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Credit Insights

Markets Rally When Europe's Quiet

As investors focus on individual credit quality, they like what they see.

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Earnings season is beginning and analysts are switching their attention to earnings reports, but the demand for corporate bonds continues to drive the market higher.

We have highlighted since the beginning of October that credit spreads are cheap compared with our view of the underlying fundamentals. Considering that the news flow of dire headlines proclaiming systemic risk and collapse coming from Europe have died down since the December EU summit, investors have been able to focus on fundamentals. As investors focus on individual credit quality, they like what they see. The Morningstar corporate bond index tightened 8 basis points last week to +230, and it has tightened 20 basis points since the beginning of the year.

Even so, we think there is still room for credit spreads to tighten further over the next few weeks. Credit is still at levels that compare with the average credit spreads the market traded at during the 2001-02 recession. In addition, the near-term technicals are very positive. Corporate bond fund portfolio managers are flush with new money that needs to be put to work, and the new issue market has slowed down as firms enter their quiet periods before earnings reports.

However, we are concerned that we may be just experiencing a lull in the headlines. The announcement of the European Union's intention to increase fiscal discipline by implementing constitutional budgetary restraints occurred in December before the holidays. At this summit, the EU agreed to prepare a framework to present in March 2012. By mid-February, we may begin to see iterations of the framework emerge. We expect that many countries will have a difficult time allowing a bureaucrat in Brussels to dictate their budgets. Once those headlines begin to appear, it's quite possible that the fear of systemic risk in Europe will rear its ugly head again.

Also by mid- to late February, the haircut on Greek bonds needs to be settled in order to allow enough time to complete the documentation and provide the EU and International Monetary Fund enough time to arrange another loan to fund Greece's March debt maturities. These events could become the impetus for another round of selling.

No News Out of Europe Is Good News for the Markets
Remember S&P's sovereign debt downgrades? The market forgot about them as well. As there weren't any dire headlines proclaiming systemic risk and collapse coming from Europe, European sovereign debt rallied and credit default swaps tightened across the board. Ireland's 4.50% notes due 2020 rose to a 52-week high, and Italy's 10-year bond continued to push higher and its yield dropped to 6.25% by the end of the week.

The only loser last week was Portugal, whose long-dated bonds dropped to new lows. It appears that the market is pricing in an increased probability that the Portuguese government is watching how the voluntary haircut is playing out with Greece; if the Greek government is successful, the Portuguese may look for the same sort of treatment. The negotiations for the "voluntary" debt forgiveness for Greece are continuing to play out, but we don't foresee any agreement in the next week or two. Our understanding is that the parties have until mid-February to reach a conclusion. That is expected to provide enough time for the EU and IMF to arrange the next installment of Greece's bailout package before a significant amount of Greece's bonds mature in March. Next week could also be quiet from a sovereign risk perspective, as there don't appear to be any auctions from the peripheral nations.

Technology Earnings Takeaways
Several broad-based chipmakers have reported predictably weak fourth-quarter results, but guidance for the first quarter suggests that the recent chip industry downturn is nearly over. Many chipmakers indicated that at the end of 2011 customers continued to draw down chip inventory levels and took a wait-and-see attitude regarding end market demand. The customer outlook appears to have improved in recent weeks, however, and bodes well for the broader chip sector.  Linear Technology (ticker: LLTC, rating: A+) expects first-quarter revenue to grow 4%-8%, as bookings improved in December and have improved even further thus far in January. Linear believes that the U.S. economy is not worsening, and industrial customers in particular are starting to replenish chip inventory levels. Linear also expects relatively healthy demand from the automotive market and is getting a shot in the arm from chip sales to solid-state disk drive makers.  Xilinx (ticker: XLNX, rating: A) also saw an improvement in new orders late in the December quarter and expects 2%-6% sales growth in the March quarter.

 Intel (ticker: INTC, rating: AA) posted solid fourth-quarter results, considering that disruptions in the PC supply chain have temporarily cut demand for microprocessors. For the quarter, revenue was $13.9 billion, down 2% sequentially, but at the upper range of management's forecast of $13.4 billion-$14.0 billion provided in December, when Intel lowered its fourth-quarter outlook in light of the PC supply chain problems. For the first quarter, management expects revenue of $12.3 billion-$13.3 billion, which at the midpoint would represent a sequential decline of 8%. Intel typically sees a seasonal sales drop in the first quarter, but the projected decline will be greater than usual, as the PC industry continues to suffer from the limited availability of hard disk drives. In addition, the firm announced that it plans to increase capital spending to about $12.5 billion in 2012 from $10.8 billion in 2011.

Overall, we're pleased that earnings and guidance from the semiconductor industry thus far have generally been positive, supporting our view that the industry slowdown that set in during the second half of 2011 will be short-lived. This news, coupled with Intel's increased capital budget, should provide support for semiconductor equipment makers  KLA-Tencor (ticker: KLAC, rating: A+) and  Applied Materials (ticker: AMAT, rating: AA-). As suppliers to the semiconductor industry, these firms could see continued weakness in orders over the next couple of quarters while customers restore capacity utilization. We expect conditions will improve during the second half of 2012, but we'd note that KLA and Applied are well prepared to financially handle a significantly longer downturn if need be.

Contributed by Michael Hodel, CFA

New Issue Commentary
Rockwell Collins Reports Solid 1Q Results; We Remain Market Weight on the Bonds (Jan. 19)
We are maintaining our market weight rating, as  Rockwell Collins' (ticker: COL, rating: A) first-quarter results and 2012 outlook were in line with our expectations. The firm reported a slight decline in revenue as its defense-oriented government systems sales declined more than commercial sales increased, but earnings per share adjusted for taxes improved about 5% and beat consensus estimates by 2 cents. Overall government systems revenues declined about 10%, while commercial sales improved almost 13%. The company reiterated its expectations of soft second-quarter government sales followed by mid-single-digit growth in the second half as the impact of the continuing resolution goes away and orders and deliveries ramp up on several programs. Margins remain impressive in the government systems business at slightly above 20%, roughly flat versus last year despite the lower top line. Overall EBITDA improved modestly to $237 million from $230 million, with EBITDA margins improving almost 100 basis points to 21.7%. Rockwell Collins management highlighted the risks of unknown defense spending budget cuts resulting from sequestration, which could affect 2013 and beyond.

While the commercial business was strong across the board--original-equipment manufacturer, aftermarket, large commercial, and business jet--the outlook for the business jet segment was particularly notable. Management indicated that OEM customers are preparing the supply chain for increased production over the course of the year across small, medium, and large business aircraft. This reflects solid corporate profitability and pent-up demand.

Net leverage increased about a half turn during the quarter to 0.5 times on an LTM basis due to significant cash usage. The firm burned through more than $100 million of cash (versus positive free cash flow in the year-ago quarter) in part because of increased inventories and incentive compensation payments, and it also spent more than $400 million on share repurchases and dividends. This was supported by a new $250 million 10-year bond and $48 million of commercial paper issuance. Based on our expected free cash flow for the year, which is in line with management's guidance, and assuming the firm buys back its remaining $318 million authorization of stock, we believe cash balances could improve by around $200 million. This would push total cash close to $500 million by year-end. This would still leave the firm in a net debt position, but is well within the parameters of our rating. The next debt maturity is $200 million due in December 2013.

We have a market weight rating on Rockwell Collins' bonds based on recent trading levels for its 2021 bonds that are roughly in line with  General Dynamics (ticker: GD, rating: A) and  Boeing (ticker: BA, rating: A-). However, Rockwell Collins retains a better fundamental outlook than General Dynamics as a result of its heavy commercial aerospace exposure and directionally similar fundamentals to Boeing, but with a higher rating.

Goldman Sachs' Capital Position Makes Its New 10-Year Attractive (Jan. 19)
 Goldman Sachs (ticker: GS, rating: A-) announced Thursday that it is issuing new benchmark 10-year notes. Talk on price guidance is 385 basis points above Treasuries, which would represent about 25 basis points of new issue concession. We remain concerned about Goldman Sachs from a credit standpoint. Goldman's recent years of excess profitability were fueled by the combination of leverage and risk-taking with the firm's own capital and not by actions that would be consistent with a bank. Goldman is highly exposed to future banking regulation, such as the Volcker Rule, which curbs or eliminates proprietary trading and investments in hedge funds and private equity for those who accept deposits. While we question the business model, Goldman maintains a sound capital position--with its Tier 1 capital at 13.8% and its Tier 1 common ratio at 12.1%--which drives its rating into the A- range. At 380 basis points above Treasuries, this deal is attractively priced for the rating when compared with the large U.S. banks. Of course, large U.S. banks have a much better business model, and if this deal is priced much tighter than 360 basis points above Treasuries, we think it makes sense to consider names like  Citigroup (ticker: C, rating A-) or  J.P. Morgan (ticker: JPM, rating: A).

Citi's New 30-Year Notes Look Attractive (Jan. 19)
Citigroup announced today that it is issuing new benchmark 30-year notes. Whisper on price guidance is 325 basis points over the Treasury curve, which would represent no new issue concession from its existing 30-year. Even with no new issue concession, we think this deal is attractive. We continue to be positive on Citigroup. While this latest quarter was sluggish because of declines in investment banking revenue, the company continued to bolster its capital position. Citi's core Tier 1 capital now stands at 11.8%, and its Tier 1 ratio stands at 13.6%, making it the best capitalized of the large four U.S. banks. At 325 basis points over Treasuries, this new deal would price at almost 100 basis points wide to J.P. Morgan's 30-year. While we rate J.P. Morgan higher, we think 100 basis points is too great of a differential. We think this deal is attractive all the way to a spread of 290 basis points over Treasuries.

Scana's New Issue Looks Fairly Valued to Slightly Cheap (Jan. 18)
 Scana (ticker: SCG, rating: BBB+) announced Wednesday that it plans to issue $250 million of new 10-year notes at the parent company level. We've heard whispers in the range of 238 basis points above Treasuries, which we believe to be fairly valued to slightly cheap when compared with Morningstar's 10-year BBB+ index of 214 basis points above Treasuries and Scana's current 10-year bonds trading at 216 basis points above Treasuries.

Scana benefits from leading shareholder returns resulting from strong regulatory relationships in the Southeast, much like its higher-rated peer,  Southern Company (ticker: SO, rating: A-). Scana is investing heavily in its infrastructure and building one of the first new nuclear plants in the United States (South Carolina) in more than three decades. South Carolina legislation supports timely recovery of its construction work-in-progress investment and protection from stranded costs for its new nuclear plant, both of which are credit supportive.

Fresenius Continues To Refinance Existing Issues (Jan. 17)
 Fresenius Medical Care (ticker: FMS, rating: BB+), the world's leading provider of dialysis services and products, announced plans to issue $1.2 billion and EUR 250 million of senior notes with maturities of 7.5 and 10 years. The firm appears to be refinancing existing obligations, which we already thought was necessary and informs our BB+ rating. Last September, in the midst of a highly volatile credit market, Fresenius was able to sell EUR 400 million senior bonds with a coupon of 6.5% that comes due in 2018, or a spread of 539 basis points, and $400 million senior bonds with a coupon of 6.5% that comes due in 2018, or a spread of 533 basis points. Currently, the dollar-denominated 2018 issue trades with a 5.4% yield and a spread of 415 basis points above Treasuries. We'd expect the new notes to price at similar levels when adjusting for duration. For the new issues, we'd expect a fair yield around 5.5% for the 7.5-year maturity and 5.75% for the 10-year, or spreads slightly higher than 400 basis points above Treasuries.

PPR Issues Bonds at Uncharacteristically Wide Levels (Jan. 17)
 PPR (ticker: PP, rating: BBB-) recently issued EUR 250 million in notes due 2015 at a spread that was spot on for the rating, yet wide for the retailer. With globally popular brands such as Gucci and Puma, PPR is a cachet name for debt and equity holders alike, and bonds have typically traded quite tightly to the firm's rating. The firm issued its medium-term notes at 268 basis points above Treasuries, yielding a coupon of 3.75%, compared with the Morningstar 10-year BBB- index at 341 basis points above Treasuries. Adjusted for maturity, we consider this roughly on top of the index. PPR's bond issuance was probably pressured by the issues in Europe, and while the rumor was in the market for some time, France's downgrade to AA+ from AAA by S&P probably did not help matters.

These bonds were quite wide relative to where similarly rated retailer  Macy's (ticker: M, rating: BBB-) priced bonds the week prior. High demand in the U.S. corporate bond market pushed spreads down to a level where we did not view the notes as attractive. The firm issued $800 million in 10- and 30-year notes inside where the firm's existing bonds traded, and well inside Morningstar's BBB- index. The 10-year priced at 200 basis points above Treasuries, yielding a coupon of 3.875%, and the 30-year priced at 212.5 basis points above Treasuries, yielding a coupon of 5.125%. This compares with Morningstar's 10-year BBB- index at 344 basis points above Treasuries.

Click here to see more new bond issuance for the week ended Jan. 20, 2012.

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