Economic Roller Coaster Takes Credit Spreads Back to Where They Started
Things look great in the rearview mirror, but the windshield is becoming increasingly foggy.
As we make our way through earnings season, reports have been generally in line with expectations and management teams have mostly reiterated their guidance for the year. However, the economic reports that have been released over the past few weeks have taken investors on a wild roller coaster ride.
At the beginning of last week, regional economic reports such as the Chicago PMI fell further than economists expected. But the next day, the national ISM manufacturing report significantly surpassed expectations, bolstering investor hopes that the U.S. economy was holding up despite the European slowdown. In fact, not only did ISM come in higher than expected, it rose from last month, whereas economists had been expecting a fall. On Wednesday, the ADP payroll report was significantly below consensus, tempering the high hopes for strong employment growth. Investors cheered jobless claims Thursday, which fell further and faster than anyone had expected. On Friday, however, the employment situation sapped any remaining hope from the market.
Through these peaks and valleys, as it became increasingly harder to discern the economic trend, credit traders were unwilling to commit in either direction. Credit spreads stayed in a relatively tight trading band throughout the week and ended up right back where they started. The average spread of Morningstar's Corporate Bond Index was unchanged at +192, and the European Corporate Bond Index held steady at +223. Each time it appeared that credit spreads were attempting to move wider, we saw a rush to buy strong single A bonds on the dips; however, there was no follow-through to the upside as investors would not chase the spreads tighter when the economic news was positive. This highlights to us the lack of conviction in the strength of the economy, yet tells us that there is a strong technical bid for paper as many portfolio managers continue to receive cash inflows that need to be put to work.
We Remain Neutral on Corporate Credit Risk Exposure
Since we moved to a neutral view on corporate credit risk exposure April 9, the average spread in the Morningstar Corporate Bond Index is unchanged. Corporate earnings and credit fundamentals are stable to slightly improving; however, until we gain additional clarity into the impact on corporate risk because of the recessions in many European nations and the slowdown in emerging markets, we believe a neutral stance in corporate bonds is warranted.
If the situation in Europe deteriorates, the emerging markets descend into a hard landing, or growth in the United States dwindles, then the contagion from heightened credit risk will hurt the corporate bond markets and spreads will widen across the board. However, if we gain additional visibility that these issues are alleviated, then we think corporate credit spreads will resume their tightening trend as stable corporate fundamentals and positive technicals provide greater demand for corporate bonds.
French Presidential Election Could Have Global Implications
On Sunday, socialist candidate Francois Hollande won the French presidential election against incumbent Nicolas Sarkozy. This heightens political risk in the eurozone, specifically between France and Germany. Hollande has been very critical of the European Union's response to the sovereign debt crisis, made numerous statements questioning the role of the European Central Bank, and voiced his desire to renegotiate France's financial support for the sovereign rescue funds. Under his leadership, we may see a re-emergence of political volatility in the eurozone member nations.
While there have been disagreements as to the specifics of the actions taken to alleviate the sovereign debt crisis, member nations have been working in good faith to keep the EU together. However, if Hollande tries to renegotiate many of the pacts that France agreed to under Sarkozy's tenure, we think it could undermine many of the accords that have already been established, amplify the political tension between the policymakers and ECB, and upset the political relations among many of the other members in the EU. Any one of these disruptions would probably unnerve investors.
While the political risk in France may be poised to flare up, the sovereign bond market in Europe continued to improve as the yield on Spain's 10-year bonds dropped 15 basis points last week to 5.73% and the yield on Italy's 10-year bond dropped about 20 basis points to 5.43%. As long as the yields on Spanish and Italian bonds stay contained, those countries may have enough time to implement the structural changes needed to place both on sound footing and lead them back to economic expansion.
Further Signs of Global Economic Slowdown
Australia cut its short-term interest rates 50 basis points to 3.75%, which brings the rate to its lowest level in two years. This is the third cut in the overnight borrowing rate since late 2011. This follows interest rate cuts in several emerging markets over the past few weeks, such as Brazil and India. Economic indicators are just as confusing overseas as they are in the U.S. China's official PMI report rose to 53.3, indicating that the economy continues to expand, albeit at a rate slower than consensus expectations. However, this contrasts with HSBC's China PMI Index, which at 49.1 in April indicates that the Chinese economy is contracting. HSBC's China PMI report has been below 50 since last June.
New Issue Commentary
ABB Finance's New Issue Looks Attractive (May 3)
ABB (ticker: ABB, rating: A), a Switzerland-based provider of power and automation products and systems, plans to issue benchmark 5-, 10-, and 30-year debt from its ABB Finance (USA) subsidiary. Proceeds are expected to be used to round out financing for the pending Thomas & Betts (ticker: TNB) acquisition, which is expected to close by the end of the second quarter. The new bonds will carry a guarantee from ABB Ltd., the parent company. ABB currently has two dollar-denominated bonds outstanding, with 2016 and 2021 maturities. These bonds were issued from ABB Treasury Center (USA) and currently benefit from a keep-well agreement, but not a parent guarantee. Importantly, the company announced in its first-quarter press release that it intends to provide a parent guarantee for these existing bonds, which should result in pari passu treatment for all the bonds.
The existing bonds were recently quoted at attractive levels for an A rated diversified industrial credit, with the 2016 bonds at a spread of 128 basis points over Treasuries and the 2021 bonds at a spread of close to 170 basis points over Treasuries. We think these spreads could tighten meaningfully once the impact of the parent guarantee is fully reflected in the market. Whisper talk on the new bonds is also attractive, at a mid-100s spread for the 10-year, with the 5-year 25 basis points tighter and the 30-year roughly 30 basis points wider. For comparison purposes, within diversified industrials, United Technologies (ticker: UTX, rating: A) has a 2020 bond that was recently quoted around a spread of 80 basis points over Treasuries, which we view as fairly valued. Honeywell (ticker: HON, rating: A) has a 2021 maturity that was quoted closer to 65 basis points, which we view as rich. Given our similar rating, we think fair value for the new 10-year ABB bond should be closer to UTX levels.
Our credit rating reflects ABB's strong financial position, including cash in excess of debt, as well as its size and entrenched position in the power generation market. While the latter supports our view that ABB possesses a narrow economic moat, our Business Risk score also considers the firm's inherent cyclicality. In January, ABB announced an agreement to acquire Thomas & Betts for $72 per share, or $3.9 billion, valuing the target at around 10.4 times 2011 EBITDA. ABB made it clear that penetrating North America was a major objective, and through the Baldor and now Thomas & Betts transactions, the company has adequately addressed what used to be a portfolio gap. Thomas & Betts' strong distributor network and niche electrical equipment should be a boon to ABB with a strengthening North American construction and utility infrastructure market. ABB expects total cost and revenue synergies to reach $200 million by 2016. Assuming the transaction is ultimately financed with $3.0 billion of incremental debt and the remainder with cash, we estimate pro forma TD/EBITDA will increase to 1.2 times from 0.7 times at the end of 2011, reasonable for our A rating.
U.S. Bank Prices Another Tight Deal (May 3)
U.S. Bank (ticker: USB, rating: A+) announced that it is issuing new benchmark 5-year notes. Whisper on price guidance is in the area of 90 basis points above Treasuries, which appears to be about a 10-basis-point concession to the existing 5-year benchmark. From a credit perspective, we are very positive on the name. Our A+ rating reflects the company's diversified revenue stream and wide economic moat. In addition to a highly profitable banking business benefiting from a low-cost deposit base, U.S. Bancorp has two businesses that generate stable high returns with little capital employed: wealth management and payment processing. These fee-based businesses are highly scalable and account for more than 30% of the company's revenue. Traditional consumer and wholesale banking represent more than 50% of revenue, and the bank's prudent underwriting practices are now resulting in lower-than-peer net charge-off rates.
While investors would receive a discount from the existing notes, the overall spread level for our ratings is not attractive. Wells Fargo (ticker: WFC, rating: A+) recently issued a 5-year deal, and that note trades in the area of 125 basis points above Treasuries to the curve, for the same rating. However, U.S. Bank is a name that is usually hard to get, and that scarcity drives it spreads tighter than any comparable. Investors who need the diversity are going to have to hold their noses and buy.
Rumored Pricing Looks Attractive for Glaxo (May 2)
GlaxoSmithKline (ticker: GSK) announced plans to issue 3-, 5-, and 10-year notes Wednesday. In Glaxo's first U.S. dollar-denominated offering since 2008, we suspect investors will clamor to get their hands on this high-quality paper; we have issued Glaxo a AA- credit rating. Glaxo plans to use the proceeds for general corporate purposes, including existing debt repayment and acquisitions, such as the recent offer for Human Genome Sciences. We don't believe this new issuance or potential deal will change our credit rating on Glaxo. Early rumors on pricing could make these new issues even more attractive to investors, in our opinion. Currently, we're seeing potential spreads to Treasuries of +70 for the 3-year notes, +90 for the 5-years, and +115 for the 10-years. At those levels, we'd view those notes as trading about where we'd expect for an issuer with an A rating, or two notches lower than where we rate Glaxo and one notch below where the agencies rate it. For example, if those prices hold up, investors could get over 20 basis points more in spread on the 10-year notes than we'd deem fair. We'd find those rumored spreads attractive.
While holding a bit more leverage and shoveling out more in dividends than some of its large pharmaceutical peers, we still believe Glaxo remains a very low-risk issuer. Our rating mostly reflects our positive view of Glaxo's business quality where we think Glaxo boasts a wide moat. Like most large pharmaceutical firms, that moat is based on existing, patent-protected products and the firm's ability to reinvent itself in the long run through internal development and external means. We believe Glaxo's vast resources have created multiple opportunities for new blockbuster drugs. For example, the company is riding strong tailwinds from 2011 (approval for Benlysta for lupus and Trobalt/Potiga for epilepsy). Further, the company is off to a strong start in 2012 with the positive EU recommendation for Nimenrix (AWCY meningitis vaccine) in February. Also, while the first of eight Phase III studies with Syncria (weekly glucagon-like peptide diabetes treatment) failed to show noninferiority to Victoza (daily), we expect further data that will support the drug's approval in 2013. Additionally, even though Relovair (the potential replacement for Advair) reported disappointing data in early January (a fatal pneumonia side effect and a lack of superiority to Advair in some chronic obstructive pulmonary disease and asthma studies), Glaxo nonetheless increased its ownership to 27% (from 18%) in Theravance (a partner on Relovair), which we believe shows its confidence in the drug.
We Expect a Fair New Issue Offering From WellPoint (May 2)
Following Aetna's (ticker: AET) $500 million note issuance Tuesday (see below), WellPoint (ticker: WLP) announced plans to price 10-year and 30-year debt on Wednesday for general corporate purposes, including debt repayment. We rate WellPoint A- compared with BBB+ for Aetna based on the greater scale WellPoint possesses at a regional level in the managed-care business, which results in more negotiating power with local caregivers for WellPoint, compared with Aetna's more fragmented presence and influence across the nation. However, the agencies make no differentiation between the two entities, making Aetna's 30-year notes direct comparables to WellPoint's planned 30-year issue in the marketplace. Aetna issued $250 million in 30-year notes at a spread of 160 basis points wider than Treasuries on Tuesday. We'd expect similar pricing on WellPoint's 30-year notes. While we think the risk/reward opportunity at WellPoint would be better than at Aetna given our differentiated ratings, we'd still find an offering at this level to be only fair, rather than attractive, for WellPoint. For the 10-year note, we think the average spread to Treasury of about 135 basis points on an A- rated firm's issue would be about fair for WellPoint's new issue, as well.
Investors may want to look elsewhere for better values in managed care. For example, our favorite managed-care firm in terms of bond valuation remains Amerigroup (ticker: AGP). We rate the firm BBB-, but the agencies rate it below investment grade. Amerigroup's recently issued 2019 notes offer a spread around 468 basis points wider than Treasuries, which is nearly 200 basis points wider than we deem fair, and 300 basis points wider than Cigna, another BBB- rated managed-care firm on our coverage list. Also, Amerigroup remains one of the top M&A targets in the health-care industry, and we believe likely acquirers would be other managed-care organizations with better credit profiles than Amerigroup. Therefore, should expected suitors make an offer for Amerigroup, we could see tightening in its notes.
Aetna Plans to Issue New Notes (May 1)
Aetna plans to issue $500 million in 5- and 30-year notes. We currently rate Aetna BBB+ and don't anticipate changing our credit rating due to this news. The firm plans to use the proceeds to fund general corporate purposes, including repayment of existing short-term debt issues. In general, we view trading in Aetna's notes as too tight for the risk. We take a differentiated view than the agencies, which rate Aetna a notch higher than us, primarily because we view scale at the local level as the key determinant of competitive advantage in managed care rather than overall size, on which we believe the agencies focus too heavily. So although Aetna is the third-largest firm in the United States by medical members, its members are spread throughout the country, and it typically doesn't garner enough scale in a particular geographic region to exert much pressure on local care providers. Also, Aetna's customer mix is skewed toward large employers, which can hurt its bargaining power on customer contracts as well.
With that as background, we think the market is anchoring on the agencies' size-biased ratings, which don't compensate Aetna investors enough for the risk, in our opinion. For example, the average BBB+ rated firm's 10-year maturity traded at 184 basis points wider than Treasuries while Aetna's 2021 issue recently only traded at 125 basis points wider than Treasuries, closer to the where the 10-years of the average A- rated firm traded. We'd expect similarly tight spreads on Aetna's 5- and 30-year new issues, adjusted for duration. Initial pricing rumors suggest the 5-year notes will come to market around 125 basis points wider than Treasuries and the 30-year notes will come to market around 175 basis points wider than Treasuries. We'd view these spreads as too tight for the risk.
Colgate Selling $500 Million of New 10-Year Notes (April 30)
Colgate-Palmolive (ticker: CL, rating: AA) is reportedly in the market to issue $500 million of 10-year notes. The firm's existing 2.45% senior notes due 2021 were last trading around 60 basis points above Treasuries, an approximate 2.50% yield. Based on the firm's high credit quality (our AA rating is one notch higher than the rating agencies) and strong brand name, we expect the new notes will be heavily subscribed and price with very little concession to the existing notes. We think Colgate's existing bonds are fairly valued, as they currently trade slightly tighter than equivalently rated bonds, and the bonds will move in line with the market. As a comparison, Colgate's much larger peer Procter & Gamble's (ticker: PG, rating: AA) 2.30% senior notes due 2022 trade at 50 basis points above Treasuries, about 10 basis points tighter than Colgate's existing bonds. Considering Procter is rated AA by both rating agencies, where the rating agencies rate Colgate AA-, it seems appropriate for Procter to trade slightly tighter than Colgate. Kimberly-Clark's (ticker: KMB, rating: A+) 2.40% senior notes due 2022 were indicated around the 65 basis points above Treasuries area, about 5 basis points wider than Colgate.
Within the consumer product sector, we think Clorox (ticker: CLX, rating: A-) is a better value for the credit risk. Clorox's 3.80% senior notes due 2021 trade at about 150 basis points above Treasuries, which is 15 basis points wide of the A- component of Morningstar's Corporate Bond Index; we would expect a consumer defensive name such as Clorox to trade tighter than the equivalently rated index.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.