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Credit Insights

Credit Market Shrugs Off Crisis After Crisis

Credit spreads tightened last week, and the market easily absorbed an abundance of new issues.

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The resiliency of the credit market has been nothing short of amazing. Irrespective of all the negative global events in the headlines, credit spreads tightened last week, and the market easily absorbed an abundance of new issues. Indicative of the strength in the cash bond market, the Morningstar Corporate Bond Index tightened 3 basis points to +142; however, that change was less than the 8-basis-point tightening in the credit default swap market. Cash bonds lagged the synthetic market because of the sheer amount of new issues priced this week, but the strength in the CDS market provides a path for the cash market to continue to tighten.

A number of themes that we have outlined both in past Bond Strategists as well as our quarterly outlook are playing out in the market. Management teams have changed their focus from improving liquidity and protecting their balance sheets to expanding the income statement and returning value to shareholders. A substantial portion of new issues since the credit crisis were used to refinance short-term debt and lengthen maturity profiles. That's changing, as proceeds are now being used to fund acquisitions, share buybacks, and capital expansion. While the magnitude of these events can vary greatly and the impact may not necessarily cause a rating downgrade, they are typically detrimental to the bondholders and often increase credit risk. For example, proceeds from  Limited's (LTD; rating BB+) new issue will fund share repurchases. We are not downgrading the firm, since our rating already encapsulates the company's historical predisposition to use cash flow to reward shareholders (as opposed to repaying debt) and our expectation that management will continue the same conduct. The credit spread on the existing bonds widened out from the mid- to high 200s to around 300, resulting in a market loss to existing bondholders.

Adding to the credit risk for bondholders, we expect shareholder activism and private equity leveraged buyouts will pick up. While we have yet to see a resurgence in the LBO market, we expect it to occur soon, as credit investors are hungry for yield and private equity investors have a plethora of cash they need to put to work before their capital commitments expire. The constraint on LBO activity was the lack of available bank financing to support commitment letters. This is quickly being lifted, as banks have begun to free up capital to issue commitment letters. For example,  J.P. Morgan  (JPM) supported  AT&T's (T; rating: A-) intention to purchase T-Mobile's wireless business with a whopping $20 billion in financing.

The increased focus on shareholders is making individual security selection increasingly important. Outperformance will be driven by avoiding issuers that inflict these self-induced wounds as well as selecting individual bonds with better covenant protection. Covenants did not play a significant role in trading levels during 2010, but we expect them to become increasingly important. Investors should carefully examine covenant packages to identify the protections afforded to them and steer away from bonds that don't provide downside protection.

Europe
The credit markets in Europe performed especially admirably last week in the face of the resignation of Portugal's prime minister and subsequent sovereign rating downgrade, numerous downgrades of Spanish banks that are struggling to raise additional capital, and increasing inflation concerns. Credit spreads were essentially unchanged across the board, even including the financial sector, which typically had widened out dramatically in the face of prior near-term sovereign pressures.

Given the lack of spread movement, it appears that credit investors consider the bailout of Portugal to be fait accompli and a nonevent. While we fully expect Portugal to receive a bailout financing package in the near term, the country reportedly has EUR 4 billion in cash and EUR 4.23 billion in debt maturing next month. If bailout financing is not available by then to repay the maturing debt and a default occurs, we would expect spreads across all the credit markets to immediately gap substantially wider in a replay of the Lehman Brothers default.

Compounding Portugal's political woes, Standard & Poor's downgraded the country's rating two notches to BBB and left it on CreditWatch. In our opinion, the market has been focused on Portugal and the steps that are leading to require bailout financing. Once the bailout occurs, we believe the market will focus its full attention on Spain and its banks. While Spain's bonds and CDSs have been trading at only a moderate credit spread, it seems more likely to us that credit spreads will widen out as opposed to tighten over the medium term.

 

New Issue Market
New issue activity rebounded sharply last week. Issuers priced several transactions to fund acquisitions and dividends/share buybacks and term out short-term debt.

 DuPont (DD; rating: BBB+) issued $2 billion of new debt this week to partially fund the $6.3 billion Danisco acquisition, which is expected to close in the second half of 2011. The deal was split among a $600 million three-year floater priced at L+42 , a $400 million three-year 1.75% note priced at T+65, a $500 million five-year 2.75% note priced at T+75, and a $500 million 10-year 4.25% note priced at T+95. These bonds tightened around 6-7 basis points following issuance. Prevailing spreads on comparable DuPont issues remain slightly tighter than those offered by the new issues, which may suggest a few basis points of further tightening.

Regardless of where spreads may head in the next few days, we don't see much value in DuPont debt. In fact, the notes trade well inside of the spread implied by our BBB+ rating (about 140 basis points based on data from Morningstar's Corporate Bond Index). S&P and Moody's have assigned a negative outlook (S&P's rating is A; Moody's is A2). In the event of a downgrade from one or both, we'd expect to see spreads widen from prevailing levels.

 Gilead Sciences (GILD; rating: AA-) priced $1 billion 4.50% senior notes 2021 at T+125. By the end of the week, the bonds tightened about 5 basis points in secondary trading. Given our more positive view of Gilead compared with the agencies (S&P rates Gilead at A-; Moody's at Baa1) and with the spread 50 basis points wider than we'd expect a firm rated AA- to trade, we'd consider buying Gilead's debt at these attractive levels. Gilead plans to use the proceeds of this issuance to fund some debt repayment and share repurchases. Even after taking this new debt issuance and proceeds usage into consideration, we plan to maintain our AA- credit rating. Gilead's HIV franchise faces a big test this year, as it aims to extend its dominance of the niche well beyond the 2017 patent expiration on a key component of its current offerings by developing a new drug. Key clinical data on that new drug are expected by the end of 2011. If negative, our view of Gilead's long-term credit profile may decline somewhat. However, with a net cash position around $2 billion at the end of 2010 and our expectation that cash flows may exceed $20 billion before its key patent expiration in 2017, Gilead's ability to repay debtholders looks strong to us. Even with a modestly lower rating, this issue would still look attractive to us.

 J.P. Morgan (JPM; rating: A+) issued a $500 million five-year floating-rate note at L+103. We noted an increase in three-year floating-rate notes a few months back and posited that it may be the beginning of a new trend in short-dated floating-rate notes. Since then many issuers, both financials and nonfinancials, have structured floating-rate notes, but this is the first five-year floating-rate note structure that we have seen. Lengthening the maturity of floating-rate notes to five years is probably indicative of a new trend in the credit market as investors become increasingly concerned that interest rates may be on the rise after the Fed ends its program of U.S. Treasury purchases.

 Daimler (ticker: DDAIF, rating: BBB+) issued $1.9 billion of notes last week via its Daimler Finance subsidiary, including $450 million of three-year bonds at T+85 and $700 million of five-year bonds at T+100. Last week we recommended Honda (ticker: HMC, rating: A+) bonds, specifically Honda Motor Credit's 2.5% notes of 2015, trading around T+98. While these have tightened to T+84, we still prefer these to the Daimler five-years, as the 16 basis points of extra spread is insufficient compensation relative to our view of credit quality. While Honda's Japan production remains offline, we expect production to resume in the near term, which should keep the credit intact.

 Limited's (LTD; rating: BB+) new $1 billion 10-year senior note offering to fund a new $500 million share-repurchase authorization affirms our thesis that the firm is no friend to bondholders. This authorization follows two special dividends totaling well more than $1 billion in 2010. Our below-investment-grade issuer credit rating of BB+ reflects our thesis that Limited will favor shareholders over debtholders (particularly since the CEO and his wife own more than a fifth of the company), and it is unchanged. However, Limited generates ample free cash flow, and we expect leverage to remain in line with historical averages. With lease-adjusted debt/EBITDAR at 2.75 times at the end of fiscal 2010, leverage remains low for a below-investment-grade cyclical retailer. The new debt adds more than a quarter turn of leverage, and we estimate lease-adjusted debt/EBITDAR will be roughly 3 times in fiscal 2011, similar to the firm's five-year average leverage ratio.

While we had expected the deal to price slightly behind the firm's outstanding eight- and nine-year bond issuances (the mid- to high-200-basis-point range), we believed a 300-plus level would be appropriate, given the use of proceeds. And indeed, the deal priced at 320 basis points over Treasuries. After issuance, the new bonds have traded in and the old bonds have widened such that all bonds are currently trading around 300. We still insist there is better value in the retail sector.  Macy's (M, rating: BB+) trades in the mid-300 range for a 10-year maturity and is one of our best ideas. From our perspective, the firm's improving profitability, coupled with focused debt and pension obligation reduction, should drive spreads tighter.

 Quest Diagnostics (DGX; rating: BBB+) issued several new issues this week to fund the recent acquisitions of Athena Diagnostics and Celera. The new bonds were issued and traded in line with our current assessment of the firm's credit quality, which remains at BBB+.

  • $200 million L+85 senior notes 2014
  • $300 million 3.20% senior notes 2016 (T+120)
  • $550 million 4.70% senior notes 2021 (T+140)
  • $200 million 5.75% senior notes 2040 (T+150)

 Sanofi-Aventis (SNY; rating: AA-) priced $7 billion of bonds, including a variety of floating- and fixed-rate issues. In general, these issues are being priced at spreads that are modestly tighter than we'd expect of an issuer with a rating of AA- (which already incorporates the effects of the proposed Genzyme deal), reflecting the high interest in this new public debt issuer. The transaction consisted of:

  • $1 billion L+5 senior notes 2012
  • $1 billion L+20 senior notes 2013
  • $750 million L+31 senior notes 2014
  • $750 million 1.625% senior notes 2014
  • $1.5 billion 2.625% senior notes 2016
  • $2 billion 4.00% senior notes 2021

At current rates, Sanofi's new public debt issues will average around 2.1% annually, or a very low cost of debt for the acquisition of  Genzyme (GENZ). In general, we don't believe these issues offer investors attractive spreads for the risks inherent in them.

Overall, we see very low default risk at the combined entity. We believe Sanofi could easily return to a net cash position within a few years of this deal's closing by keeping free cash flows on its balance sheet. Sanofi-Aventis sells a wide variety of drugs and vaccines primarily in the oncology, cardiovascular, central nervous system, and diabetes fields, and we think its size and product diversity add to its creditworthiness. In general, we really like pharmaceutical businesses such as the one Sanofi-Aventis operates, with its many successful products, established manufacturing operations, and large marketing networks. These assets help pharmaceutical firms generate very high returns on invested capital. Perhaps most important, wide-moat pharmaceutical firms like Sanofi have shown an ability to reinvent themselves by introducing novel medical products to replace old ones losing patent protection. While Sanofi is not immune to the patent cliff threatening large pharma companies in the next several years, we think it will be able to reinvent itself by launching new drugs and vaccines. The acquisition of Genzyme should help offset this risk by bringing a wide variety of difficult-to-manufacture biologics into the mix. We believe Genzyme's large portfolio of products (including rare disease, renal, oncology, and osteoarthritis therapies) should reinforce Sanofi's moat.

 Verizon (VZ; rating: A-) placed a $6.25 billion debt offering, its first since 2009. The timing of the offering is interesting, following closely on the heels of  AT&T's (T, rating: A-) proposal to acquire rival T-Mobile USA from  Deutsche Telekom (DTEGY, rating: BBB-), and likely to fuel speculation that Verizon is readying a deal of its own. Verizon ended 2010 with $7.2 billion in cash and investments, the most it's held since right before the Alltel acquisition closed two years ago. The problem is Verizon's capital structure--the substantial majority of that cash is probably held at Verizon Wireless. Verizon Wireless probably generated free cash flow, before dividends paid to cover its parents' tax obligations, of around $17 billion in 2010. Verizon faces $13 billion of consolidated maturities over the next two years, about half of which sits at the parent level or at other wholly owned subsidiaries. Verizon probably wanted to raise cash to refinance these obligations and finance its planned $2 billion acquisition of Terremark Worldwide at the low rates available today. The move alleviates the need to push Verizon Wireless to increase its dividend payout.

The Verizon notes priced attractively relative to what we'd expect given our rating, but have traded up a bit in the secondary market. The 4.60% senior notes 2021 priced at +135 basis points over Treasuries, compared with around 120 basis points for the typical A- issuer in the Morningstar Corporate Bond Index. At current prices, though, the notes offer a spread of about +116 basis points. Despite the merger news at AT&T, we'd prefer to own its bonds over Verizon's. AT&T's 4.85% senior notes 2019, for example, offer a spread of +112 basis points, comparable with the new Verizon 10-year notes despite a shorter maturity and a high dollar price ($108.5). Also, AT&T offers a far simpler capital structure.

Click here to see more new bond issuance for the week ended March 25, 2011.

David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.