Skip to Content
Quarter-End Insights

Credit Outlook: Sector Updates and Top Bond Picks

Get our sector-by-sector take on the bond market, plus our five best bond ideas.

Mentioned: , , , , , , , , ,

<< Our Outlook for the Credit Markets

Banks
For the past several quarters, we've correctly predicted that concerns out of Europe would be the overriding theme for large U.S. banks, and that large U.S. bank credit spreads would remain volatile. Our outlook for next quarter remains the same. European sovereign debt fears continue to strengthen, as do the fears of a potential European banking crisis. In fact, our outlook for European financials has deteriorated, duly reflected in our recent downgrade of six European banks, based mostly in Italy and Spain. This downgrade was driven by our use of a probability-weighted rating methodology, where we estimate an approximate 30% probability of either Spain or Italy defaulting or restructuring in the next five years. This probability was calculated using market-based debt spreads, as well as our own analysis. While we expect that large U.S banks will be able to weather a European storm--thanks to their much improved capital levels--they certainly will be negatively affected. Also looming over the sector is the possibility that a European bank default would result in disastrous consequences for a large U.S. bank due to poor risk controls. While we think this possibility is limited,  J.P. Morgan's (JPM, rating: A) recent multibillion dollar loss on its credit derivatives trades does not inspire confidence that U.S. banks have dramatically improved their risk controls since the 2008 financial crisis.

For U.S. regional banks, we expect the trend of improving credit metrics to continue, as banks lower their percentage of nonperforming assets and build capital. However, we expect operating results to dampen due to further net-interest-margin compression, as the flattening yield curve persists. From a credit perspective, regional banks' improving balance sheets will override the dampening of operating results. Credit spreads for regional banks have been relatively stable for the past several quarters. Also, regional bank credit spreads have been trading approximately 80 basis points tighter, on an equivalent ratings basis, as compared to large U.S banks. We expect regional bank credit spreads to remain relatively stable, and we expect their comparatively lower spreads to stay the same or improve, as the market correctly perceives U.S. regional banks to have limited exposure to Europe.

Contributed by Jim Leonard

Basic Materials
The mood in the basic materials bond market was quite subdued, as readings from China weakened meaningfully in the last quarter. We did not see much dollar-denominated new issuance in the sector.  Existing bonds failed to hold on to the gains achieved in the first quarter, as sentiment turns sour, and spreads slowly leaked out since May. In fact, option adjusted spreads of the investment-grade basic materials bonds widened an average of 46 basis points, while the entire high-grade corporate index widened roughly 32 basis points quarter-to-date, according to the Merrill Lynch Global Index. The widening underscores the high-beta nature of the underlying basic materials companies. For example,  ArcelorMittal's (MT, rating: BBB-) 2022 issue that came at a 313 spread-to-maturity in February hovered around 500 to 530 basis points since May, trading at significant discount compared to its BBB- industrial peers, with an average t-spread of 307 basis points. The poor performance of the MT bonds was driven by the headwinds facing the global steel industry, as well as the barrage of negative news emanating from Europe.

Mounting global macroeconomic weakness no doubt augurs ill for profits in the highly cyclical basic materials sector. But we'd argue it represents less of a threat to underlying credit quality for the moatworthy names on our coverage list. On this front, we'd suggest that the corporate bond market hasn't done a great job in distinguishing between the "moatworthy firms" that will continue to generate respectable profits--even amid less buoyant end-market conditions--and those for whom a sustained period of weakness represents a true existential threat.

Consider, for example, the case of  Southern Copper (SCCO, rating: BBB+), whose bonds have taken a pounding in the past few months as copper prices plunged from $3.93/lb to begin the second quarter, down to the $3.30 to $3.40/lb range in the past couple weeks. To be sure, Southern Copper is prospectively less profitable than it had been before. But as the lowest-cost major producer in the world (unit cash costs have averaged $0.20/lb over the past five years), even a retreat in copper prices to below $3.00/lb wouldn't materially diminish the firm's ability to generate ample free cash flows. And yet we've seen spreads on Southern Copper debt widen just as much as spreads on bonds issued by decidedly less advantaged producers.

To the extent the third quarter brings another batch of disappointing macroeconomic data, basic materials bonds are bound to weaken more than most (bad numbers out of China would be particularly troubling for the most of the sector). We'd suggest investors take such a development as an opportunity to buy bonds of companies like Southern Copper that boast the competitive positioning to weather a sharp and sustained slump in end-market conditions, particularly if the market continues to lump them in with the rest of the bunch.

Contributed by Dan Rohr and Min Tang-Varner

Consumer Cyclical
During the third quarter, we expect that the bonds within consumer cyclical sector will perform in line with the general credit market. Our underlying thesis within the sector calls for a relatively slow, and at times, volatile, economic recovery in the U.S. Consumer cyclical companies have generally posted stronger-than-expected sales, margins and earnings in the first half of 2012. We see some reasons for further optimism, including the drop in unemployment, the rebound in manufacturing and service sectors, lower gasoline prices, and normalizing levels of inflation. We are maintaining our cautious optimism, as slower business spending, contagion from Europe, uninspiring consumer confidence levels, and a wildcard political environment have created a choppy economic outlook.

For the second half of 2012, we anticipate a mild deceleration in sales, as much of our coverage faces more difficult year-over-year comparisons. However, comparable stores sales growth should, in aggregate, remain within our mid-single digit forecast range. We are projecting steady, if not expanding, operating margins, as fixed-cost leverage and the reversal of last year's commodity cost headwinds flow through the income statement later this year. High-end consumers--a relatively narrow group--remain a driving force behind the U.S. economic recovery. We find this somewhat unsettling, since this segment tends to take their spending cues from equity and other asset market gains. These are individuals who don't spend if they don't want to, and if the mood of these big spenders were to become more cautious, the tone of economic sentiment could rapidly change. On average, we forecast that cash will represent approximately 20% of total assets for our consumer cyclical coverage universe at the end of 2012, which we believe is an all-time high. However, the equity market is not willing to reward companies for sitting on cash, and we expect an increasing number of companies with high cash balances to announce dividend increases and/or expanded share repurchase programs in the second half of the year.

Contributed by Dave Sekera

Consumer Defensive
We continue to expect that the consumer defensive sector will provide bond investors a safe port in the storm to weather the European debt crisis. As the European saga plays itself out, issuers within this sector will outperform to the downside if the crisis worsens, and will hold their value if the EU policymakers are able to enact the structural reforms needed to slog through. We expect that credit metrics in this sector will generally remain steady, but we could see slight improvement in many instances during the third quarter. Input cost inflation has dramatically slowed, and should allow many consumer products companies to expand their gross margins as price increases continue to roll out.

However, we recommend that investors favor bonds of domestic issuers as opposed to European issuers. As several European economies have entered recessions and others appear to be heading in that direction, issuers in those countries will be more adversely impacted than those in the U.S. For example,  Danone (BN, rating: BBB+) recently lowered its adjusted operating margin forecast for fiscal 2012 by 50 basis points. The company cited deteriorating consumption in Southern Europe (particularly Spain) as one of the reasons for its lowered guidance. In addition to lower consumption, we are also seeing a pronounced shift to lower-priced, private label goods in Europe. This shift will lower gross margins further, as firms increase investments behind their brands to stem share losses.

One issuer whose credit quality we expect will weather the storm unscathed is  Anheuser-Busch InBev (BUD, rating: A-). We recently upgraded our issuer credit rating, as integration between Anheuser-Busch and InBev is complete, and the firm has captured the preponderance of the synergies it expected to achieve. Since leveraging the balance sheet of the combined entity when InBev purchased Anheuser-Busch, ABInBev has done an admirable job of selling noncore assets, and using cash flow to repay debt. The firm has pledged to reduce net leverage to 2 times, and we project it will reach this goal before the end of 2012. As of fiscal 2011, total leverage has declined to 2.7 times, the debt/capital ratio has declined to 0.52, and EBITDA covered interest expense by 4.8 times. For fiscal 2012, we project total leverage will decline to 2.1 times (with net leverage declining below 2 times), debt/capital will decline to 0.46, and interest coverage will improve to 8.7 times. Now that management is within striking distance of reaching its debt leverage goal, we expect management will utilize cash flow to increase the dividend, repurchase stock, and make further tuck-in acquisitions.

Contributed by Dave Sekera

Energy
As the U.S. production surge from unconventional oil and natural gas plays continued, the demand picture from both Europe and China became muddled, resulting in a roughly 20% decline in oil and natural gas prices during the second quarter. Bond investors responded to the commodity price action by demanding a higher risk premium, as spreads on energy debt moved toward the wide end of their range for the quarter. As oil prices began to fall in earnest, but before the mounting global economic challenges were reflected in bond spreads, companies opportunistically took advantage of the still-open new issue market. During a frenzied two-week span in early May, energy companies issued $10 billion of new debt across investment grade and high yield (roughly 40% of total sector issuance this quarter.)

Looking forward, our chief concerns about credit metric deterioration are focused on companies with fixed capital expenditure budgets and the more leveraged exploration and production companies that have shifted drilling budgets to chase higher profits in natural gas liquids (NGLs). The credit metrics of dry gas-focused E&Ps will remain a concern if natural gas prices are further pressured, or if low prices persist through 2013.

We currently project natural gas and liquids focused  EOG Resources (EOG, rating: A) to be moderately free cash flow negative from 2012 through 2014 due to its drilling program. Although spreads widened about 25 basis points in the second quarter, it is only now in line with the Morningstar A index. As the supply glut of NGLs builds and price declines continue, EOG could experience further widening, as only a modest portion of production is hedged, and 28% of EOG's capital structure matures in next three years.

In the oil field service space,  Rowan (RDC, rating: BBB-) bonds have recently outperformed peers, and trade in line with the Morningstar BBB- index, but the company recently committed $2 billion to buy three new-build deepwater drilling rigs. Rowan is new to the deepwater market, and has yet to sign drilling contracts for its rigs. With the first delivery scheduled for late 2013, Rowan's ability to de-lever its balance sheet will be in question if future deepwater rig demand does not meet current high expectations. On the opportunity side,  Cameron International's (CAM, rating: A-) recent spread widening looks overdone on a relative basis. Cameron was one of May's opportunistic issuers, bringing a total of $500 million of debt to market at attractive rates. Proceeds funded an acquisition and termed out certain credit facilities. With its improved capital structure and its Macondo-driven strong order backlog, Cameron 2022 notes look cheap compared to the Morningstar A- index.

Contributed by David Schivell

Health Care
Next quarter, we suspect regulatory issues and capital allocation practices will dominate credit headlines in health care. Specifically on the regulatory front, at the end of June, the Supreme Court plans to rule on the constitutionality of the PPACA law, which is reforming the U.S. health-care system. At our publishing deadline, the Court had yet to rule. However, from a credit perspective, its decision likely won't affect our credit ratings significantly. The Court has several questions to answer in reviewing the PPACA, and we see four possible directions the Court could take. It could strike down the entire law; it could strike down just the individual mandate and related insurance market regulations while upholding the rest of the law; it could uphold the entire law; or it could postpone judgment until after 2014. We think postponement could be the worst option for sentiment in the health-care industry for both investors and business leaders.

Also on the regulatory front, all eyes will be on the U.S. presidential election next quarter. If Republicans take back the White House, industry leaders may gain more hope of increasingly pro-business regulations in the future. For example, the House recently passed a bill repealing the medical device tax that is scheduled to be enacted in 2013 as part of the PPACA. Currently, President Obama is threatening a veto if the bill gets to his desk. We suspect a Republican president would be much more amenable to this repeal, which could boost the long-term earnings power at device firms we cover roughly 5% to 10%. Similar pro-business actions could emerge if a change of leadership is made in November.

From a capital allocation perspective, many well-heeled health-care firms have the problem of not being able to generate much income through typical investments. As such, they continue rewarding shareholders with increasing share repurchases and dividends, which is cutting into their debt repayment cushions. Also, with low-coupon debt readily available too, M&A activities will likely continue. For example, we expect DaVita to come to the bond market this quarter to fund its recently announced acquisition. Overall, while we don't expect these capital allocation activities to cause severe deterioration of credit quality in the industry, we continue to warn investors that they do create a negative fundamental bias in the industry, all else being equal.

Contributed by Julie Stralow

Industrials
During the second quarter, industrial spreads moved wider, stoked largely by fresh concerns out of Europe. Spreads will likely remain under pressure until we see some sustained progress on that front.

Across the key subsectors that we follow, we're still generally positive regarding the outlook for the diversified industrial sector, although credits with significant European exposure could face meaningful headwinds over the near term. Notable during the quarter was the $9.8 billion mega new issuance from  United Technologies (UTX, rating: A) to help fund its pending acquisition of Goodrich. The deal was launched with close to $40 billion of investor demand, and performed well on the break, highlighting the depth of the market for high-quality issuers.

Our outlook for rails also remains positive. First quarter earnings were generally strong, as all Class I rails registered improved operating ratios. However, low natural gas prices adversely impacted utility coal demand, a trend that will likely continue over the near term. Although spreads across the sector remain relatively tight, within the sector we like the bonds of  Union Pacific (UNP, rating: A-) given its exposure to cheaper Powder River Basin coal, and the roughly 40-basis-point spread premium available relative to comparably rated  Canadian National (CNI, rating: A-).

In the agricultural and construction equipment space, fundamentals have improved out of the downturn, although slower growth is anticipated in the emerging markets, and leverage has ticked higher for several names due to debt-financed acquisition activity. We generally view the sector as fairly valued at this time, although we like the bonds of  AGCO (AGCO, rating: BBB-), given its relatively wide spreads for what we view as investment grade risk. 

The big move in the auto sector during the quarter was  Ford's (F, rating: BBB-) shift into the investment grade indices and out of high-yield territory, following upgrades from both Fitch and Moody's. We've rated the credit investment grade since late 2010. Ford's intermediate-term bonds were generally flat during the quarter on a spread basis, but significantly outperformed the market, which saw spreads move wider. We now view Ford as fairly valued, down from our prior overweight rating, although our expectations of a robust North American auto sector could result in further credit improvement.

We expect the housing and building materials sectors to continue to emerge from the depths of the recession, and like the bonds of  Owens-Corning (OC, rating: BBB) and USG (USG, rating: B-).

Finally, we remain cautious on the defense sector as we approach the fiscal cliff and elections in the fall.

Contributed by Jeff Cannon and Rick Tauber

Technology & Telecommunications
Large-cap tech firms have taken it on the chin of late, as a handful of off-cycle firms, including  Cisco (CSCO, rating: AA),  Dell (DELL, rating: A+), and  Hewlett-Packard (HPQ, rating: A), have provided lukewarm or downright dour outlooks for the second half of 2012. Such pessimism is largely the outgrowth of the European debt crisis and the resulting weakness in public sector spending. Credit spreads across much of the tech sector have widened out considerably over the past quarter, providing some buying opportunities. We would focus on those firms that have been most maligned, but that possess solid competitive positioning to prosper once the current environment passes. HP is at the top of our list. Spreads on the firm's 4.05% notes due 2022 have widened from around 190 basis points over Treasuries at the end of March, to around 250 basis points over Treasuries, currently. While sales and margins have remained under pressure, we’ve seen some signs of stability and, more importantly, HP management has started to make good on its promise to repair the balance sheet. We expect the firm's focus on its current businesses, especially services, will continue to stabilize cash flow while debt repayment takes priority over share repurchases.

We're also seeing value among firms that don't face HP's balance sheet and execution issues. Cisco's 4.45% notes due 2020, for example, are trading around their widest point of the year, at about 114 basis points over Treasuries. The bonds have moved from a few basis points tighter than the AA bucket within the Morningstar Corporate Bond Index to about 20 basis points wide. We don't believe the European situation will have a lasting impact on Cisco, and we continue to like the moves the firm has made over the past year or so to refocus on those areas where it possesses the strongest competitive advantages.

The semiconductor equipment market has been largely immune to the troubles in Europe. The rising popularity of smartphones has been driving demand for state-of-the-art chips, which has produced shortages of cutting-edge, 28-nanometer (circuit size) production capacity. We expect foundries to increase capital spending in the coming months, which should benefit semiconductor equipment firms such as  KLA-Tencor (KLAC, rating: A+) and  Applied Materials (AMAT, rating: AA-). Despite this outlook, spreads on KLA's 6.9% notes due 2018, a fixture on our investment grade best ideas list, have moved wider over the past couple months, to around 230 basis points over Treasuries, a very attractive level, in our view.  

Contributed by Mike Hodel

Utilities
Two relatively new environmental regulations continue to cloud the sector's near-term landscape. Coal plant retirements and increased capital investment are two likely outcomes we expect from the EPA's Cross-State Air Pollution Rule (CSAPR) and the Air Toxics Rule, both finalized in 2011. Additional environmental rules could follow in 2012-2013, addressing water cooling and coal ash disposal. All of these likely will raise costs for consumers, and put more rate pressure on utilities.

Despite environmental compliance risks, we view domestic utilities as a defensive safe haven for investors who are skittish about near-term European-induced market volatility. As European sovereign uncertainties begin to fade, we expect spread contraction to occur, particularly down the credit quality spectrum. However, given already tight spreads on higher-quality issuers that face lackluster earnings growth and the prospect of falling allowed return on equity, or ROE, we urge bond investors to approach investment-grade utilities with caution while focusing on a longer duration yield orientation.

We expect high-quality utility issuers to remain active in the debt markets as they continue to take advantage of low rates to refinance and prefinance up to $80 billion of projected 2012 capital investments. Environmental capital expenditures will be a significant component of debt-funded capital expenditures, although also highly dependent on the severity of ongoing regulatory rulings, implementation timelines, and energy efficiency initiatives. Utilities are eager to secure financing ahead of potential allowed ROE cuts, as regulators align their outlook with a sustained lower interest rate environment. Already this year, several state regulators have approved or proposed allowed ROEs below 10%, limiting creditors' margins of safety as this regulatory lag diminishes.

Unregulated independent power producers face high uncertainty during the next quarter, and through 2012. As long as natural gas prices remain low, power prices will remain severely strained. Excess natural gas supply and an unseasonably warm winter have pushed gas prices to historic lows. However, a warm summer could help reduce historically high gas storage levels. We continue to expect merchant power producers to experience elevated liquidity constraints, especially within companies that own older coal plants in need of control upgrades. Restructuring at  Edison International's (EIX, rating BBB-) merchant generation company, Edison Mission Energy, is the first casualty following  Dynegy Holding's (DYN, no credit rating) bankruptcy filing during 2011's fourth quarter.  Ameren Corp's (AEE, rating BBB-) merchant generation company, Ameren Energy Generation Company, also faces margin contraction and possible liquidity constraints, as it awaits its final emissions implementation ruling from the Illinois Pollution Control Board later this summer.

The industry's broad desire to accumulate regulated assets, whereby offsetting and/ or shedding merchant power plants, has fueled M&A activity thus far in 2012. We expect this pace to continue through the remainder of the year. We anticipate the all-stock merger between  Duke Energy (DUK, rating BBB+) and  Progress Energy (PGN, rating BBB+) to close by July 1, now that the FERC has approved the merger. Representative deals which closed during the first half of 2012 include all-stock mergers between  Northeast Utilities (NU, rating BBB) and  Nstar (NST, no credit rating) and  Exelon (EXC, rating BBB+) and  Constellation Energy (CEG, no credit rating).

We expect further industry consolidation to capture cost efficiencies, geographic diversification, and growth opportunities in new retail markets, particularly in Ohio. Along these lines, we highlight ongoing regulatory action in Ohio that could force  American Electric Power(AEP, rating: BBB+) to divest its power generation business from its transmission and distribution business by 2014.

Contributed by Joe DeSapri

Our Top Bond Picks
We pick bonds on a relative-value basis. Typically, this means comparing a bond's spread against spreads on bonds that involve comparable credit risk and duration.

When selecting from bonds of different maturities from a single issuer, we weigh a variety of factors, including liquidity, our moat rating (we're willing to buy longer-dated bonds from a firm with sustainable competitive advantages), and our year-by-year forecast of the firm's cash flows in comparison to the yield pickup along the curve.

Top Bond Picks
Ticker Issuer
Rating
Maturity Coupon Price Yield Spread
to Treas
Hewlett-Packard HPQ A 2022 4.05% $100.63 3.97% 238
Express Scripts ESRX A- 2022 3.90% $103.38 3.49% 190
Southern Copper  SCCO BBB+ 2035 7.50% $115.50 6.23% 368
Morgan Stanley MS BBB 2021 5.50% $99.00 5.64% 420
Owens Corning OC BBB 2019 9.00% $122.63 5.11% 402
Data as of 06-20-12. Price, yield, and spread are provided by Advantage Data, Inc.

 Hewlett-Packard (HPQ, rating: A)
Despite this issuer's decent second-quarter results, spreads on HP debt have widened further over the past month. Both revenue and margins showed signs of stability during the quarter, but most important for creditors, the firm is making good on its promise to repair its balance sheet over the near term. Share repurchases dropped to the lowest level in eight years, and for the first time in over two years, HP spent nothing on acquisitions. As a result, net debt dropped more than $1 billion during the quarter, with net leverage holding steady at 1.6 times EBITDA. HP is sitting on $8.3 billion in cash, which should cover most of the large maturities it faces through fiscal 2014. With new CEO Meg Whitman at the helm, we expect the firm will continue to limit acquisitions and share repurchases for the foreseeable future, allowing additional cash to build on the balance sheet. We also like HP's emphasis on turning around current operations rather than acquiring its way into new segments. We believe the firm has carved out strong, defensible positions in several key areas, including services, enterprise hardware, and printing. Focusing on these areas should enable the firm to return to health over the next couple of years. The 4.05% notes maturing in 2022 trade at a very attractive spread relative to our A rating. The typical A-rated issuer in the Morningstar Corporate Bond Index trades at 103 basis points over Treasuries, about 100 basis points tighter than the HP notes. 

 Express Scripts (ESRX, rating: A-)
We believe Express Scripts represents the only wide moat-rated firm in the drug supply chain, which contributes to our positive view of this credit despite its recently elevated debt leverage after merging with Medco. We expect this combined entity will be poised to exert unprecedented power over branded pharmaceutical manufacturers and retail pharmacies--such as  Walgreen (WAG, rating: A-)--and capitalize on advantages versus its PBM competitors--such as  CVS Caremark (CVS, rating: BBB+). To fund this deal, Express Scripts pushed its debt/EBITDA up to 3 times. However, management plans to reduce its leverage to premerger levels between 1 and 2 times EBITDA within 18 months of the deal's closing. If the firm is able to achieve that goal, we believe the market will recognize its progress with tighter spreads. We could even see upgrades at the rating agencies if those leverage goals are met. Currently, Express Scripts' notes trade about 40 basis points wider than Walgreen's comparable notes and about 20 basis points wider than CVS Caremark's notes. Given its wider moat, if Express Scripts deleverages as expected, we'd eventually expect its notes to trade at the tightest spreads of this group.

 Southern Copper (SCCO, rating: BBB+)
Southern Copper bonds have taken a pummeling in the past month, with spreads widening 80 bps, as copper prices have fallen below $3.40 a pound after averaging $3.77 a pound over the first four months of the year. We see compelling value for the rating, as the firm's enviable cost profile and low leverage would allow it to weather even a sharp and sustained drop in commodity prices with aplomb. Unit cash costs have averaged $0.20 per pound over the past five years, far lower than any other major copper producer, and the company ended the first quarter with a mere $1 billion in net debt (versus trailing twelve-month EBITDA of $4.2 billion).

We also like Southern Copper on a relative value basis, as they remain one of the few cheap credit plays in the mining industry. For instance, the 2035s trade roughly 75 basis points wide of similarly dated debt of mining peer  Cliffs Natural Resources (CLF, rating: BBB-) and more than 100 bps wide of  Teck Resources (TCK, rating: BBB). Given our more favorable assessment of Southern Copper's underlying credit quality, we don't think such spreads are merited.

 Morgan Stanley (MS, rating: BBB)
Morgan Stanley's 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. Approximately 50% of revenue is derived from institutional securities, 40% from global wealth management, and 10% from asset management. We like the business model's viability, as the diversified revenue stream should help alleviate problems during business cycles. With a Tier 1 capital ratio exceeding 16% and a Tier 1 common ratio of 13%, Morgan Stanley's regulatory capital position is solid. While Morgan Stanley's credit spreads have recently been quite volatile given concerns of a sovereign debt-induced European financial crisis, we think Morgan Stanley's perceived exposure to European banks has been exaggerated. Also, the European Central Bank's willingness to provide virtually unlimited liquidity to the European banks significantly reduces the probability of a near-term European financial crisis.

 Owens Corning (OC, rating: BBB)
Near-term challenges remain in Owens Corning's various businesses. Still, we're maintaining our rating and longer-term credit view of improvement in operating results 2012 and beyond, based on improving trends in the construction markets, with the U.S. residential housing market finally appearing to gain some positive traction. We expect positive free cash flow in 2012 and steady EBITDA growth that should result in improved credit metrics while also allowing the firm to fulfill its share-repurchase goals. We would buy all three of the company's issues, but we prefer the 9% of 2019, which offers a much wider spread and yield compared with the 2016s, albeit paying up several points and extending three years. The 2016s recently were indicated at 111.5, providing a yield of 3.6% and a spread of 295 basis points over Treasuries, which we also find attractive. Our rating reflects the somewhat leveraged balance sheet, but contemplates the lack of any meaningful debt maturities until 2016. Owens Corning 2019s continue to trade at spreads similar to  Toll (ticker: TOL, rating: BBB-),  D.R. Horton (ticker: DHI, rating: BB+), and  Masco (ticker: MAS, rating: BB) and wide of the Morningstar BBB- index.

David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.