C.M.O. 5.13.2009

Credit Market Overview
May 13, 2009

In bubble history, our current dilemma is being blamed on leverage. It is leverage in the traditional sense as it involves owning things without paying for them completely, up front and in cash. The banks and (ex) investment banks have been vilified for anteing up just over 3 cents of their own cash on some positions.

If this 30:1 ratio of real to monopoly money seems extreme let us not forget that through the wonder of “stated income loans”, originally designed for the self-employed whose write offs diminish income beyond recognizable amounts, people with W-2’s were able to create money out of thin air and purchase properties with absolutely no money down by using the same financial vehicle called by a slightly different name; “liar loans”. We’ll just call that infinity:1 leverage.

The bubble that burst in March of 2000 also had involved leverage but it was of the intellectual variety. While pennies might not have bought you dollars worth of exposure “.com” was a currency unto itself and having that suffix and an IPO put you in the same league as the best and the brightest from Silicon Valley without even having to move there.

Many of the companies, with market caps reaching into the hundreds of millions, don’t exist today as many of the financial entities that lent money without checking whether there was the slightest possibility of being repaid either no longer exist or won’t by the time this is all over.

Through all of this one name in the technology space stands alone, Microsoft. It is also one of just a handful of companies left that can boast an AAA rating and it sold some bonds yesterday. All three were bullets (non-callable) and ranged in maturity from 5 to 30 years.

Institutional bond investors need diversification just as much as a portfolio manager in equities does. Being able to add a new name, especially one with three A’s tagging along is a rare opportunity so needless to say there was good demand for MSFT’s paper yesterday.

Starting with the shortest maturity let’s have a look at each issue. $2BN of 5-year notes came with a 2.95% coupon at 95bps off of the UST 1 7/8 of 2014. The benchmark CDS level for “Softie” was 37.5bps mid-market yesterday so even with MSFT we see the lingering effects of the credit crisis as physical debt is priced cheaper (higher yield) than the synthetic that can be manufactured through the CDS market.

$1BN of 10-year paper had a 4.20% coupon and was priced at 105bps off of the UST 3 1/8 of 2019. The 10-year CDS market was ~38bps mid. The longest piece of paper was $750MM of debt that matures on June 1st of 2039. It also came at a spread off Treasuries of 105bps but the Treasury in this case was the 3½ of 2039 which gave the bond a 5.20% coupon. There is no easily available CDS quote for the 30 year area but as can be seen from the Treasury curve things tend to flatten out on the far end.

Because there are so few AAA issuers and none such in the tech space I thought the best way to give MSFT’s debt sale some perspective would be to look at another piece of tech debt and also another AAA name. (Triangulation in the financial sense of the word.) CSCO sold three issues back in February; only one of those was non-callable and since we’ve already got some apples and oranges mixed in it is probably best to leave the callable paper out of this.

CSCO’s 4.95% 10-year note came at 200bps off of the current Treasury at the time while the CDS for that maturity was trading at ~100bps. CSCO is rated A vs. MSFT’s AAA. From this we can see that the extra A’s and a slightly better credit environment allowed MSFT to issue paper 95bps better than CSCO.

JNJ is rated AAA by Moody’s, S&P and Fitch, which only gives MSFT AA+, so it is most certainly a premier piece of paper to own. Adding more oranges to the apple bin JNJ has not issued a 10-year non-call bond recently so we’ll have to use the 5.15% bond maturing on July 15th of 2018, issued last June.

This paper was sold at 103bps off the current TSY 10-year at the time. Here we have account for the optionality which would have made the spread wider but also that the markets had not completely imploded by last June so credit spreads were narrower. The CDX investment grade index was trading at ~113bps on 6/18/2008 vs. ~148 yesterday so that difference needs to be taken into consideration as well.

A lot of stuff to crunch on a Wednesday morning but hopefully an exercise that helps put the MSFT’s issues in perspective.

Enjoy the day.

Jim Delaney