond were to fall into high-yield territory, it wouldn't have a natural base of buyers.

As a result of its decision not to proceed, CenturyLink said wholly-owned subsidiary Qwest was terminating its previously announced cash tender offer for its outstanding 7.125% notes due 2018.

Qwest ended the offer after determining that the financing condition is unlikely to be satisfied. Qwest has previously committed to redeem on October 26 all US$550m of 8% notes due 2015. It now expects to fund this redemption with borrowings available to it under CenturyLink's revolving credit facility.

Some see the postponement as a positive sign.

"In this rate environment you will see buyers take up lower-rated credits at very tight spreads, but it's a different story when there is credit risk," said Ashish Shah, head of global credit investment at AllianceBernstein.

"I think it's a healthy sign that there is actually credit differentiation going on," Shah said.

Investors like Kimball, meanwhile, are keeping a close eye on the high-yield market's strength as an indicator of what could lie ahead.

"When the high-yield market sees pressure and widens, that has a large effect on the investment-grade performance over the near term," Kimball said.

"It's a proxy for credit risk appetite - if the high yield market shuts down, then a widening in high-grade is not too far behind."

In fact, investors have also started baulking at some high-yield deals.

Algeco Scotsman was forced to rework its multi-tranche euro/US dollar offering, originally planned to price last Friday, as it looked to refinance existing debt and fund the acquisition of Ausco.

Algeco Scotsman, a modular space and storage provider, was forced to scrap a euro subordinated tranche and price the remaining three tranches well wide of original guidance.

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