Investors Put the Economy Back Under the Microscope
Following a lackluster job report, we expect a significant amount of confusion in the markets over the next few days as investors reassess the strength and direction of economic growth.
The nonfarm payroll number, released last Friday, was a huge miss compared with expectations. Consensus expectations were for a gain of slightly more than 200,000 in March, but the Bureau of Labor Statistics reported a gain of only 120,000. This was significantly below even the most pessimistic forecast. A flight to the safety of U.S. Treasury bonds was evident during the abbreviated trading session Friday, as interest rates on 10-year Treasury bonds declined 13 basis points to 2.05% and are 17 basis points tighter compared with the prior week. The equity markets were closed Friday, but the S&P 500 futures reportedly dropped 1.1% to 1,375. Earlier in the week, the Morningstar Corporate Bond Index had widened out 2 basis points to +184 by the close of trading Thursday. However, we expect spreads will widen first thing Monday as investors look to reduce risk.
We expect a significant amount of confusion in the markets over the next few days as investors reassess the strength and direction of economic growth. Although the employment report was significantly lower than expectations, it may not necessarily portend a general economic slowdown, as favorable weather conditions earlier in the year may have pulled forward seasonal job growth. Average payroll growth between December and February was a healthy 246,000. Investors may also begin to second-guess many of the other economic indicators that have been released over the past few weeks. Generally, these metrics have indicated slow but steady progress, but they have often been softer than consensus estimates.
The Federal Reserve has also given the market mixed signals over the past two weeks. Chairman Ben Bernanke gave a speech March 26 in which he had specifically intimated that the Fed would step in with additional easing measures if job growth faltered. At that time, there was speculation that he may have had advance knowledge that the payroll number might be soft and that he was providing the market with comfort that the Fed would provide additional accommodation if growth slowed. However, the Federal Open Market Committee minutes from the March meeting, released last Tuesday, seemed to indicate that the economy was growing more strongly than the Fed had expected and implied that they were not considering any near-term easing.
The traditional start of earnings season begins Tuesday after the market close, with Alcoa (AA) reporting its first quarter. While our equity analysts generally expect earnings this quarter to be in line with expectations, the market will be paying especially close attention to any guidance that management teams provide.
In addition to the concern that the U.S. economy may not be growing as quickly as investors hoped, a few cracks in Europe's progress in containing the sovereign debt crisis began to appear. The spread on Spanish 10-year bonds over German bonds widened 46 basis points last week to +402, resulting in a yield of 5.76%. The spread on Italian 10-year bonds widened 40 basis points to +372, resulting in a yield of 5.45%. While these yields are not yet at the point where we think the European sovereign debt crisis re-emerges, the pace of widening last week picked up steam and is very concerning. If either bond breaches the 6% level and respective credit curves begin to flatten, renewed headline risk out of Europe would probably cause us to re-evaluate our outlook for continued corporate credit tightening.
New Issue Commentary
A few issuers tapped the market early in the week, but the total volume was minimal compared with the deluge of the past few weeks. We expect it will take a few days this week before the market fully digests the implications of the employment report and that bankers will recommend to clients to hold off pricing any new bond deals until later in the week.
We Think Actuant's New Senior Notes Will Look Attractive (April 2)
Actuant (ticker: ATU, rating: BBB-) plans to issue $250 million of 10-year, noncall 5-year senior notes, with the proceeds expected to fund the tender offer of its $250 million 6.875% senior notes due 2017. The company is offering to purchase the 6.875% notes at a price of 104.216, slightly above the June 15, 2012, call price of 103.438. In addition to the tender offer, the company announced last week that it intends to redeem the remaining $118 million of its 2% senior subordinated convertible notes due 2023. Given that the converts are substantially in the money, we expect holders to opt to convert to shares, thus reducing total debt outstanding. For the 12 months ended Feb. 29, total debt/EBITDA was 1.9 times. Pro forma for the above transactions, TD/EBITDA is expected to decline to 1.5 times, although we expect the company to remain acquisitive and would expect leverage to gradually increase over time.
Our investment-grade rating on Actuant is one notch higher than Moody's and S&P, which rate the company below investment grade, although they both recently upgraded their ratings by one notch, moving closer to the Morningstar rating. The new senior notes will be subordinated to a $100 million secured term loan and a $600 million secured revolver (roughly $60 million outstanding). As such, we would expect these new notes to price around a 5.75% yield, equating to a spread of about 350 basis points over Treasuries. At that level, we think the bonds offer value relative to our rating as well as comps, such as SPX Corporation (ticker: SPW), which we rate one notch lower at BB+. SPX has a 6.875% bond due 2017, which recently traded at a yield of 4.75% and a spread of 360 basis points over Treasuries. Adjusting for the one-notch rating differential as well as the longer tenor of the new Actuant note, we would place fair value for a new 10-year Actuant note in the area of 5.25%.
Actuant is composed of seemingly unrelated businesses, glued together with deep distribution networks and a strong Asian sourcing group. These strategic assets give Actuant the ability to develop and deliver its products at a lower cost than others in the industry, contributing to its narrow economic moat. Coupling this cost advantage with broad diversification across customers, product lines, and geographies has allowed Actuant to grow profitably in the face of competition and market cyclicality. A key part of Actuant's growth strategy has been acquiring smaller companies that can be easily deployed to supplement its core industrial business. Acquisitions provide the firm with broadened product offerings and increased cross-selling opportunities, while the newly acquired firms benefit from Actuant's scale and distribution network. Actuant's lean manufacturing techniques also help improve the acquisition target's profitability and working capital management.
Daimler North American Finance to Issue Three- and Five-Year Bonds and Two-Year Floaters (April 2)
Daimler (ticker: DDAIF, rating: BBB+) subsidiary Daimler North American Finance is in the market once again with a multitranche benchmark bond offering. We view Daimler's finance subsidiaries as similar credits to the parent, given the inextricable link between the two and the guarantees in place. We also view Daimler as a slightly weaker credit to Volkswagen (ticker: VOW, rating: A-). As such, we would expect a concession to Volkswagen's trading levels. Volkswagen Finance issued five-year bonds in March at a spread of 133 basis points above Treasuries, and these bonds are currently indicated at about 121 basis points above Treasuries. We view this as fair value, and thus would view fair value on the Daimler's new five- and three-year bonds at about 140 and 125 basis points above Treasuries, respectively. We also note that fairly valued Honda (ticker: HMC, rating: A) subsidiary American Honda Finance has 2016 maturity bonds indicated at about 103 basis points above Treasuries. We continue to prefer Ford Motor Credit (BBB-), which has six-year bonds indicated at about 300 basis points above Treasuries.
We Recommend Avoiding Hartford's New 5-, 10-, and 30-Year Notes (April 2)
We are hearing that Hartford (ticker: HIG, rating: BBB-) is in the market Monday with 5-, 10-, and 30-year notes. In conjunction with this debt offering, Hartford announced that it will repurchase all outstanding 10% fixed-to-floating-rate junior subordinated debentures due 2068 and outstanding warrants from Allianz for about $2.425 billion of consideration. It should be noted that the repurchase of these debentures is contingent on being able to terminate a related capital covenant on the outstanding 6.10% senior notes due 2041. The moves announced Monday are part of a larger restructuring at Hartford, driven by pressure from activist shareholder John Paulson of Paulson & Co. The company plans to exit most of its life insurance businesses and refocus on its higher-return segments. Hartford plans to place its individual annuity business into runoff beginning in late April while seeking a sale or other strategic alternatives for its individual life, Woodbury Financial Services, and retirement plan businesses. The new Hartford will focus on its property and casualty, group benefits, and mutual fund businesses. Paulson has argued that the company's shares are mispriced by the market because of the complexity and unusual nature of having both life and property and casualty insurance under one roof.
We have not heard any information on pricing yet, but Hartford's current 10-year trades with a spread above the Treasury curve of 265 basis points and its 30-year trades with a spread of 320 basis points above the curve. These are both senior notes, and we expect any newly issued senior notes would come with a spread 10-15 basis points wider. At those levels, it would be hard to recommend Hartford's bonds. The company is going through major restructurings and is in a serious battle with Paulson. While it is very possible that bondholders might be better off as some of the company's leverage might be reduced in the long run, there are no guarantees. For those looking to invest in the insurance industry, we recommend ACE (ticker: ACE, rating: A-). Although its spread is about 140 basis points tighter, the three-notch rating improvement is a nice place to stay until the smoke clears at Hartford.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.