Voracious Appetite for Corporate Bonds
Portfolio managers of corporate bond funds have reportedly been inundated with new money and were desperately searching for bonds to put that cash to work.
The voracious appetite for corporate bonds continued last week, driving credit spreads tighter even in the face of some negative news. The corporate bond market paused Friday after the rumors of several imminent European downgrades leaked into the market, but for the week, the Morningstar Corporate Bond Index tightened 6 basis points to +238.
Portfolio managers of corporate bond funds have reportedly been inundated with new money and were desperately searching for bonds to put that cash to work. There were a number of new issues that priced last week, but the volume of new bonds was not enough to satiate demand. The new issues we followed were all heavily oversubscribed, priced at levels that we thought were generally on the expensive side, and still proceeded to trade higher in the secondary markets. Wall Street dealers had little to offer investors, as brokers had run their inventory down by year-end to levels we had not seen since 2002.
At the beginning of October, when credit spreads hit their peak, we wrote that at those heightened levels, credit risk was attractive from a fundamental viewpoint. We have viewed credit risk as modestly increasing--last quarter, the number of downgrades from Morningstar substantially outpaced the number of upgrades--but not to the degree that the market had sold off. However, the issuer downgrades largely centered on a few specific sectors that have experienced deteriorating fundamentals: shipping and transportation, building materials, and basic materials. The other downgrades were issuer-specific, based on either a decline in credit quality from weakening metrics or a conscious decision by management to enhance shareholder value at the expense of bondholders.
While the fixed-income markets are typically very adroit in evaluating inflationary risks and default risk, investors struggle with how to appropriately price the political dynamics that could lead to the low probability--but high severity--of a full-blown financial meltdown in the European peripheral nations. It appeared to us that a significant amount of the spread widening encapsulated heightened systemic risk emanating from Europe, as opposed to an increased probability of default due to deteriorating individual issuer fundamentals. Considering that we think credit spreads are cheap from a fundamental point of view, we were not surprised that credit spreads tightened when the headlines surrounding the political risk subsided.
The long-rumored downgrade of France by S&P to AA+ finally came to fruition. Trading in the European markets was a little skittish as the rumors surfaced, but bond traders in the United States yawned at the news and were more interested in leaving early to start the three-day weekend. Considering that French sovereign bonds have been trading at a widening spread over German bonds for a while now, and the rumor has been in the market for months, it appears that the downgrade had already been priced in.
We've written in previous Bond Strategists (most recently on Nov. 14) that if France lost its AAA rating, the European Financial Stability Facility would either lose its AAA rating as well or have to be downsized by the amount of France's guarantee. If the size of the EFSF is decreased, it is unknown how this could affect existing and future bailouts. In addition to the impact on the EFSF, the downgrade may also affect the French presidential elections scheduled for April 22. If Nicolas Sarkozy loses the election, it's unclear to us what would happen to the negotiations among the many players in Europe's sovereign debt crisis. We don't know how much the negotiations could be set back, as a new president would probably look to implement his or her own policies, which may differ from the existing agreements. The last thing the European fixed-income markets need is more uncertainty.
Spanish and Italian bonds rose significantly over the course of last week and held most of their gains. On the days immediately preceding bond auctions from Spain and Italy, the yields on those countries' outstanding debt declined substantially. We suspect the European Central Bank was intervening in the market to bring yields down before the auction, and both auctions were successfully conducted at reasonable terms. Spanish 10-year bonds dropped 40 basis points to 5.60% before their auction and continued to rally, bottoming out as low as 5.35% before backing up to 5.50% after the downgrade rumors. Italian 10-year bonds declined about 50 basis points to 6.60% before their auction. Those bonds also continued to rally, bottoming out at 6.45% before backing up to 6.60%. Yields may have risen even further, but the ECB was reportedly in the secondary market supporting bond prices. At 6.60%, the yield on the Italian 10-year bond is comfortably lower than the market's 7% hurdle rate, which many think would be unsustainable for the country over the long term.
As part of S&P's sovereign review released Friday, Spain and Italy were downgraded two notches to A and BBB+, respectively. As with France, we don't think the downgrades will have an appreciable impact on the countries' debt or the markets. Both countries were already trading at credit spreads wider than the prior ratings would have implied. In fact, the credit spreads of both countries are trading at spreads wider than even the new lower ratings would imply.
New Issue Commentary
J.P. Morgan Chase Plans New Benchmark 10-Year Notes (Jan. 13)
J.P. Morgan Chase (ticker: JPM, rating: A+) announced that it is issuing a new benchmark 10-year note. We have not heard any price guidance yet, but given that the current 10-year trades +245 to the Treasury curve, we think this new deal would come at around +270, which would be about 25 basis points of new issue concession. J.P. Morgan released earnings today, and the headlines from the media point to 23% lower profits because of lower trading and investment banking revenue. From a credit perspective, however, the fourth quarter was fairly solid as the firm's Tier 1 common ratio (using Basel I) rose to 10.0% from the previous year's 9.8%. Using Basel III calculations, the firm's Tier 1 common ratio is estimated to be 7.9%, which is a fairly significant increase from the previous year's 7.0%. This is a hard name not to like from a credit perspective, especially considering that similar-rated names like Wells Fargo (ticker: WFC, rating: A+) trade almost 100 basis points tighter. Assuming investors can still buy J.P. Morgan and are not filled up by diversification constraints, this new deal is very attractive.
Kroger Issuing New Bonds, but We Think Safeway's Are Cheaper (Jan. 12)
Kroger (ticker: KR, rating: BBB) is reportedly issuing $400 million of new five-year notes today. We are hearing that the whisper is around the mid-100s basis points over Treasuries. As a comparison, Kroger's 6.40% senior notes due 2017 were last indicated around 160 basis points over the curve, and its 6.15% senior notes due 2020 were 145 basis points over Treasuries. Safeway (ticker: SWY, rating: BBB) recently issued five-year and ten-year notes that are currently trading at 197 and 245 basis points over Treasuries, respectively. We rate both the companies the same, as we view the long-term credit risks of the firms to be substantially similar. However, we do believe that Kroger is a better-run company and has slightly better credit metrics. Based on the demand we have seen for bonds in the market this week, we expect this deal will be substantially oversubscribed and will easily price within the whisper price talk. However, we think Safeway 10-year notes (one of our Best Ideas) provide a better risk/reward profile and the current spread between Safeway and Kroger bonds will tighten over time.
Lennar Posts Solid Fourth Quarter as Homebuilding Industry Shows Signs of Life; Bonds Attractive (Jan. 11)
Lennar's (ticker: LEN, rating: BB) fourth-quarter results showed continued strong performance in the homebuilding operations along with good margin performance. The results showed that this high-performing homebuilder remains positioned to sustain profitable operations in the current depressed environment and prosper when production resumes more normal levels.
Homebuilding sales of $817 million were 12.5% ahead of last year, driven by a 9.8% increase in consolidated deliveries and a 2% increase in average selling price. Importantly, consolidated orders increased by an impressive 20.8% in the quarter, Lennar's highest growth in several years (including more than the tax-credit-fueled days of early 2010). As a result of the strong orders, the company's backlog now sits almost 36% above last year. Yet at only 2,169 consolidated units, it's still very small by historical standards; Lennar regularly sported a backlog of 15,000-20,000 units throughout the mid-2000s.
Profitability remained high compared with all other publicly traded builders, with adjusted home sale gross margins at 21.6%, or 80 basis points above the year-ago period. Lennar has for several quarters maintained margins near or above 20%, a feat that's not been matched by any large competitor that we know of. The company enjoyed a bit of leverage on its sales increase as well, as selling, general, and administrative expenses fell modestly to 13.5% of sales from 14.1% in the third quarter. Even so, this year's result is only about equal to last year's fourth-quarter SG&A of 13.4%, so there's more work to be done.
Earnings were negatively affected by results from Rialto, the distressed-investment arm. Its consolidated earnings fell to $6 million from $25.1 million last year, due in part to expenses associated with owning and maintaining real estate assets, costs that were not there last year. The equity loss of $3 million for the segment was $12 million lower than last year's $9 million in equity income because of mark-to-market losses on the AllianceBernstein fund. Still, Rialto is well funded, and Lennar did not contribute to the fund during the quarter. Management believes that there are compelling opportunities in this business as banks continue to sell assets and that Rialto will soon begin to return cash to the parent.
For the year, Lennar earned $0.48 in diluted earnings per share, roughly even with 2010's $0.51. The fact that the company has been solidly profitable for two straight years is highly impressive and indicative of just how far ahead it is of its competitors, many of which have yet to log even several straight profitable quarters together.
Lennar's balance sheet remained solid, with homebuilding cash sitting at about $1 billion after $400 million of convertible bond sales, which were partially used to retire $113 million of debt maturities. The next debt maturities aren't until 2013. Total homebuilding debt of $3.4 billion results in net debt/cap of 46%. Lennar's stock price marked a new 52-week high after the release, although the company still trades at only about 83% of our fair value estimate. As such, we still believe there is good upside for the firm's three convertible bonds. Lennar's 6.95% senior notes due 2018 were recently indicated at a yield of about 7.0%, which we still view attractive relative to BBs and considering the positive momentum in the sector.
We Expect Advance's New Bonds to Be Very Expensive (Jan. 11)
Advance Auto Parts (ticker: AAP, rating: BBB-) is coming to market with a new $300 million, 10-year issuance. Given the market's demand for paper during the past week, we expect the deal to be well bid, despite the fact that Advance's notes trade well inside of what we believe is appropriate for a BBB- credit. Advance has benefited from the weak economy, as its business relies on demand for necessity and repair items (such as maintenance and failure auto parts). Accordingly, investors' desire to hold bonds in more defensive categories has resulted in Advance's notes trading at a narrow credit spread. The firm's notes due 2020 trade around +280 basis points over Treasuries--very tight relative to Morningstar's BBB- index, which is currently at +341 basis points. We expect this deal may come inside of existing bonds because of high demand. Still, these bonds shouldn't trade any tighter than those of peers AutoZone (ticker: AZO, rating: BBB) and O'Reilly (ticker: ORLY, rating: BBB), as we rate Advance a notch lower. AutoZone and O'Reilly have 10-year bonds that trade around +175 and +220 basis points over Treasuries, respectively.
Late last year, we performed a credit review that included the auto parts retailers and said we believed Advance may tap the credit markets to finance share repurchases (129% of 2010 free cash flow). Accordingly, we expect proceeds to be used for share-repurchase activity. With no near-term debt maturities, this is not much of a concern--for now.
Valspar Expected to Issue $300 Million of 10-Year Bonds (Jan. 10)
Valspar (ticker: VAL, rating: BBB) is expected to issue $300 million of 10-year notes. We expect proceeds will be used to pay down existing commercial paper borrowings and prefund the repayment of a $200 million bond maturing in May. Valspar is one of the 10 largest players in the global paint and coating industry. It has grown both internally and through acquisitions, with a focus on international expansion, primarily into emerging markets. This has proved to be a prudent strategy and positions the company to take advantage of faster-growing markets in Asia and Latin America. However, the industry remains highly competitive, and Valspar is significantly smaller than a number of its major competitors. For its fiscal year ended Oct. 28, Valspar reported sales of $4 billion and total debt/EBITDA of 2.3 times.
We're hearing price talk on the new deal in the area of 262.5 basis points over Treasuries. That would put pricing right on top of the BBB bucket of the Morningstar index, which seems modestly attractive to us given that most industrial names tend to trade inside the index. For example, Roper Industries (ticker: ROP), which we also rate BBB, is a diversified industrial credit that has a 2019 maturity that was recently quoted around a spread of 205 basis points over Treasuries. Valspar is a relatively illiquid name and we would expect the new bonds to be quickly tucked away, but we see value at the price talk for buy-and-hold investors.
SABMiller's New Issue Looks Extremely Cheap (Jan. 10)
SABMiller (ticker: SBMRY, rating: A) announced it is issuing debt this morning consisting of a wide range of maturities from 3 to 30 years in benchmark size. The proceeds will be used to term out the financing for the acquisition of Foster's Group. We have opined that the existing trading levels for SAB were cheap for the rating and relative to Anheuser-Busch InBev (ticker: BUD, rating: BBB+). We have heard talk that the pricing on SAB's new 10-year note is around 220 basis points over Treasuries, which seems way too cheap to us, and we expect that will tighten when official price talk is released. Even if talk is tightened up a little, we still think the new bonds are cheap and will tighten toward ABInBev's levels over time. As a comparison, Morningstar's single A corporate bond index is currently at 126 over Treasuries, and ABInBev's 5% senior notes due 2020 were last offered at 128 basis points over Treasuries. Now that the overhang of a prospective new deal to fund the acquisition of Foster's will be removed, we expect credit spreads will tighten significantly.
Macy's Tapping Debt Market for First Time in Over Three Years; Demand Could Push In Spreads (Jan. 10)
Macy's (ticker: M, rating: BBB-) is coming to market with a 10- and 30-year note offering today. Given where existing bonds trade, and Morningstar's 10-year BBB- index at 344 basis points over Treasuries, we would expect the 10-year bonds to price in the low 300s, including a new issue concession. Limited Brands (ticker: LTD, rating: BB+) has a 10-year bond that trades around 380 basis points over Treasuries, and we believe Macy's 10-year should price well inside of that, not only because of the firm's higher, investment-grade rating, but also because of Macy's focus on debt reduction contrasted with Limited's egregious shareholder-friendly actions. We expect the deal to be well bid, given that this is the retailer's first foray into the debt markets in three and a half years, and Macy's posted solid holiday comps last week. We caution that this demand could push the 10-year spreads tighter to below 300 basis points over Treasuries, where we would not be interested in the notes.
Allstate Plans New 30-Year Notes (Jan. 9)
Allstate (ticker: ALL, rating: BBB) announced today that it is issuing $500 million of 30-year notes. The whisper on price guidance is 230 basis points above Treasuries, which would represent very little concession to where Allstate's current 30-year note is trading. While the majority of Allstate's revenue has been driven by the property-casualty business, where results have been strong, margins have been lower in the life insurance division, which has hurt overall profitability. To operate a life insurance operation, albeit a small one, Allstate is forced to model its balance sheet more closely upon that of a life insurance company than a property-casualty insurer. Consequently, the company scores poorly on our financial risk metrics, which drives our rating for Allstate one to two notches lower than the rating agencies. While finding an exact comparable for Allstate is difficult, we note that Travelers' (ticker: TRV, rating: A-) 30-year trades at about 145 basis points over the Treasury curve. For Morningstar, 85 basis points is not enough yield pickup for the lower rating and new issue concession, and we would prefer this deal to come 10-20 basis points wider.
Toyota Motor Credit to Issue Benchmark 5-Year and 10-Year Bonds (Jan. 9)
Toyota Motor (ticker: TM, rating: A+) subsidiary Toyota Motor Credit is in the market again with a benchmark offering of 5-year and 10-year bonds. We view Toyota Credit similarly to Toyota. Toyota Credit issued 5-year and 10-year notes in September at 125 and 145 basis points above Treasuries, respectively, and the price talk on the new notes is at the same level. We view this as fair value. The new price talk is about 20 basis points wide of indicated levels on the old notes. In comparison, Daimler's (ticker: DDAIF, rating: BBB+) finance subsidiary priced a 5-year offering at 210 basis points above Treasuries last week, which we viewed as slightly cheap. Volkswagen's (ticker: VOW, rating: A-) finance sub U.S. dollar-denominated bonds due 2016 recently were indicated at about 168 basis points above Treasuries. Finally, Honda (ticker: HMC, rating: A+) subsidiary American Honda Finance has 2015 maturities indicated around 148 basis points above Treasuries and 2020s around 173 basis points above Treasuries, which we view as attractive, given similar fundamental issues as Toyota but substantial incremental spreads.
With its well-illustrated problems after last March's earthquake, the Thailand floods, and the impact of the strong yen, we view Toyota as weakly positioned in the A+ category with downside rating risk and would prefer to get paid at least at A levels. We believe auto original-equipment manufacturers are being negatively affected by overriding global macroeconomic concerns. Also, Honda and Toyota are still working their way back to full production and have lost market share along the way. We expect Toyota to report an operating loss for its March-ending fiscal year. We do expect financial results to improve substantially in the next fiscal year and thereafter as production ramps up to normal levels. Toyota's manufacturing operations continue to have a strong balance sheet and excellent liquidity, with cash well in excess of debt.
France Telecom to Offer 30-Year Notes (Jan. 9)
France Telecom (ticker: FTE, rating: BBB+) plans to issue 30-year notes for general corporate purposes. France Telecom is one of our favorite carriers in Europe, and we believe sentiment toward the firm's equity has turned overly negative recently on the entrance of rival Iliad into the French wireless market. Given trading levels of France Telecom's existing U.S. dollar-denominated notes, we believe the new 30-year issuance could price at a relatively attractive level versus U.S. telecom peers. We like France Telecom's market position in France and believe the firm has taken steps to improve exposure outside its home country, including the recent sale of assets in Switzerland, its partnerships with Deutsche Telekom (ticker: DTEGY, rating: BBB-), and investments in emerging markets. Overall, we expect France Telecom will prove to be a stable credit during the next several years, though investors will have to take on the added risk that comes with investing in Europe.
France Telecom doesn't have U.S. dollar notes near 30 years to maturity, but its 4.125% notes due 2021, issued last September, have been trading in the area of 210 basis points above Treasuries, around 5 basis points tighter than we'd expect given the typical spread on BBB+ rated nonfinancial issues in the Morningstar Corporate Bond Index. Most telecom carriers that we follow trade significantly tighter to the index. For example, AT&T's (ticker: T, rating: A-) 3.875% notes due 2021 trade at around 120 basis points above Treasuries, more than 30 basis points tighter than similarly rated issues in the Index. Verizon (ticker: VZ, rating: A-) tends to trade even slightly tighter than AT&T. Using the spreads between 10-year and 30-year debt at AT&T and Verizon as a guide, we would expect France Telecom's 30-year issue to trade in the range of 230-240 basis points above Treasuries.
Target's New 10-Year Notes Look Attractive on a Relative Basis (Jan. 9)
Target (ticker: TGT, rating: A) plans to issue 10-year notes and 12-month floating-rate notes to refinance existing debt. Price talk for the 10-year is in the area of 100 basis points above Treasuries. While this is well inside Morningstar's A index (+133), the indicated spread does offer roughly 20 basis points of new issue concession relative to where Target's 3.875% notes due 2020 currently trade. In addition, similar-rated Home Depot's (ticker: HD, rating: A) 4.4% notes due 2021 trade around 100 basis points over Treasuries. We believe Target is a more defensive credit, given its assortment of food and other basic necessities, and should therefore trade slightly inside Home Depot, even with the same credit rating.
That said, demand for the notes will probably be pressured by Target's disappointing December same-store sales numbers and reduced earnings per share guidance, both announced last week. Comps came in below management and consensus expectations at 1.6% (versus 3%)--particularly weak given the prior year's easy comp (0.9%). As a result, the company lowered its fourth-quarter EPS guidance to $1.35-$1.43 from $1.43-$1.53. We contend that Target has a number of issues to resolve, including the final impact to margins from the grocery PFresh rollout, the terms of the eventual receivables divestiture, filling recent senior management departures, and better visibility on the Canadian market entry. Still, relative to where existing notes and some peers are trading, we believe the area of 100 basis points above Treasuries is good value for a new Target 10-year issuance.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.