Once Again, European Headlines Dominate
We remain skeptical that the Europeans are close to being able to announce a decisive and comprehensive plan.
The market's faith that European policymakers will soon create and implement a coordinated plan to stem the European sovereign debt crisis continued unabated last week. The news flow out of Europe emphasized the behind-the-scenes discussions that European policymakers were conducting to develop a way to curtail the sovereign debt crisis from morphing into a full-blown financial meltdown. These reports fed the market's animal spirits, driving gains for several trading sessions. In addition, several economic indicators released in the United States (especially payrolls and ISM services) were better than expected and helped to alleviate much of the negative sentiment on the Street.
We, on the other hand, remain skeptical that the Europeans are close to being able to announce a decisive and comprehensive plan. Rhetoric on the surface from numerous politicians, such as Germany's Angela Merkel ("time is pressing," "should be decided on quickly"), appears to underscore the fact that politicians realize they need to act quickly. But other reports highlight that politicians have not yet even gotten to the stage where the discussions can be formalized and presented to the regulatory bodies, much less brought back to the home countries where each of the 17 European Union members will then have to discuss and approve the plans. While the rumors leaked to investors have acted as a salve, the market is inherently an inpatient animal that will require decisive action, sooner rather than later.
Away from the positive tone that policymakers finally get it, there were a number of worrying indicators that Europe continues to slide downhill. For example, Italy was downgraded three notches to A2, which was striking, considering how rare it is to see a three-notch downgrade in corporate ratings. In theory, it seems to us that the rate of change in sovereign ratings should be less volatile than that of corporate ratings.Further, Moody's warned that other European countries with ratings already below AAA may also be facing downgrades.
European bank Dexia, whose main operations are in Belgium and France, faced such insurmountable funding pressures that those two countries began discussions to nationalize the bank's assets and possibly break up the company into a "good bank/bad bank" entity with those governments guaranteeing the bonds at the surviving entity (the "bad bank" will house the distressed assets). While this may have been a shock to many, it was not a surprise to Erin Davis, Morningstar's equity analyst who follows the bank. Irrespective of the European stress tests, Erin has long believed the bank would require additional capital.
Furthermore, on Thursday, the European Central Bank president acknowledged that Europe was facing "intensified downside risks." While the ECB didn't cut its interest rate, it did provide several new liquidity facilities to alleviate funding pressures. Closer to home, Fed chairman Ben Bernanke's speech to the Joint Economic Committee was mostly overshadowed, but he did say the U.S. economy was on a perilous path and the Federal Open Market Committee now expects a somewhat slower pace of economic growth over coming quarters than it did at the time of the June meeting.
Since our Bond Strategist published May 23, 2010, when we first began to make our case on why we prefer corporate credit over sovereign credit, we have repeatedly opined that U.S. credit markets would outperform those in Europe, and we are not yet ready to reverse that call. While the underlying fundamentals of most individual issuers within our coverage universe generally remain strong, for the foreseeable future the credit market will continue to be driven by headlines from Europe. Considering that the downside is so dire and transparency is so opaque, we anticipate maintaining our preference for U.S. corporate credit until the European policymakers formalize a specific, decisive plan to address this situation. We remain skeptical that this will occur in the near term.
New Issue Commentary
Restaurant Chain's New Bond Issuance Still Whets Our Appetite
Darden Restaurants (ticker: DRI, rating: BBB+), one of our investment-grade Best Ideas, priced $400 million in 10-year senior notes at +265, yielding a coupon of 4.50%. This was wide of Morningstar's BBB+ index at +251, and as expected, the bonds tightened after issuance. They are now trading around +245, but we believe there is still room for upside given similarly rated restaurant chain Yum Brands' (ticker: YUM, rating: BBB+) 3.75% notes due 2021 are trading in the area of +170. With lease-adjusted leverage in the mid-2 range, Darden is less leveraged than Yum (leverage around 3 times), and we assert the two firms' bonds should at least trade on top of each other. The liquidity of this new bond issuance should be greater than the bond we have on our investment-grade Best Ideas, and we will probably swap out the 6.20% notes due 2017 for the new notes due 2021.
As one of the largest casual dining chains in North America, Darden earns a narrow economic moat because of its bargaining power over suppliers, scale advantages, and convenient restaurant locations. Suppliers are eager to partner with Darden and its strong unit growth potential, thus ensuring the most favorable purchasing terms possible. Given the company's strong knowledge of global commodity markets, we believe the firm is well equipped to manage food cost volatility. Moreover, because the firm owns more than 50% of its locations, it has greater flexibility to renovate or relocate units. Its brands consistently have outperformed the Knapp-Track industry same-restaurant sales benchmark, which we attribute to strong brand loyalty and an increasing emphasis on everyday value offerings. Given the firm's continued success, coupled with moderate lease-adjusted leverage, we believe the bonds trade much too wide and could tighten over time.
As Expected, Retailer's Bonds Price Cheaply, But Demand Drives Spreads Down to Fair Value
Nordstrom (ticker: JWN, rating: A-) issued $500 million in 10-year notes at a coupon of 4.00%. As we had expected, the deal priced attractively at +212. The firm's 4.75% notes due 2020 had been trading around +175, and 40 basis points for a new issue concession and just a year longer in maturity is very appealing. Strong demand for the retailer drove the bonds 30 basis points tighter--much more than the 10-15 basis points we had expected. The bonds are currently around +180, and with the Morningstar's A- index at +176, we believe the bonds are trading at fair value. We view Nordstrom positively from a credit perspective, with its solid credit metrics and lack of near-term debt maturities. Lease-adjusted leverage is around 2 times, and the firm has a Cash Flow Cushion well above 1 times our base-case expense and obligation forecast. In our view, free cash flows are sufficient to service long-term debt, expand the store base, improve existing stores, and pay a dividend to shareholders.
John Deere Capital's New Issue Tightens on the Break
John Deere Capital tapped the bond market, pricing $500 million of 10-year bonds at a spread of 130 basis points over Treasuries and $500 million of 2-year floaters at LIBOR plus 40 basis points. Proceeds are expected to be used for general corporate purposes. We recently initiated a credit rating on Deere Capital (rating: A), which is directly linked to the rating of Deere (ticker: DE, rating: A) based on the strong interrelationships between the two entities.
In July, Deere Capital issued 10-year bonds at a spread of 77 basis points over Treasuries. We saw them trading around 105 basis points over Treasuries just before the new issuance, implying a decent new issue concession of 25 basis points. Although markets remain volatile, we said we wouldn't be surprised to see the new bonds tighten in materially on the break, and we weren't disappointed. Since issuance, the new 10-year has tightened about 20 basis points. We still maintain a slight preference for Deere Capital relative to Caterpillar Financial Services (rating: A-), given our one notch higher rating and similar trading levels for the two issuers. Just before the new issuance, the Cat Financial 2.05% notes due 2016 traded around a spread of 110 basis points over Treasuries. Assuming 15-20 basis points to move out the curve to 10 years implies a spread of 125-130 basis points over Treasuries for a hypothetical Cat Financial 10-year offering, roughly in line with the new Deere Capital issuance.