All Quiet on the European Front
We are cautious that the current credit rebound will persist.
Last week was relatively uneventful, as Europe was quiet and the few economic indicators released were within expectations. Credit spreads ground 2 basis points tighter, with the Morningstar Corporate Bond Index declining to 181 basis points over Treasuries. We think credit spreads will continue to constrict over the next few months and may tighten back to last April's levels (+134). After peaking at almost 2.40%, the 10-year Treasury bond recovered some of its recent losses and ended the week at 2.23%, about 7 basis points lower than the end of the prior week.
However, we are cautious that this rebound will persist. With no additional quantitative easing programs on the horizon, Operation Twist winding down by early summer, and the safe-haven demand for Treasuries dwindling, we think interest rates are poised to rise over the next few months.
If interest rates rise gradually, we do not think it will have a significant impact on investor appetite for corporate bonds. We expect that spread tightening would generally offset slowly rising rates, leaving prices steady. In fact, investors may wish to switch their allocations within fixed income to corporate bonds to pick up additional income from the credit spread and help shield some of the losses from rising rates. However, if interest rates were to sharply gap wider, as in the prior week, leading to significant price declines, we think that would shake investor confidence enough to cause significant disruption in the credit markets. In that scenario, we believe investors would pull in the reins to re-evaluate their asset allocations, leading to a double whammy of rising rates and widening credit spreads. We don't believe such a scenario is likely, given the widespread belief that the Fed will step in to blunt a serious jump in rates.
The new issue market sprang to life last Monday. Out of concern that interest rates were headed higher, many CFOs who were planning on accessing the market over the near term decided to hit the market sooner rather than later. After a flurry of trading on the break as new issues were free to trade, volume seemed to slow a bit. A few traders reported that a number of investors who had a significant amount of cash to put to work have been filled up with the deluge of new issues that have priced over the past few weeks. The new issue market has been supported by a significant amount of new money flowing into fixed-income mutual funds. If fund flows were to slow, those investors could need some time to rebuild their cash balances before they are back in the market in a significant way. If so, we'd expect the credit markets may be range-bound over the next few weeks.
We have heard that the size of the shadow calendar for this week ranges between $10 billion and $15 billion, which is lower than we've seen lately as many deals were pulled forward last week. With the Easter holiday approaching the week thereafter, we expect bankers are advising clients to take advantage of the new issue market this week while the window is open.
New Issue Commentary
Tenneco Announces Debt Refinancing; Credit Trends Remain Favorable (March 22)
Tenneco (ticker: TEN, rating: BB) announced a refinancing of its credit facilities that will extend maturities and lower interest costs, both of which will have a favorable impact on the credit. The company had previously announced it is tendering for its $250 million 8.125% senior unsecured notes due 2015 at a price of 104.438. These notes are currently callable at 104.060. Tenneco will use a new $250 million term loan A facility to finance the 2015 notes. The term loan A will amortize quarterly and have a final maturity of March 22, 2017, and include pricing of Libor plus 250 basis points. In addition, Tenneco announced a new $850 million revolving credit facility, with the same maturity date and pricing as the term loan A. The revolver will be used to replace the former $556 million revolver, a $148 million term loan B, and a $130 million letter of credit/revolving facility. We believe the new facilities will continue to be secured and rank ahead of the senior unsecured bonds. Tenneco previously paid Libor plus 400 basis points on the old revolver and Libor plus 450 basis points on the term loan B. As such, the firm expects annual interest expense reduction of $20 million.
Tenneco ended the year with total debt of about $1.2 billion and net debt of about $1.0 billion. This resulted in debt/EBITDA of 2.0 times. The firm also uses accounts receivable securitization programs, of which $121 million was used as of year-end. We continue to have a favorable view of the credit as we forecast double-digit top-line growth in fiscal 2012-14, which should drive EBITDA higher and potentially lower leverage. Based on that, we believe our credit rating may increase in the near term. We continue to view Tenneco as a solid core holding, as our favorable fundamental outlook is tempered by relatively full valuations. Tenneco's $500 million 2020 maturity senior note is currently trading at about a 5.5% yield, representing an option-adjusted spread of about 365 basis points above Treasuries. This compares with the Merrill Lynch BB index at a similar yield but an option-adjusted spread of about 414. We note that the refinancing of bonds will effectively move more debt ahead of the senior unsecured notes in the capital structure. We continue to have a preference for TRW (ticker: TRW, rating: BBB-), whose 2017 senior unsecured notes are indicated at a spread of about 345 basis points above Treasuries. We believe TRW, with gross leverage of less than 1 times, may achieve additional investment-grade ratings at the rating agencies (Fitch upgraded the credit to BBB- on Thursday) within the next year, which should drive additional spread tightening.
Terex to Issue $300 Million in Senior Unsecured Bonds; We View Existing Bonds as Fairly Valued (March 22)
On Thursday, Terex (ticker: TEX, rating: BB-) announced that it will issue $300 million in senior notes to cover some corporate expenses and the remaining payments on its Demag acquisition. This debt will share a position in the capital structure with the firm's other $300 million 10.875% senior notes, originally issued in 2009 and callable in June 2013 at a 105.438 price. Those bonds are currently trading at a yield to that call date of about 4.0%, representing an option-adjusted spread of about 380 basis points over Treasuries. We still believe Terex will call these next year, and as such we view this most recent debt issuance as a de facto early refinancing of the bonds. We don't plan to alter our $33 fair value estimate or our BB- credit rating.
We believe the new bonds, which will be an 8-year noncall 4 structure (callable in 2016), should price in the range of 6.25%-6.50%, with a spread in the area of around 450 basis points over Treasuries. This compares with the Merrill Lynch BB index at 5.46% and an OAS of 410 basis points over Treasuries. Other similarly rated names covered by Morningstar include Navistar (ticker: NAV, rating: BB-), whose 2021 maturity senior unsecured bonds are trading at about 6.1% to a 2014 call date, providing a spread of about 450 basis points over Treasuries. Oshkosh (ticker: OSK, rating: BB) has senior unsecured notes due 2020 indicated at about 6.2% to the 2015 call date, providing a spread of about 475 basis points over Treasuries. Finally, Terex's 8.0% senior subordinated notes due 2017 are trading at about 6.2% and a spread of about 500 basis points over Treasuries.
We anticipate that Terex will enjoy about $200 million in free cash flow (cash from operations less capital expenditures) this year; it also holds about $775 million in cash on its balance sheet. Given its already-earmarked $160 million in tax payments related to 2011's sale of Bucyrus shares to Caterpillar and the aforementioned Demag purchase (probably $200 million-$200 million for the remaining minority stake), we had previously expected Terex to burn through some of its cash hoard. Instead, we now forecast the firm to maintain a relatively high cash level, likely in anticipation of debt repayment and potential bolt-on acquisitions. Terex ended the year with total debt of about $2.3 billion, including about $1 billion of subordinated debt. Based on our estimated 2012 EBITDA, which includes the impact of the Demag acquisition, we estimate pro forma total debt/EBITDA of about 4.6 times. However, on a net basis this drops to about 3.2 times, and only about 1.2 times through the senior unsecured notes.
Fresenius Taps European Debt Market Again (March 21)
Fresenius Medical Care (ticker: FMS, rating: BB+), the world's leading provider of dialysis services and products, announced plans to issue EUR 500 million of senior notes this week. Initial pricing on the seven-year bonds suggest a 4.25% coupon, or about 280 basis points over the bund. We do not have good comps in the high BB European health-care market, but we would note that Merrill Lynch's nonfinancial BB Euro index currently shows an OAS of 414 and a yield to worst of 5.42%, so we believe fair value for this security would be closer to 325-350 basis points over the Bund, or about 4.75%-5% in yield. Investors may be rewarding Fresenius for finally having enough liquidity on its balance sheet to avoid further refinancing during the next five years, if cash flows build up as we expect. Of note, this issuance is Fresenius' third major debt financing since September. However, we'll remain cautious on this issuer because of its significant leverage, which we estimate stands around 3 times EBITDA and 4 times EBITDA when including lease obligations. As such, we don't plan on changing our BB+ rating, and this new issuance will probably come in too tight to tempt us. At current price talk, we don't believe investors will generate enough return on the notes for the risk.
Caterpillar Finance to Issue $600 Million of Three- and Five-Year Notes; Existing Bonds Look Rich (March 21)
On Wednesday, Caterpillar Financial Services announced plans to issue $600 million of three- and five-year notes with proceeds expected to be used for general corporate purposes. Our A- rating on Cat Finance is directly linked to the rating of Caterpillar (ticker: CAT, rating: A-) based on the strong interrelationships between the two entities. Caterpillar enjoys a wide-moat position as the world's largest manufacturer of heavy equipment and has a very substantial dealer network, which allows it to dominate the U.S. market and provide competitive advantages. However, the cyclicality inherent in the company's business combined with the largely debt-financed acquisition of Bucyrus constrains our rating.
Within the heavy equipment sector, we think Cat Finance trades tight for its rating and we maintain an underweight recommendation on the name. The company issued five-year bonds in July 2011 and we recently saw them trade at a spread of 52 basis points above Treasuries. For comparison, John Deere Capital, which we rate one notch higher at A, has a 2017 bond that recently traded at a spread of 59 basis points above Treasuries. Given our market weight view of John Deere Capital bonds, we would place fair value for a new Cat Finance five-year around 65-70 basis points above Treasuries and about 20 basis points tighter for a new three-year bond.
For investors looking for a little more yield in this industry, we recommend the AGCO (ticker: AGCO, rating: BBB-) 2021 bonds, which were recently quoted around a spread of 300 basis points above Treasuries. AGCO wields formidable positions in international markets and has sharply improved profitability in North America. The company's recent purchase of GSI should further help in this regard, but weakening economic conditions could create a near-term headwind. That said, we think the incremental spread offered on AGCO's bonds is relatively attractive for what we view as investment-grade risk.
We Expect AK Steel's New Issuance to Price Attractively, Reflecting Industry Headwinds (March 19)
AK Steel (ticker: AKS, rating: B) is coming to market with a $250 million senior unsecured offering, which will be applied primarily to repay its asset-backed revolver. The new notes will mature in 2022, but are callable after 2017. Provided the new issue comes at levels commensurate with the company's outstanding bonds, we'd expect to see a yield in the neighborhood of 8%. If the new deal prices higher than that level, we find it fairly attractive relative to our B issuer rating.
AK Steel's existing 7.625% 2020 bond was trading at a yield to worst of 7.80% before the announcement. U.S. Steel (ticker: X, rating BB-) tapped the market last week, and its 2022 bond priced at a spread of 548 basis points above Treasuries and a coupon of 7.50%. We think AK Steel's 10-year note should price outside the U.S. Steel bond, considering the two-notch rating differential. With the average single B name in the Merrill Lynch High Yield Index yielding 7.65% (585 basis points above Treasuries), AK Steel's new deal may present some fairly good absolute value at an 8% yield.
However, relative value aside, we think the wide yield is indicative of the obvious near-term headwinds facing the industry and AK Steel's funding gap after last October's acquisition of Solar Fuel and joint venture with Magnetation. We downgraded AK Steel's issuer rating in November 2011, mostly driven by a tepid turnaround in its credit metrics and the near-term liquidity drain due to its latest vertical integration investments. The company spent $124 million in 2011 for the coal and iron ore assets and intends to spend another $50 million in 2012, which in the long term should be value accretive. Despite its effort in staggering the payment terms, we think the company headed into 2012 with an obvious funding gap and very tight headroom under its revolving facility. We expect its credit metrics to stabilize in 2012 as raw-material prices decline from 2011 levels. However, if the company fails to realize raw-material cost reduction in the near term and macroeconomic conditions become increasingly uncertain, we still see some downside risk. For investors seeking exposure to this industry, we'd recommend ArcelorMittal's (ticker: MT, rating: BBB-) 10-year bonds, which sport a speculative-grade yield in exchange for what we believe is an investment-grade risk profile. The steel giant's 6.25% notes due 2022 currently yield 5.89%, or nearly 380 basis points wide of the curve.
Bank of America's New Five-Year Notes Seem Rich (March 19)
Bank of America (ticker: BAC, rating: BBB) announced Monday that it is issuing new benchmark five-year notes. Whispers on price guidance are in the area of 285 basis points above Treasuries, which appears to be about a 15-basis-point concession to the existing five-year benchmark. From a credit perspective, we continue to take a skeptical view on Bank of America. Our rating reflects Morningstar's updated assessment of possible mortgage-related losses due to legal claims associated with past underwriting, as well as more conservative estimates around the extent and timing of the company's return to "normalized" earnings. Considering our rating, we think the price guidance on the five-year note is too rich, and we recommend investors look to Morgan Stanley's (ticker: MS, rating: BBB) new five-year benchmark also being issued Monday at about 80 basis points wider. If investors desire to stay with a true money center bank, then we recommend Citigroup (ticker: C, rating: A-), as you only lose 70 basis points of spread for two notches higher of rating.
Morgan Stanley's New Five-Year Notes Look Attractive (March 19)
Morgan Stanley (ticker: MS, rating: BBB) announced Monday that it is issuing new benchmark five-year notes. Whispers on price guidance are in the area of 365 basis points above Treasuries, which appears to be about a 10-basis-point concession to the existing five-year benchmark. For the rating, we think this deal is very attractive. Although Morgan Stanley is tied with Bank of America for our lowest rating of BBB for any of the large six banks, it trades about 70 basis points wider. From a credit perspective, we like where the business model is headed at Morgan Stanley. Its three primary businesses are institutional securities (investment banking, sales and trading, and corporate lending), global wealth management (brokerage and investment advisor services, including Morgan Stanley's 51% interest in Morgan Stanley Smith Barney), and asset management. About 50% of revenue is derived from institutional securities, 40% from global wealth management, and 10% from asset management. We like the viability of the business model, as the diversified revenue stream should help alleviate problems during business cycles. We give Morgan Stanley a BBB rating mostly because of its lower tangible equity/tangible assets ratio, which we look for the company to improve over the coming quarters. We think this deal makes sense all the way down to a spread of 340 basis points above Treasuries.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.