Fed's Lowered Projections Not a Surprise
A lower inflation forecast may provide room for further monetary accommodation or quantitative easing, but the amount of room the Fed has to maneuver is still limited.
The G20 and FOMC failed to make any substantive policy changes last week, but after bottoming out early last Monday morning, Spanish and Italian bonds rallied strongly throughout the rest of the week. Both dropped to levels comparable to those seen prior to the Spanish bank bailout announcement. This movement allowed the strong underlying demand for corporate bonds to outweigh concerns over either sovereign risk or slowing economic indicators. The Morningstar Corporate Bond Index tightened six basis points to +210 and the Morningstar Eurozone Bond Index tightened three basis points to +239 last week.
We continue to recommend a neutral weighting on corporate credit and favor bonds issued by U.S. over European issuers. While the decrease in these sovereign yields is encouraging in the short term, we still doubt that the sovereign debt crisis--and the contagion effect it could have on corporate credit spreads--has been resolved. We believe that losses need to be realized, not covered up, and the structural issues across the EU's labor and regulatory regimes need to be resolved before the long-term situation will improve.
The Federal Reserve updated its economic projections and revised its expectations for 2012 real GDP growth down to a range of 1.9% to 2.4% from its prior projection of 2.4% to 2.9%. This was no surprise to Robert Johnson, Morningstar's director of economic analysis, who has been steadfast in his 2012 forecast for 2.0% to 2.5% real GDP growth. Reduced expectations were not contained to this year, as the Fed also reduced its 2013 GDP projection by half a percent to a range of 2.2% to 2.8%. In conjunction with the forecast for slower growth, the Fed increased its unemployment forecast by 20 basis points, from 8.0% to 8.2%.
The Fed's inflation forecasts also declined, which may provide room for further monetary accommodation or quantitative easing; however, with five-year forward inflation expectations still at 2.6%, the amount of room the Fed has to maneuver without raising market implied inflation expectations is still limited.
Moody's Spanish Bank Ratings Higher Than Large U.S. Banks
Moody's finally released the reassessment of its credit ratings for large U.S. banks and downgraded several institutions one to two notches. The changes bring its ratings closer in line with many of our issuer level credit ratings. For example, Moody's ratings are in line with our ratings on Bank of America (ticker: BAC, rating: BBB) and J.P. Morgan Chase (ticker: JPM, rating: A), but Moody's is still one notch higher on Goldman Sachs (ticker: GS, rating: BBB+) and Morgan Stanley (ticker: MS, rating: BBB). We think Moody's Baa2 rating is overly punitive on Citibank (ticker: C, rating: A-) and view the bank's credit profile as improving. We also think Citibank's credit spread is too wide for the credit risk.
After downgrading Spain's sovereign rating to Baa3 on 13 June, Moody's will likely downgrade its ratings on Spanish banks, in our view. For example, Moody's credit rating is an A3 for each of Banco Santandar (ticker: SAN, rating: BBB), Banco Bilbao Vizcaya Argentaria (ticker: BBVA, rating: BB+), and Banco Popular Espanol (ticker: POP, rating: B+), which is higher than Spain's sovereign credit rating. We downgraded our credit ratings on these banks (which were already below Moody's ratings) earlier this month as we reassessed the probability of one or more sovereign restructurings in Europe, and lowered our ratings on the banks with the largest exposures to Spanish and Italian sovereign debt as a result.
ECB Loosens Collateral Rules
Highlighting the lack of liquidity among the European banks, the European Central bank announced that it intends to loosen collateral requirements by expanding the types of securities eligible to be used as collateral within its lending programs. We also think this action may be a precursor to further downgrades of the Spanish banks' credit ratings as the ECB prepares to provide liquidity if the banks are frozen out of other lines of credit due to downgrade triggers.
At the margin, this action should help the Spanish banks' liquidity needs, but it won't do anything to help allay the amount of capital that the Spanish banks need in order to convince investors and depositors that the banks are sound and well capitalized. Last week, the two independent auditors commissioned by the Spanish government to determine the amount of additional capital required to adequately capitalize the banks released their results. In a downside scenario, Spanish banks may need an additional EUR 62 billion to absorb losses. These reports provided some comfort, as the losses in a downside scenario are less than the EUR 100 billion that the EU has pledged to recapitalize Spanish banks.
The amount of capital to be injected into each individual bank will be determined in a separate report conducted by several auditing firms, which is expected to be released at the end of July. However, the analysis reportedly does not contemplate a default or restructuring of Spanish debt. Considering the Spanish banks generally have been increasing the amount of capital they hold in Spanish government bonds, the solvency of the banks has become increasingly intertwined with that of the government. If bondholders of Spanish government debt were forced to realize a loss on their holdings, it would likely throw many Spanish banks into insolvency.
Headlines on the Horizon
Other than the durable goods report, we don't expect any of the news this week to have much of an impact on the corporate debt markets. Italy is scheduled to issue new bonds on June 26 and 28, but with its yields declining substantially from their highs, these auctions will likely be non-events.
Greece has formed a coalition government and, to the consternation of the Germans, is going back to the EU and IMF to ask for relief to the conditions of their bailout financing. We suspect this game of chicken will be played out in the headlines over the next few weeks as each side tries to use the media to support their respective positions.
The quarterly European Council summit is scheduled for June 28 and 29. It should provide a plethora of headlines as leaders discuss Greece's request to ease the terms of its bailout, Spain's bank recapitalization, demands for stimulus, and greater centralization of banking and fiscal authority. However, we have not heard of any specific policies that may be agreed upon that would significantly alter the issues plaguing the EU over the near term.
New Issue Commentary
Whisper Talk on Target's New 30-year Bond Is Cheap (Published June 21)
Target (ticker: TGT, rating: A) was reportedly in the market Thursday morning to issue new 30-year notes. We have heard that whisper talk on the notes is 145 to 150 basis points above Treasuries. This appears on the cheap side, as the firm's existing 2.90% senior notes due 2022 are trading at about 100 basis points above Treasuries; we think the right spread between the 10s/30s curve should be around 25 basis points. Target's existing long-dated notes are both trading in the area of low-160s basis points above Treasuries, but considering both bonds are trading at a price above 135% of par, we think the spread is 30 to 35 basis points wider than where a bond priced near par would trade. We would be willing to buy the notes down to a spread of 125 basis points above Treasuries, which we consider to be fair value for the name.
Comparatively, similarly rated Home Depot's (ticker: HD, rating: A) 5.95% senior notes due 2041 trade at 143 basis points above Treasuries, but considering the price on these bonds is also above 130% of par, the price-adjusted spread likely would put the long-dated Home Depot notes about 20 basis points tighter. We believe Target is a more defensive credit given its assortment of food and other basic necessities, and should therefore trade slightly inside Home Depot, even with the same credit rating.
For investors looking to pick up extra spread for a single-A-rated issuer in the retail sector that we view to have a similar risk, we think Lowe's (ticker: LOW, rating: A) provides an attractive pickup in spread. Lowe's 3.75% senior notes due 2021 are trading around 140 basis points above Treasuries and last we saw, the 4.65% senior notes due 2042 were in the mid-150s basis points above Treasuries.
Whisper Talk on New 3M Issuance Seems Fair, but Will It Hold? (Published June 21)
On Thursday, 3M (ticker: MMM, rating: AA) announced plans to sell $1 billion of five- and 10-year notes. The company's innovative culture, bottom-line focus, and low-cost manufacturing have carved a wide moat around its business that we believe will enable the firm to reap outsized rewards over the long run. Although 3M has several outstanding bond issues, they tend not to trade very frequently as investors typically buy the bonds and tuck them away for the long term. As such, we would expect significant demand for any new issuance.
Whisper talk is 70 basis points above Treasuries for the 10-year and 45-50 basis points above Treasuries for the five-year. Although the absolute spread levels are difficult to get excited about, and likely will tighten prior to pricing, we think they represent fair value in the diversified industrial space. For comparison, United Technologies' (ticker: UTX, rating: A) recently issued 2022 notes were quoted around 95 basis points above Treasuries, which we view as fair value. Honeywell (ticker: HON, rating: A), which we rate underweight, has a 2021 maturity that recently was quoted around a spread of 82 basis points above Treasuries. Given the three-notch rating differential between the names, we think the initial price talk on 3M looks reasonable, although we wouldn't chase it much tighter.
Packaging Corp.'s New Deal Should Price Attractively to Compensate Bondholders for Lack of Liquidity (Published June 21)
Packaging Corp. of America (ticker: PKG, rating: BBB+) announced that it is issuing a new 10-year $400 million bond. We expect the company to use the majority of the proceeds to repay its 2013 senior note, of which
$400 million remains outstanding. Outside of this 2013 bond, Packaging Corp. has only one outstanding public bond of $150 million, which matures in 2018 and is rarely traded.
We think the new issuance likely will bring some visibility to the company. However, a relative lack of name recognition, coupled with a large amount of new issuances in the market today, probably will translate to a relatively wide spread for Packaging Corp. If the new deal is priced at a T-spread of around 250 basis points, we would consider the price to be quite attractive for this containerboard and corrugated packaging company. The level is considerably wider than the more liquid International Paper's (ticker: IP, rating: BBB) 2022 issue, which trades at a T-spread of 220 basis points. However, we think creditors should be fairly compensated for a potential lack of liquidity in the bonds.
Caterpillar Inc. in the Market With Three-, Five-, and 10-Year Offerings (Published June 21)
On June 21, Caterpillar Inc. (ticker: CAT, rating: A-) announced plans to raise $1.5 billion, split among three-, five-, and 10-year maturities. 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 a sizable pension deficit and the largely debt-financed acquisition of Bucyrus, constrains our rating.
Within the heavy equipment sector, we think Caterpillar trades tight for its rating, and we maintain an underweight recommendation on the name. The company's 3.9% due 2021 were recently quoted around 100 basis points over Treasuries. For comparison, Deere & Co (ticker: DE), which we rate one notch higher at A, has a 2022 bond that was recently quoted around that same level. Given our market weight view on Deere bonds, we would place fair value for a new Caterpillar 10-year around 115-120 basis points over Treasuries, with the five-year about 20-25 basis points tighter, and the three-year another 20-25 basis points tighter.
For investors looking for a little more yield in the space, we recommend the AGCO (ticker: AGCO, rating: BBB-) 2021 bonds, which were recently quoted around a spread of 320 basis points over 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.
Alleghany's New 10-Year Looks Attractive (Published June 21)
Alleghany Corporation (ticker: Y, rating A-) announced on June 21 that it is issuing new benchmark 10-year notes. Whisper on price guidance is in the area of 350 basis points above Treasuries, which appears to be about 30 basis points cheap to existing notes. Alleghany trades wide to comparables due to its relatively smaller size and given that the rating agencies rate the company in the mid-BBB area. Accounting for these factors, we think these new bonds are attractive and would recommend the bonds all the way down to a spread of 280.
From a credit perspective, we like the company's lower use of debt, but we are wary that an acquisition could fall short of expectations. Alleghany has a history of making both equity and direct investments in wholly owned insurance subsidiaries. Traditionally, the company has held excess capital as it seeks the right opportunity to make deep-value investments (both in its investment portfolio and through acquisitions), which it will hold for long periods. Although we appreciate the company's strategy, we do not think Alleghany has an economic moat, as it has not shown the ability to consistently earn excess returns on capital. Recently, the company has deployed that capital toward the acquisition of Transatlantic, a larger reinsurance firm. Although we think a significant acquisition was long overdue, we wish it could have been in a better industry. Reinsurance is a high-risk activity whose fortunes are tied to unpredictable events.
Initial Price Talk Is Very Attractive for Wells Fargo's New Three-Year Notes (Published June 20)
Wells Fargo & Co. (ticker: WFC, rating A+) announced Wednesday that it is issuing new benchmark three-year notes. Whispers on price guidance are in the area of 125 basis points above Treasuries, which appears to be about 25-30 basis points cheap to existing notes. We think this starting price talk is well wide of where these bonds will price, and we would recommend the bonds all the way down to a spread of 110.
Of the four largest U.S. banks, we are most impressed with Wells Fargo from a credit perspective. The firm has a clear funding cost advantage as low-cost deposits fund its entire loan book and approximately 75% of its earnings assets. Its capital position is quite strong with a Tier 1 capital ratio at 11.8% and a Tier 1 common equity ratio at 10.0% as of March 31, 2012. The company also has estimated that its Tier 1 common equity ratio under Basel III would have been 7.8% as of March 31, 2012. Wells Fargo, however, trades tight to its peers, even after adjusting for rating. For example, at the 10-year point, J.P. Morgan trades more than 50 basis points wider for a rating just one notch lower. This tightness, however, is driven in large part by the scarcity of the Wells Fargo name.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.