Third-Largest Corporate Note Offering Easily Digested by Bond Market

With a lack of market-moving news and the absence of meaningful movement in the indexes, last week appeared quiet on the surface; however, underlying market action revealed the depth of demand for risk assets. From a microeconomic perspective, second-quarter earnings reports have generally been in line, with the usual amount of hits and misses. Thus far, our corporate credit analysts have not discerned any significant change to their sector outlooks. From a macroeconomic perspective, second-quarter real GDP was reported to have expanded an annualized 2.6%, and as widely expected by the market, the Federal Reserve did not make any change to monetary policy. The only change of note was that the Fed revised its language in the postmeeting statement regarding the timing of when it would begin to normalize its balance sheet. The language was changed to "relatively soon" from "this year." Assuming there aren't any significant negative catalysts until the next meeting in September, this language change is construed to mean that the Fed will begin to gradually reduce the amount of interest income and principal repayments it reinvests by $10 billion per month. Once the reduction program begins, the Fed will increase the amount of reduction by another $10 billion per month until it reaches a cap of $50 billion per month. The Fed will then let $50 billion per month roll off its balance sheet until it decides that it is no longer holding more securities than necessary to implement its monetary policy.

In the corporate bond market, the average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) continued its tightening trend but declined only 1 basis point to end the week at +106. In the high-yield market, the BofA Merrill Lynch High Yield Master Index tightened 5 bps to +359. In equities, the S&P 500 was unchanged and volatility sank to new lows.

While the average spread in the investment-grade market hardly budged, the market easily digested the third-largest corporate bond deal in history. AT&T (rating: BBB/UR-) issued a $22.5 billion seven-part transaction with maturities ranging from 5.5 years to 41 years. Proceeds from the new senior notes will be used as a final installment for the permanent financing of the pending acquisition of Time Warner (rating: BBB/UR-). The order book was reportedly over $65 billion (almost 3 times the size of the transaction), which reveals the depth of demand for corporate bonds in the marketplace. After issuance, the new notes were easily digested in the secondary market as the credit spreads on the bonds traded anywhere from 2 to 6 basis points tighter than the new issue spread.

We had placed our credit ratings for these two companies under review with negative implications after AT&T announced it had agreed to acquire Time Warner. We project this will increase pro forma net debt to about 2.9 times EBITDA and will probably weaken both Business Risk and Cash Flow Cushion. This marks AT&T's second large acquisition in less than three years and further weakens its credit metrics. We view the merger as an attempt to spur growth and development of AT&T's DirecTV investment as well as an ambitious bet on the future of wireless video delivery.

Fund flows in the high-yield market came to a near standstill last week, as the amount of redemptions from high-yield exchange-traded funds more than offset inflows into open-end funds, resulting in a net outflow of $0.1 billion.

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