Credit Has Run Its Course Until Greece Is Resolved
For credit spreads to tighten further, we expect the market will require three things.
The corporate credit market started off strong last week. Bonds tightened another 6 basis points, and a prodigious amount of new issuance was brought to market. However, by the end of the week, the credit market gave up some of its earlier gains, and the Morningstar Corporate Bond Index ended the week at about a 200-basis-point spread over Treasuries.
After highlighting our opinion that credit spreads were cheap on a fundamental basis last October, we pointed out two weeks ago that we thought the preponderance of credit spread tightening had probably taken place until further clarity emerges from Europe. While we were probably a week too early in that call, we continue to think that credit spreads will level out until greater clarity surrounding Greece and the implications of whatever happens are digested by the market.
The on-again/off-again drama surrounding Greece's negotiations for debt relief and the resulting will-it/won't-it default speculation took their toll on the market at the end of the week. The latest headlines suggested that neither a deal with existing bondholders nor additional bailout funding from the European Union and International Monetary Fund were near completion. For credit spreads to tighten further, we expect the market will require:
The negotiations surrounding Greece's debt forgiveness continue and the headlines evolve by the minute. While many of the headlines suggest that the public and private negotiators are getting closer to an agreement, we believe a final agreement will not be reached before the middle of February. While that should provide enough time to work out the mechanics of a debt exchange, we are concerned that there will be bondholders that will either try to hold out for better terms or will free-ride and not exchange their bonds, expecting to be repaid at par upon maturity. In our opinion, the success or failure of a voluntary debt exchange will depend on the participation rate. Unless the participation rate is well above 90%, we think any agreement would be in jeopardy.
If Greece and its creditors are not able to reach an agreement by the March 20 bond maturities, and Greece defaults, it will cause short-term dislocations; however, we do not think it will lead to a systemic failure in the financial markets. Unlike Lehman Brothers, which quickly spiraled into bankruptcy, the issues surrounding Greece and its potential for default have been around for more than two years. Institutions have had plenty of time to mitigate their risks, and policymakers have learned from the Lehman bankruptcy how to better deal with systemic risks brought about by a major restructuring. We expect the European Central Bank has contingency plans in place, ready to provide short-term liquidity to banks if traditional liquidity channels freeze and recapitalize any insolvent institutions.
In addition, since Lehman's failure, financial intermediaries of all types have learned to better monitor and manage their credit counterparty risk. Compared with 2008, we believe financial institutions and corporations have implemented much stronger credit counterparty risk processes. A credit risk officer we spoke with at one of the larger regional banks said that not only has the bank examined and reduced risk exposure to all of its counterparties, but also it has taken risk management to the second derivative, examining the counterparty risk of its counterparties. Margin requirements are higher and strictly enforced, and individual credit limits are much lower. Also, many large corporations have greatly improved their own internal credit risk management to monitor customers and counterparties within their own hedging or trading operations. Unlike 2008, the risks from sovereign debt are more easily identified as opposed to the derivative exposures on subprime debt (anyone remember structured investment vehicles, collateralized debt obligations, or CDO-squared?).
Servicers Reach Agreement on Foreclosure Issues: Little Impact on Credit
(contributed by Jim Leonard, CFA)
The five largest mortgage servicers in the United States-- Bank of America (ticker: BAC, rating: BBB), Wells Fargo (ticker: WFC, rating: A+), Citigroup (ticker: C, rating: A-), J.P. Morgan Chase (ticker: JPM, rating: A), and Ally Financial--reached a $25 billion agreement with the federal government and 49 state attorneys general, settling an ongoing civil dispute over the banks' foreclosure practices. While on the surface this would appear to be significant news, we ultimately do not think the settlement makes much of a difference to the credit of the big banks. For comparison, the four major banks we cover recorded about $11 billion in net income in the fourth quarter alone. Furthermore, the banks have recorded reserves to some extent against this exposure. While disclosures are incomplete, we suspect the reserves will largely cover the settlement. In fact, right after the settlement was announced, J.P. Morgan released a filing stating that it did not expect the settlement to materially affect the first quarter of 2012 or beyond.
S&P Downgrades Italian Banks--Again--and Moves Even Closer to Our Ratings
(contributed by Jim Leonard, CFA)
On Friday, Standard & Poor's announced that it had lowered its ratings on numerous Italy-based financial institutions. The move appears to have been caused by S&P's earlier downgrade of Italy's sovereign debt. S&P had made a similar round of downgrades to Italian financial institutions on Oct. 19. As part of this set of downgrades, UniCredit (ticker: UCG) and Intesa Sanpaolo (ticker: ISP) were lowered to BBB+. Both had been rated A, and these downgrades move S&P's ratings closer to Morningstar's ratings, which are BBB on both banks. We expect that the other rating agencies will also lower their ratings, as both Moody's and Fitch are at about the A level.
New Issue Commentary
The floodgates to the new issue market broke open as issuers took advantage of historically low interest rates and the recent rally in the credit market. We have been expecting a significant amount of volume and a number of new deals once earnings season ended, and we were not disappointed. Investors clamored for yield as the issues with the widest spreads performed the best on the break into the secondary market. For example, early whisper talk was +250 on BMC Software (ticker: BMC, rating: A+) and official price guidance was subsequently tightened to +235. Investors could not get their fill and immediately drove the notes another 20 basis points tighter in the secondary market. We wrote that the new notes would prove attractive and agree with the market's reaction, as our rating on the firm is about three notches stronger than the agencies'. We think the firm exhibits the characteristics of a narrow economic moat, and we like the solid recurring cash flow characteristics of its business and its position providing solutions geared to manage increasingly complex IT environments.
Disney Taps the Debt Market Again; We Expect the Deal to Be Too Rich (Feb. 9)
Walt Disney (ticker: DIS, rating: A+) is tapping the debt markets for the fourth time in a year with a 5- and 10-year notes deal. As with Disney's earlier issuances, we expect the bonds to price expensively to the firm's A+ issuer credit rating, given high demand from retail accounts and the firm's robust growth outlook and credit stability. Disney has maintained leverage around the mid-1 times range for the past few years, and we don't foresee a change in this strategy. The firm's existing 5- and 10-year bonds trade around 40 and 50 basis points over Treasuries, respectively--much tighter than Morningstar's 10-year A+ index at nearly 90 basis points over Treasuries.
We expect the notes to come in close to current trading levels--likely inside--and we would view the transaction as expensive relative to where the bonds of other household names trade. While Disney operates in the entertainment industry, we believe its stability and robust growth outlook make it a better comparison with firms in the consumer defensive industry. Coca-Cola (ticker: KO, rating: AA-) and Pepsi (ticker: PEP, rating: AA-) are both rated a notch higher than Disney, but their bonds trade in the same area (more appropriate for their ratings). We rate Disney slightly lower because of a more cyclical business, slightly weaker credit metrics, and a lower percentage of free cash flow generated from sales. As such, for the same level, we would rather own Coca-Cola's or Pepsi's bonds.
Despite $3 billion in cash, management is probably taking advantage of the market's demand for high-quality paper amid the current uncertainty, as well as demand for yield in what is likely to be a low-yield environment for some time by issuing longer-term paper. We expect the firm to use the cash on share repurchases ($5 billion worth of shares was repurchased in fiscal 2011) and capital expenditures. Management expects capital expenditures to increase by $500 million this year, to $4 billion, with spending on a new cruise ship, the revamping of domestic parks, and the beginning of investment in the China Disney property. Still, Disney maintains moderate leverage, and we are not concerned about this use of cash from a debtholder's perspective.
Freeport to Issue 3-, 5-, and 10-Year Notes: Pricing Uncertain, and We Don't Expect to See Much Value (Feb. 8)
Copper mining giant Freeport-McMoRan (ticker: FCX, rating: BBB) announced that it would issue 3-, 5-, and 10-year notes with net proceeds to be applied to redeeming a portion of its 8.375% notes due 2017. Like many miners, Freeport ended 2011 very lightly leveraged ($3.5 billion gross debt and $4.8 billion in cash) relative to its earnings power ($10.3 billion EBITDA for the year). As such, the new offering is highly unlikely to mark a worrisome increase to the firm's debt burden.
With the exception of Freeport's aforementioned 2017 notes, the outstanding issues are very small in size. None are larger than $200 million and the 2017s themselves had long been trading to a March 2012 call at 104.188, making it more difficult than usual to gauge the likely pricing of the new offering. We've relied primarily on levels of comparably rated mining peers Southern Copper (ticker: SCCO, rating: BBB+), Teck Resources (ticker: TCK, rating: BBB), and Cliffs Natural Resources (ticker: CLF, rating: BBB-) to get a sense of where the new bonds might price.
Based on this analysis and the assumption that the market will view Freeport more favorably than Southern Copper and more akin to Teck, we expect the 3-year notes to be priced with a spread of 140-165 basis points, the 5-year at 145-170 basis points, and the 10-year notes at 150-180 basis points. These would be fairly rich levels, in our view, but new issuances in basic materials have been light as of late, and Freeport has little in the way of liquid debt at the moment, so investors could be particularly keen to participate. However, our confidence level on the prices is lower than it usually is. Regardless, we think it's unlikely that the bonds will come at a level that makes them more attractive than Southern Copper notes, which continue to rank as our favorites in the mining industry.
AT&T Issuance Looks Fair, but Not Compelling (Feb. 8)
AT&T (ticker: T, rating: A-) has announced plans to issue 3-, 5-, and 10-year notes. Given recent trading levels on the firm's existing debt, we wouldn't expect the new issuance to price attractively relative to the Morningstar Corporate Bond Index. The typical 10-year for an A- issuer in the index, excluding financials, is currently priced to yield about 140 basis points above Treasuries. Spreads on AT&T's 3.875% 2021 notes, for example, have traded around 105 basis points above Treasuries. Initial talk indicates that the new AT&T issues also will price tightly to the index, with the 3-, 5-, and 10-year notes expected to come out around 70, 90, and 115 basis points above Treasuries, respectively. We believe these levels are reasonable, if not overly compelling. We continue to like AT&T relative to Verizon (ticker: VZ, rating: A-) because of the simplicity of the former's capital structure. As such, we'd rather hold AT&T's debt, assuming similar spreads, at any given maturity. Verizon's 3.5% notes due 2021 are currently priced tighter than AT&T at around 101 basis points above Treasuries. While we aren't crazy about current pricing on AT&T's debt, we don't see anything more compelling in the investment-grade telecom universe.
Wells Fargo's New Three-Year: Tighter Spreads but Still Attractive (Feb. 8)
Wells Fargo announced Wednesday that it is issuing new benchmark three-year notes. Price guidance is 105 basis points above Treasuries, which appears to be about 20-25 basis points cheap to existing notes. Of the four largest U.S. banks, we are most impressed by Wells from a credit perspective. Wells Fargo has a clear funding cost advantage as low-cost deposits fund its entire loan book and about 75% of its earnings assets. Its capital position is quite strong, with a Tier 1 capital ratio at 11.3% and a Tier 1 common equity ratio at 9.5% as of Dec. 31, 2011. The company has also estimated that its Tier 1 common equity ratio under Basel III would have been 7.5% as of Dec. 31. Wells trades tight to its peers, even after adjusting for rating. For example, at the five-year point, J.P. Morgan's trades more than 50 basis points wider for just a one-notch lower rating. This tightness is driven in large part to the scarcity of the Wells Fargo name. Still, we think these new Wells Fargo bonds are attractive and we would recommend them all the way to a spread of 90 basis points over Treasuries.
BMC's 10-Year Notes Could Provide Nice Opportunity (Feb. 8)
BMC Software's plans to issue $500 million of new 10-year notes could offer an interesting opportunity. Our rating on the firm is about three notches stronger than the agencies, as we generally like the solid recurring cash flow characteristics of its business and its position providing solutions geared to manage increasingly complex IT environments. Despite a ramp-up in share repurchases during fiscal 2012, the balance sheet remains a source of considerable strength, with $1.5 billion in cash and investments against $350 million of debt. BMC recently agreed to acquire Numara Software for about $300 million and will probably use the proceeds of the 10-year offering, in part, to fund that deal. While the jump in acquisition and buyback spending versus the recent past bears watching, BMC has carried more than $1 billion in cash for the past several years.
BMC has only one existing debt issue outstanding, a 7.25% note due in 2018. That note offers a very generous spread of around 310 basis points over Treasuries based on recent trading levels. We've been reluctant to recommend the 2018s, though, because the notes trade at a high dollar price (around 116) and we view the firm as a potential private equity acquisition target. The notes are also illiquid. We haven't heard price talk on the new BMC 10-year notes. Spreads on rival CA's (ticker: CA, rating: A) 5.375% 2019 notes, currently around +241, offer some indication, but this issue also trades at a fairly high dollar price. With the typical nonfinancial A+ issuer in the Morningstar Corporate Bond Index trading at a spread inside of +100, there is a lot of room for the BMC notes to price significantly tighter than recent trading levels and remain very attractive.
Express Scripts Continues Medco Merger Funding With Notes That Are Likely to Be Attractive for Investors (Feb. 6)
On Monday, Express Scripts (ticker: ESRX, rating: A-) announced plans to issue 3-, 5-, and 10-year debt to fund the pending Medco (ticker: MHS, rating: A-) merger. We anticipate keeping our A- rating for Express Scripts whether it is a stand-alone or combined entity. We would maintain our rating for the same reason regulators may reject the merger: the unprecedented leverage that the combined entity would have over suppliers, putting competitors at a significant disadvantage. That increased power and scale could cause us to increase our moat rating to wide for the combined entity from narrow for the stand-alone entities; that change would elevate our Business Risk score enough to offset the expected increase in leverage for the combined entity. Management aims to reduce its leverage to more normal levels of 1-2 times EBITDA within 18 months of the deal's closing, when it is expected to be at 2.9 times EBITDA. This plan to deleverage reinforces our A- view of the combined entity.
For the average A- rated firm, we'd expect a 10-year maturity to price around 140 basis points above Treasuries. However, the agencies rate Express Scripts two notches lower on average than we do, and the firm's existing issues tend to anchor on those ratings. For example, its existing 2021 issue trades around 225 basis points above Treasuries. Therefore, we wouldn't be surprised to see Express Scripts issue these new notes at wider spreads than we'd deem necessary for the risk, potentially giving investors an opportunity to purchase notes at attractive spreads. Within the sector, key competitor CVS Caremark's (ticker: CVS, rating: BBB+) 2021 issue recently traded at a spread of 115 basis points above Treasuries, providing further support to our view that investors can get more return for the risk in the pharmacy benefit management industry by investing in Express Scripts' notes rather than CVS'.
Kimberly-Clark Coming to Market, but We See Better Value in Other Bonds (Feb. 6)
Kimberly-Clark (ticker: KMB, rating: A+) announced it is issuing debt this morning consisting of $300 million of 10-year notes. Before the new issue announcement, Kimberly's 3.875% notes due 2021 were trading around 80 basis points to Treasuries. We have heard early talk on pricing in the low to mid-80s, which seems fair to us as compared with where the existing bonds were trading. Considering the existing bonds were trading at a 10-point premium over par, we expect that the new issue will probably trade tighter than the existing issue as investors prefer a bond closer to par. As a comparison, similarly rated Campbell Soup's (ticker: CPB, rating: A+) 4.25% notes due 2021 were around 95 basis points over Treasuries and Clorox's (ticker: CLX, rating: A-) 3.80% notes due 2021 were at about 155 basis points. The Campbell's bonds also trade at a 12-point premium over par, but we think the yield pickup is attractive for an issuer with the same rating as Kimberly. We also think the Clorox bonds are a better buy than the Kimberly bonds, picking up about 75 basis points for a two-notch differential in our issuer credit rating.
While we believe Kimberly-Clark has a stable, narrow economic moat, the company has been struggling with rising input costs, resulting in declining gross margins. The firm has increased prices to offset input cost inflation; however, the price increases have had a negative impact on volume and hurt fixed-cost leverage. For example, last quarter the firm reported a 5% decline in the North American personal-care segment as higher prices failed to offset volume declines. Management reported that it expects economic conditions to remain difficult in the near term, particularly in the developed markets. This outlook is in keeping with our own thesis for household staple manufacturers, but we also look to Kimberly to stem the declines in this segment, which is its largest in sales and operating profits. If Kimberly is unable to halt the deterioration in its gross margins, it could begin to erode its credit quality.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.