Credit Markets Poised to Resume Rally
Now that Greece has successfully pulled off what is essentially an out-of-court bankruptcy restructuring, we think the credit market will pick up speed again.
In October, we highlighted that corporate credit spreads were cheap on a fundamental basis and the corporate bond market has rallied significantly since then. However, we moved to a more neutral stance a few weeks ago as we thought that the preponderance of credit spread tightening had occurred and the market would pause until greater clarity emerged regarding Greece's proposed debt restructuring. Now that it appears that Greece has successfully pulled off what is essentially an out-of-court bankruptcy restructuring, we think the credit market will resume its rally.
Corporate credit spreads ended last week largely unchanged as the market quickly rebounded from Wednesday's losses. At +188 basis points, the Morningstar Corporate Bond Index is 80 basis points tighter than the widest levels we experienced last October (+267), and about 50 basis points wider than the tightest levels last April (+134). During the next month or two, we think corporate credit spreads could tighten back to last April's levels. Although some of Greece's bondholders who own bonds that were issued under foreign law may try to either block the collective action clauses or accelerate their bonds, we don't think these actions would subvert the restructuring. We do not foresee any other near-term hurdles in the short run that could pressure the credit markets. With the Greek drama over (for now, anyway), over the medium term, we think investors will turn their focus to first-quarter earnings reports, which will begin in mid- to late April. Another possible headwind facing the markets will be a slowdown in the growth rates of the emerging markets. For example, on Wednesday, China reduced its 2012 target gross domestic product by 50 basis points to 7.5%; in Brazil, fourth-quarter GDP growth decelerated to 1.4%, lower than the 2.7% the country reported for the full year.
While the corporate bond market sold off rather significantly last Wednesday, this did not have the feel of the beginning of a major reversal. For example, one technical aspect we noticed in the market during the brief sell-off was that corporate credit spreads on short-dated bonds did not widen out in sympathy with longer-dated bonds. What this tells us is that the market was not pricing in higher near-term default or "jump to default" risk. If investors were really concerned about the possibility of heightened counterparty default risk in the near term, credit spreads on short-term bonds should have risen, causing the spread curve to flatten.
New Issue Commentary
Consolidated Edison's 30-Year New Issue Appears Fairly Rich (March 8)
Consolidated Edison (ticker: (ED), rating: BBB+) announced last week that it plans to issue $300 million of new 30-year notes to repay preferreds and for general corporate purposes. We believe these bonds will price around 110 basis points to Treasuries, given where existing 30-year Con Ed of New York bonds are trading while accounting for a modest 5- to 10-basis-point new issue incentive. We believe Con Ed's new issue at this level looks fairly rich when compared with Morningstar's 10-year BBB+ index of 180 basis points over Treasuries as well the BBB+ utility subsector within the index, which trades tighter to the overall index at roughly 151 basis points over Treasuries. In comparison, BBB+ peers Duke Energy's 10-year trades at roughly 100 basis points over Treasuries while Scana's (ticker: (SCG), rating BBB+) 20-year trades at +200 basis points. In fact, Scana represents one of our Best Ideas, and we'd encourage investors to consider buying Scana's bonds rather than Con Ed's.
Consolidated Edison is a primarily regulated (85% of revenue) utility with reliable income generation. Con Ed operates in a generally constructive regulatory environment in New York and currently earns average allowed returns on equity based on automatic adjustments of roughly 10.15%, which we expect to decline into the mid-9% range. Con Ed's largest segment, CECONY, benefited from its most recent favorable rate case, which will help fund needed investments in Con Ed's 200-year-old infrastructure to meet population growth. Lenient capital investment recovery mechanisms allow for reasonably streamlined infrastructure spending. Furthermore, New York regulators maintain high operating standards by imposing modest annual fines on Con Ed for not meeting strict reliability benchmarks.
New Xerox Notes Likely Unattractive (March 8)
Xerox (ticker: (XRX), rating: BBB-) plans to issue 18-month floating-rate notes and five-year fixed-rate notes. We don't expect the five-year notes will price at an attractive level, given our view of the firm and its heavy current emphasis on share repurchases. The majority of Xerox's debt is used to support its leasing and customer financing business. The firm's debt maturity profile is shorter in nature as a result, presenting the need to steadily refinance maturities. Xerox has a solid position in the commercial printing and services businesses, but its reliance on the debt markets to finance its customers presents some concern. The firm currently carries $8.6 billion in debt, equal to about 2.6 times earnings before interest, taxes, depreciation, and amortization. Xerox also held $900 million in cash at the end of 2011, but this balance has been steadily declining over the past couple of years. Xerox spent $700 million on share repurchases during 2011 and plans to spend about $1 billion in 2012. Combined with an expected $300 million dividend payout and acquisition spending, the firm's cash flow in 2012 is largely spoken for.
Xerox's 4.5% 2021 notes currently trade at about 220 basis points over Treasuries. That is far inside the typical BBB- credit in the Morningstar Corporate Bond Index (272 basis points over Treasuries), which has a similar term to maturity. We'd expect the new five-year notes to price around 30 basis points tighter than the existing 2021, which we don't believe is attractive.
Genworth's Risk Profile Outweighs the Higher Yields (March 8)
Genworth Financial (ticker: (GNW), rating: BBB-) announced Thursday that it plans to sell $300 million 7.625% 2021 notes through a tap issuance. No information has been given on price guidance yet, but the existing notes trade with a spread above Treasuries of about 475 basis points, so we would expect this offering to be priced in the 485-basis-point area. Although the spread to our rating is very attractive, we cannot recommend these bonds, given the volatility inherent in Genworth's business. We view Genworth Financial as having one of the highest-risk profiles of any of the insurance names we cover. A significant portion of Genworth's business is in U.S. mortgage insurance, where claims from foreclosures are rising and the final payout is widely uncertain. Genworth continues to contribute capital to its troubled U.S. mortgage insurance operations while two leading competitors already have ceased doing business. Also, Genworth scores poorly in our rating model because of its higher debt/capital and reserve/capital ratios.
CMS Energy's 10-Year New Issue Looks Fairly Valued (March 7)
CMS Energy (ticker: (CMS), rating: BBB-) announced Wednesday that it plans to issue $300 million of new 10-year notes at the parent level to repay converts and for general corporate purposes. We believe these bonds will price around 325 basis points above Treasuries, given where existing 10-year CMS bonds are trading. We view CMS' new issue at this level to be cheap compared with Morningstar's 10-year BBB- index of 273 basis points above Treasuries as well as to the BBB- utility subsector of the index, which trades tighter to the overall index at roughly 228 basis points above Treasuries. However, given Scana's higher relative parent company leverage as well as our expectation that the rating agencies apply Ba1/BB+ ratings, we believe the notes look fairly valued.
CMS Energy is fully regulated and operates in Michigan in a supportive regulatory environment. However, its rate case strategy has been to pursue smaller, more frequent rate increases, which has allowed it to meet its allowed returns on equity of 10.5% and 10.7%. These frequent rate cases expose it to relatively more regulatory ROE volatility, as its allowed ROE is routinely under review. This strategy bodes well in higher-interest-rate environments but creates more uncertainty in softer economic times, particularly given the weakness in Michigan's economy. The latest round of rate cases could bring ROEs below 10%. We note the progress CMS has made in transforming its business into a fully regulated utility as it has focused on shedding noncore, nonperforming assets to reduce debt. But we believe management should concentrate on further debt reduction. These efforts have contributed, in significant part, to its streamlined rate case structure.
Hewlett-Packard Issues More Debt, Spreads Look Attractive (March 7)
Hewlett-Packard (ticker: (HPQ), rating: A) is once again looking to issue debt, its fourth offering in the last year. The new notes reportedly will be split between 5.5- and 10.5-year maturities. Spreads on HP's debt have tightened considerably in the three months since its last debt offering; the 10-year notes offered at that time have tightened about 75 basis points versus about 40 basis points for the A rating bucket in the Morningstar Corporate Bond Index. HP's notes still look appealing given our relatively positive view of the firm. The typical A credit in the index currently yields about 98 basis points above Treasuries. Initial pricing talk on the new HP issuance is 185-190 basis points above Treasuries for the 5.5-year notes and 210-215 basis points above Treasuries on the 10.5 years. If the notes come to market in this range, we'd find both very attractive. HP's 3.30% 2016 notes recently were trading in the area of 125 basis points above Treasuries while its 4.65% 2021s were around +185. Demand for shorter-term paper could push pricing on the 5.5-year notes tighter. The spread between HP's notes that mature in 2016 and those that mature in 2021 has widened to about 60 basis points versus about 20 basis points three months ago. If the gap between the new 5.5- and 10.5-year notes widens, we would look at the longer notes first.
We don't have a clear sense why HP is raising new money at this point, though the current low cost of funds is probably a factor. The firm has said that large-scale acquisitions are off the table for now, and we don't believe a major deal is imminent. HP faces a multiyear turnaround effort as new management works to restore operational excellence in its core business units. But we believe management is attacking the right issues and setting reasonable targets for the business. The firm's first-quarter results met expectations and management reaffirmed expectations for fiscal 2012. While 2012 will be a rebuilding year, we expect HP will exceed its full-year targets. Longer term, we continue to believe that HP has solid competitive advantages in several key areas, including services and enterprise hardware, that will enable it to return to strength.
Office Depot Stretches Out Maturities With New Bond Deal (March 6)
Office Depot (ticker: (ODP), rating: B-) is pricing a new bond deal to fund its tender offer of as much as $250 million of senior notes due 2013. The firm has received tenders for $360 million of the $400 million outstanding, but will not exceed the intended cap of $250 million. The new transaction is expected to be $250 million in senior secured notes due 2019.
While stretching out maturities gives us a slightly more positive view of the credit, as it should improve the five-year cash flow cushion (currently at just 1 times our base-case expense and obligation forecast), we would hesitate buying a five-year maturity at any level. From our perspective, the firm's deteriorating fundamentals amid the hefty competition it faces from industry leader Staples (SPLS), along with nontraditional office products players such as Wal-Mart (WMT) and Amazon.com (AMZN), gives us limited visibility into Office Depot's cash flows. We believe the firm's ability to survive is shaky, at best.
We prefer the bonds of riskier credits with positive credit trends such as
Hanesbrands (ticker: (HBI), rating: BB), which has been reducing leverage. While the firm's bonds currently trade in line with a typical BB credit--around 400-430 basis points above Treasuries--volatility in input costs could push spread levels out toward 500 basis points above Treasuries, where we would view them as attractive.
Masco to Issue 10-Year Bonds (March 5)
Masco (ticker: (MAS), rating: BB) intends to issue $400 million of new 10-year bonds with proceeds used to address a maturity of almost $800 million in July. Management had previously indicated it probably would refinance half of this maturity and use existing cash balances for the remainder. The firm ended the year with almost $1.7 billion of cash, so liquidity will remain solid after the debt paydown. Price talk on the new bonds is in the 6% area, representing a spread of about 400 basis points above Treasuries. We view this as fairly valued. We note that the Merrill Lynch BB index is at 5.3% and a spread of 417. In building products and homebuilding, we find Owens Corning's (ticker: (OC), rating: BBB) bonds more attractive, with the 2019 maturity bonds indicated at about 5% and a spread of 350, a modest concession for a three-notch upgrade. We also prefer Lennar's (ticker: (LEN), rating: BB) 2018 maturity bonds at about 5.7% and a spread of 445 and Toll Brothers' (ticker: (TOL), rating: BBB-) 2022 maturity bonds at 5.4% and a spread of 336.
Masco remains heavily leveraged to the residential construction market. While we like the long-term prospects of this market, Masco's recent performance has been disappointing. The firm ended 2011 with debt of about $4 billion and debt/EBITDA of more than 8 times. We expect this to approach 5 times in 2012 as a result of debt reduction and improved operating results and to fall to levels more in line with the rating beginning in 2013, assuming more normalized operating results.
CenturyLink's Notes Probably Fairly Priced, Shorter Notes Interesting (March 5)
CenturyLink's (ticker: (CTL), rating: BB+) planned issuance of 10- and 30-year notes is likely to price around fair value, in our view. The firm's existing 6.75% 2021 notes are priced at about 375 basis points over Treasuries, while its 7.6% 2039 issue trades at about 440 basis points over Treasuries. CenturyLink, which is split-rated between investment-grade and high-yield at the major agencies, is well positioned relative to other smaller phone companies thanks to its relatively modest leverage--net debt stands at 2.8 times EBITDA--reasonable dividend payout ratio, and commitment to repay debt in the near term. The typical BBB- rated issuer in the Morningstar Corporate Bond Index is priced to yield 267 basis points over Treasuries, with around 10 years to maturity. The broader BB bucket in the Merrill Lynch High Yield Index currently trades around 417 basis points over Treasuries. As such, we'd view fair value for the CenturyLink 10-year notes within the range of where the existing bonds trade.
While we like CenturyLink relative to other small phone companies, we believe its competitive position is in decline, and we'd prefer to stay on the shorter end with this firm as a result. At the very short end, say within five years to maturity, we believe the firm's bonds offer a reasonable place to pick up yield within the telecom industry for those able to take on greater risk. CenturyLink's 6.0% 2017 notes, for example, trade at about 370 basis points over Treasuries. We don't believe comparable firms like Frontier Communications (ticker: (FTR), rating: BB+) and
Windstream (ticker: (WIN), rating: BB+) offer the same level of credit stability, though Frontier's recent dividend cut should support the near-term credit profile of that firm.
Newmont's New Issue Unlikely to Come Cheaply; We See More Value Elsewhere (March 5)
Newmont Mining (ticker: (NEM), rating: BBB+) is coming to market with benchmark-size 10- and 30-year notes. Newmont's existing 2019 notes trade at a spread of 114 basis points above Treasuries and its 2039s at a spread of 155, roughly comparable with levels on Barrick Gold's (ticker: (ABX), rating: BBB+) similar-dated debt. Both names are trading inside the average BBB+ name in the Morningstar Corporate Index, which sports a spread of 177 basis points above Treasuries (with an average maturity of 10 years), so we don't see much relative value in either.
We think the new issuance is probably the first of several incremental debt offerings for the company in the coming years. Newmont plans to undertake a multitude of capital projects in 2012 at a total price tag of $4.0 billion-$4.3 billion. The aggressive capital expenditure budget is likely to leave the company slightly in the red with regard to free cash flow generation in 2012, and that is before its gold-price-linked dividend, which we estimate will amount to roughly $700 million. While we expect more modest capital outlays thereafter, levels will remain high relative to operating cash flows, diminishing free cash flow generation.
In mining, we prefer Southern Copper (ticker: (SCCO), rating: BBB+). Its 2035 deal offers a spread of 328 basis points above Treasuries, almost 130 basis points wider than Newmont's 2035 debt. We think Southern Copper's bond offers more attractive relative value and gives long-term investors an appealing exposure to a low-cost copper producer.
Bombardier's New 10-Year Bonds Are Likely to Look Attractive (March 5)
Bombardier (ticker: (BBD.B), rating: BBB) surprised us with its announced new benchmark 10-year bond offering. The firm concluded its fiscal year with cash of about $3.4 billion, total liquidity of $4.1 billion, and no meaningful debt maturities until 2016, so we are curious as to why the firm would look to raise additional cash. We believe the firm may be taking advantage of attractive markets to both refinance a small ($150 million) maturity coming up this year as well as enhance liquidity even further ahead of ongoing large capital spending programs. We expect free cash flow to approach break-even in the current fiscal year despite management's guidance of spending about $2 billion on developmental programs in the aerospace business. With added leverage, however, our credit rating could be under pressure, although we do not envision a scenario of going below investment-grade.
With the existing 2020 maturity offering a yield of about 5.25% and a spread of 365 basis points above Treasuries, we still view the bonds as moderately cheap. We would expect the new 10-year bond to come cheap to existing levels, suggesting a potential yield around 6%. We still see fair value for the new bonds closer to 5%, reflecting investment-grade levels. As a comparable, Spirit AeroSystems Holdings (ticker: (SPR), rating: BBB-) 2020 maturity bonds, which are subordinated to secured debt, are trading at a yield of 5%. That said, we do not expect the rating agencies to move Bombardier into investment-grade territory--management's stated goal--in the near term due to various challenges.
Our investment-grade rating is based on the firm's market-leading positions in aerospace and transportation, which supports our narrow economic moat rating. Still, the firm is under near-term pressure, particularly in its regional jet business where sales are weak because of caution by airlines and a focus in the North American and European markets. Emerging markets tend to be stronger, and Bombardier has a weaker presence there. The evolving C-Series aircraft, which will compete with the 737 and A320 models, among others, is requiring significant amounts of cash while producing only modest orders thus far. While we don't expect sales to ramp up to meaningful levels for several years, we will continue to monitor the progress of this program and cash implications.
Philips Electronics Expected to Issue Benchmark 10- and 30-Year Bonds (March 5)
Philips Electronics (ticker: (PHG), rating: BBB+) is expected to come to market with benchmark 10- and 30-year bonds. We think the company may be taking advantage of strong investor demand and low interest rates to opportunistically raise cash to help fund its recently announced EUR 2 billion share-repurchase program, which was roughly 35% complete at the end of 2011. Recent earnings have fallen short of expectations on concerns regarding the near-term outlook in the lighting business as well as the company's exposure to the European market, which may be heading into recession. Having said that, the balance sheet was in decent shape at the end of 2011 with cash of EUR 3.2 billion, total debt of EUR 3.9 billion, and TD/EBITDA of only 1.5 times.
The company's 2018 bond recently traded around a spread of 153 basis points above Treasuries, which we would view as fair value and would expect the 10-year tranche to price around this area. Typical for diversified industrials, this spread is tight of the Morningstar index, which was at 177 basis points above Treasuries for the BBB+ bucket. We would expect the 30-year tranche to price about 20 basis points wide of the 10-year, but given some of the near-term concerns and the lack of an economic moat, we would prefer to stay shorter with this name.
Progress Energy's 10-year New Issue Looks Slightly Rich Compared With Existing Scana Bonds (March 5)
Progress Energy (ticker: (PGN), rating: BBB+) announced today that it plans to issue $450 million of new 10-year notes at the parent level for general corporate purposes. We believe these bonds will price around 135 basis points over Treasuries, given where existing 10-year Progress bonds are trading. We view Progress's new issue to be slightly rich compared with Morningstar's 10-year BBB+ index of 177 basis points above Treasuries as well the utility subsector of the Index, which trades tighter to the overall index at roughly 150 basis points above Treasuries. When compared with Progress' closest BBB+ rated peer, Scana's 10-year parent company bonds look more attractive at around 200 basis points over Treasuries.
Progress Energy and Duke Energy are on target to complete their proposed all-stock merger by mid-2012, to which we assign a 75% probability of occurring. Progress will become a wholly owned subsidiary of Duke Energy. Because both Progress and Duke operate in favorable regulatory territories in the Southeast, their bonds trade roughly in line with each other. Upon the merger's close, we believe that the consolidated company's credit statistics will improve and project leverage of roughly 4 times and interest coverage of roughly 5 times, slightly better metrics than Scana. However, given that both the consolidated Duke-Progress and Scana are fully regulated utilities with equally favorable means of recovery, we prefer Scana's 65-basis-point spread pickup.
PNC's New 10-Year Would Be Attractive With the Right New Issue Concession (March 5)
PNC Financial Services Group (ticker: (PNC), rating: A-) announced Monday that it plans to issue new benchmark 10-year notes. No information has been given on price guidance yet. PNC's current 10-year trades with a spread above Treasuries of about 130 basis points, which we view as fairly valued for a superregional bank with its rating. We would recommend the new deal if it came with a new issue concession of at least 10 basis points. From a credit perspective, we like the PNC name as the bank's conservative approach has allowed the company to avoid many of the problems its competitors experienced during the financial crisis. PNC maintains strong regulatory capital levels, with its Tier 1 common ratio above 10% and its Tier 1 risk-based ratio at about 13%. PNC also maintains strong actual capital levels as its tangible equity/tangible assets ratio is above 8%. If the new issue concession is less than 10 basis points, we think investors should consider
BB&T (ticker: (BBT), rating: A-), as its 10-year trades more than 10 basis points wider than PNC. BB&T is another solid conservative superregional bank with a strong deposit-funded balance sheet.
UnitedHealth's New Issue Could Come Wide of Existing Bonds, but We See Better Value Elsewhere (March 5)
UnitedHealth Group (ticker: (UNH), rating: A-) is coming to market with $1 billion in 10- and 30-year notes. This frequent issuer came to market twice in 2011, each time pricing just inside Morningstar's A- index, which we believe is reasonable given UnitedHealth's diverse revenue mix and manageable leverage. Accordingly, with the A- index at 128 basis points over Treasuries, we would expect the 10-year notes to price just inside of that level. Still, the firm's existing 10-year notes are trading around 100 basis points over Treasuries, which we believe is much too tight. UnitedHealth's 20-year notes are trading around 120 basis points over Treasuries--also too rich for our blood.
In health care, we prefer Amgen's (ticker: (AMGN), rating: AA-) 10-year notes, which are trading around 145 basis points over Treasuries. We believe investors are getting a higher spread than warranted for this high-quality biotech issuer. The market and rating agencies don't appear to be giving Amgen credit for the cash it plans to hold on its books, which we estimate will largely offset its recently inflated debt position despite its plans to make large share repurchases. We also like
Zimmer Holdings' (ticker: (ZMH), rating: AA) 10-year notes, trading around 120 basis points over Treasuries, as an absolute and relative valuation play. The firm's 2021 issue is trading more like a 10-year issue from a weak A rated firm, which we believe is too pessimistic. Also, Zimmer stacks up as a similar credit to Stryker, another orthopedic firm that we rate AA. However, Zimmer's 10-year notes trade about 25 basis points wider than Stryker's 2020 issue, and we think investors should take advantage of this relative spread differential, which gives investors in Zimmer debt a higher reward opportunity for the risk.
DirecTV Issuance Unattractive as Leverage Pushes Higher (March 5)
DirecTV's (ticker: (DTV), rating: BBB) planned issuance of 5-, 10-, and 30-year notes is unlikely to price at levels that we'd find attractive. The firm's existing notes currently trade in a range of about 175 basis points above Treasuries for maturities around 8-9 years out, through about 200 basis points above Treasuries on notes maturing in 2040 or later. This compares with an average spread on BBB rated issuers in the Morningstar Corporate Bond Index of about 207 basis points above Treasuries, with an average maturity of about 10 years. We haven't been particularly keen on DirecTV's management of its capital structure during the past couple of years, with the firm striving to take total debt to 2.5 times consolidated EBITDA. The firm ended 2011 with gross debt at 1.9 times EBITDA, but approved a fresh $6 billion share-repurchase program last month with the intention of taking leverage up further. DirecTV has repurchased $10.6 billion of its shares during the past two years versus about $5 billion of free cash flow.
Our rating on DirecTV contemplates its desire to take leverage higher, but we believe the company faces several challenges that leave it susceptible to a rating downgrade in the future. In the near term, management has signaled a desire to ratchet back promotional activity in the face of a very mature U.S. television market, but its ability to do this without losing customers depends on the behavior of the firm's competitors. We expect that the cable and phone companies will continue to aggressively push bundled service offerings. Longer term, and more critical to DirecTV's financial position, the evolution of the television business and consumer preferences threatens to reduce demand for DirecTV's services. Rival DISH Network's (ticker: (DISH), rating: BBB-) debt is priced more attractively than DirecTV's, but DISH's spreads also have tightened sharply during the past several months on solid performance and takeover speculation. Though the Federal Communications Commission recently dealt a blow to DISH's ambitions, the firm still could undertake a costly--and risky--attempt to enter the wireless industry. We recently removed DISH Network's bonds from our high-yield Best Ideas list as a result. We don't see much value in satellite bonds at present.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.