Corporate Finance : Fed’s Shift From Automatic To Neutral Leaves Next Move Up In The Air, Analysts Say

When the Federal Open Market Committee (FOMC) concludes its next meeting on June 29, it could raise interest rates for the 17th consecutive time, or it could pause in its long series of tightening moves to assess more incoming data on the economy, analysts say. The only outcome that can be reasonably ruled out is that the Fed will lower rates, they say.

There has been a shift from a steady, planned increase in rates by a quarter point at every meeting to a let’s-decide-month-to-month approach,” says Keith Stock, president of MasterCard Advisors, the consulting arm of MasterCard International. “There is a certain comfort level at the Fed in feeling they are at the neutral point,” he says.

Now that monetary accommodation has been removed, the timing and extent of any future rate increases will be influenced by short-term data. Another increase is likely at this month’s meeting because of strength in the US economy, according to Stock. While consumer spending may slow, economic growth is shifting to a more balanced basis, he says, with capital spending by corporations on technology and other core investments at the highest level in about seven years.

“Fed chairman [Ben] Bernanke reiterated that he is a hawk on inflation,” Stock says. The Fed stated in its press release last month announcing an increase in its short-term interest rate target to 5%, a five-year high, that some further policy firming may yet be needed to address inflation risks. “Despite the rhetoric from some observers in terms of the historical overshooting in raising rates, Bernanke will err on the side of tightening,” he says. “The market should not misread the Fed’s statement [after the May 10 meeting of the FOMC] to imply that a pause is at hand.” The Fed could pause, or it could increase rates, which is really the optimal point for a new Fed chairman to take control, he adds.

Yield Curve Flattens

The increase in the federal funds rate target last month to 5% brought the short-term rate almost exactly even with the yield on the 10-year treasury bond. The yield curve likely will remain relatively flat for months, while the Fed’s policy-making committee pauses to assess incoming data on the economy, according to the latest quarterly survey of primary dealers of US treasury securities, which was issued by the Bond Market Association on April 27.

“Traders remain confident in the Fed’s ability to keep inflation under control,” says Micah Green, president of the association, which represents banks, securities firms and asset managers that underwrite, invest in and trade debt securities. Green says market participants will continue to pay close attention to the Fed for any indication about future rate movements.

Asked about potential events that could affect the direction of rates, survey participants said a sharp increase in inflation could lead to further tightening by the Fed, raising the target funds rate higher than currently expected. Other participants said the combination of a significant weakening in the housing market and higher energy prices could ultimately lead to lower bond yields as consumers cut back spending and businesses lower their demand for resources.

Based on the median projection of those surveyed, the two-year to 10-year treasury yield curve will be flat at the end of June and just five basis points, or 0.05%, at the end of September. The consensus of participants was that long-term treasury yields will stabilize and demand for bonds will continue to grow in the belief that the Fed is successfully fighting inflation and could be approaching the end of its tightening cycle.

The last series of economic reports, including the weaker-than-expected labor report for April, suggest that this is the time for a pause, says Kingman Penniman, director of research at Montpelier, Vermont-based KDP Investment Advisors, a firm that provides research and pricing services on high-yield bonds. “The quarter-point increase [in May] was just what the bond market wanted from the Fed-a commitment to inflation fighting,” he says. “The question now is how long that pause will be. After the summer, will the next move be up, or will the next move be down in 2007? For the Fed, it’s a good time to sit back and watch and see what happens,” according to Penniman.

Peak in Rates Debated

“There is certainly a camp that says high oil prices are a tax on the consumer and that $70 [a barrel] oil is here to stay for a while,” Penniman says. “If the housing market gets weaker, it could be the top for rates. But the FOMC is not implying that a pause is the end of the tightening cycle,” he says.

The good news for the high-yield bond market is that the economy is still firm without inflation pressures, Penniman says. The yield curve, going forward, will reflect a decision by market participants about how strong the economy is, he says. The curve is likely to stay relatively flat for quite some time until it’s clear what is happening with the economy.

Meanwhile, this is a good time for corporations to get financing if they need it, Penniman says. “Go when the window is open,” he says. Spreads of corporate bond yields to those on treasury securities have narrowed considerably since late last year and are staying low. “Don’t wait for lower rates, because if the Fed is done raising rates, which implies a slower economy and increased credit risk, then spreads will widen,” Penniman says. “Right now, spreads are priced for perfection.”

The high-yield market has been extremely receptive to new supply from corporate issuers, Penniman says. In fact, it could have handled more new issues, but some of the borrowing demand has been siphoned off by loans, with companies drawing on bank lines instead of entering the bond market.

US high-yield new-issuance volume rose to $10.2 billion in April from $9.6 billion in March, according to KDP Investment Advisors. Ford Credit, the finance arm of Ford Motor, issued $1.5 billion of six-year floating-rate notes at 4.45 percentage points above the London interbank offered rate. The notes include an option allowing investors to sell them back to Ford Credit in 2.5 years.

In a conference call with analysts and investors, Anne Marie Petach, Ford Motor vice president and treasurer, said the cost of the borrowing was acceptable. She said Ford Credit has a policy of maintaining access to a wide range of funding sources until Ford Motor’s investment-grade credit rating is restored.



Clearing the Decks

“Although Ford Credit paid a high price, it was worth it,” according to Penniman of KDP Investment Advisors. “The company was able to minimize event risk and clear the decks,” he says.

General Motors, the biggest high-yield borrower, is expected to offer only asset-backed securities until it closes its sale of a controlling stake in General Motors Acceptance Corporation, or GMAC, to a group of investors led by Cerberus Capital Management and including Citigroup and Aozora Bank.

GM’s bonds performed very well in the first quarter and have not been a catalyst to create volatility in the high-yield market, according to Penniman. KDP Investment Advisors has had a “buy” rating on GM debt for quite some time, he says. “Now, the consensus seems to be coming around to the view that GM will avoid a strike at Delphi, or if there is a strike, it will be very short,” he says.

As Global Finance went to press, GM was scheduled to ask a US bankruptcy court in New York for permission to nullify its labor contracts, allowing it to cut union workers’ wages and benefits. The unions have threatened to strike Delphi, an automotive parts supplier, if GM goes ahead with its plans.

Oxley said last month that the US should be welcoming and encouraging foreign investment, not shutting it out. Lets not be ruled by our worst fears, he said. Lets not close off America as the terrorists would hope we would.

The Dubai Ports World and CNOOC deals send a message of caution to potential foreign investors, says Jeffrey Houle, partner at Greenberg Traurig, an international law firm with 1,500 attorneys. There likely will be new legislative authority enacted, and CFIUS in the future will more highly scrutinize proposed deals, Houle says. This will make cross-border mergers and acquisitions more challenging, he says, although it wont necessarily have a chilling effect.

Too many people would have to be notified, including members of Congress and state governors, according to Houle. The more hands you have stirring the pot, the more opportunity there is for politicizing particular investments, he says. Instead of there being a momentary pause or a passing chill in cross-border deals, the proposed legislation, which was spurred by the Dubai Ports World controversy, will institutionalize the reaction into law, he adds.

XM Radio Refinances

XM Satellite Radio placed a total of $800 million of debt in the high-yield market on April 21, consisting of $600 million of 9.75% senior notes due in 2014 and $200 million of senior floating-rate notes due in 2013. The company is using the proceeds to repurchase or redeem its 14% senior secured notes due in 2009 and to make a $240 million prepayment to retire debt under its distribution agreement with GM, which was the first automaker to install XM radios in its vehicles.

Chemtura, a Middlebury, Connecticut-based chemicals manufacturer, offered $500 million of 6.875% senior notes due in 2016 under a shelf registration previously filed with the Securities and Exchange Commission. Credit Suisse and Citigroup led the offering.

The first quarter of 2006 had the largest volume of SEC-registered high-yield debt deals in more than seven years. The increase could be attributed to a new SEC rule allowing larger companies and frequent issuers to tap the market without waiting for the Securities and Exchange Commission to review the proposed deal, according to Thomson Financial.

Princeton, New Jersey-based NRG Energy placed a $3.6 billion senior note offering in January, via Morgan Stanley and Citigroup, taking advantage of the new rule. The notes were issued as part of a financing package to fund the company’s $8.6 billion acquisition of Texas Genco from a private-equity consortium.



Gordon Platt