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Credit Insights

EU Crisis Still Not Behind Us

Credit markets rallied on news of the latest EU plan, but a long-term resolution will require individual countries to relinquish budgetary authority to an EU agency, the implementation of a banking union, and more.

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Corporate Credit Rallies on Latest EU Plan
Corporate credit spreads rallied significantly on Friday after the EU released a statement that proposed directly recapitalizing the Spanish banks, as opposed to the prior plan, in which Spain would have been liable for the debt. The statement also proposed that the bailout funds would not entail a preferred creditor status.

The Morningstar Corporate Bond Index rallied three basis points to +206 and the Morningstar Eurobond Index rallied one basis point to +236. Spanish and Italian bonds ripped tighter across the yield curve. The yield on the Spanish two-year bond dropped 144 basis points to 4.27%, and the yield on the 10-year bond dropped 61 basis points to 6.33%.

These moves are breathtaking for a market that was relatively staid prior to the European debt crisis. While Spain's 10-year yield is now back to its pre-bailout level, it still leaves the country's long-term rates above 6%. We would like to see the yield drop meaningfully below 6% and stay there for a significant amount of time before we believe the coast is clear over the medium term.

We still remain unconvinced that the sovereign debt crisis is behind us, as a long-term resolution will require individual countries to relinquish their budgetary authority to an EU agency, the implementation of a banking union, and structural changes in the labor markets of the peripheral nations.

Click to see our summary of recent movements among credit risk indicators.

SCOTUS Ruling Immaterial to Our Credit Ratings
The U.S. Supreme Court upheld the individual mandate in a narrow ruling Thursday, clearing the main hurdle for health-care reform known as the Patient Protection and Affordable Care Act (PPACA). While it is possible that the battle over the fate of the health-care law will now shift to the legislature, given the low probability of Republicans gaining a filibuster-proof majority in the Senate, we now believe the PPACA isn't likely to be repealed. We've already incorporated the anticipated effects of the PPACA in all of our projections, and as a result, the ruling's effect on our credit ratings across the health-care sector is immaterial.

For the managed-care sector, the ruling is largely a positive, as alternatives were a lot more punitive, particularly for firms operating in the individual marketplace. We factor in our models the more than 30 million individuals that are expected to gain insurance coverage as a result of the law through a combination of expansions to the Medicaid program (although the court's ruling on this issue may limit the magnitude of this expansion) as well as new subsidies that can be used to buy insurance in the state-based exchanges.

Medicaid MCOs like  Amerigroup (ticker: AGP, rating: BBB-), one of our best ideas in the credit space, are best positioned to benefit from broader Medicaid eligibility, adding to the already-robust growth story from increased outsourcing of Medicaid. We expect most commercial insurers to compete for new individual members in the exchanges, but those with a strong historical position in the individual market and well-known brands, such as  WellPoint (ticker: WLP, rating: A-), seem particularly well positioned.

On the other hand, MCOs will continue to face margin pressure from regulatory scrutiny of premium increases, minimum medical cost ratios, and cuts to Medicare Advantage reimbursements. However, we expected most of these headwinds to remain in place even without the PPACA, and have incorporated deteriorating margins in our valuations.

The other group most affected by Thursday's ruling is health-service providers, such as hospitals, but our estimates already properly account for the anticipated effects from the law's provisions, particularly an expanded insured population. We consider the law's reduction of uncompensated care combined with an influx of newly insured patients into the health-care system as a positive for the health-services industry, while other components of the law, including lower Medicare payments and greater oversight of insurance premium increases, mostly mitigate such benefits. Overall, hospitals may breathe a sigh of relief as without the mandate, the environment for providers would have been rather dire. Regardless of this ruling, we think reimbursement pressure is here to stay thanks to government incentives to curb health-care spending growth and an industry shift to quality-of-care-based payment methods, and health providers still will face an uphill battle to maintain profitability from ongoing uncertainty of reimbursements.

For the Big Pharma group, we expect the increased demand for drugs as a direct result of the mandate will largely offset the increased fees and rebates associated with health-care reform. Our estimates remain unchanged. However, since the costs related to health-care reform are front-end loaded (which started in 2010) and the increased demand will not likely begin until 2014 (when the mandate goes into effect), we believe investors' sentiment toward the drug group should improve as the tailwind of increased demand for drugs begins to materialize in 2014.

The generic drug manufacturers are largely unaffected, in our view. Most of the generic manufacturers have broad geographic operations, and generic drug pricing was relatively unaffected by the law. We think additional drug volumes from newly insured patients are relatively immaterial to our fair value estimates for the generic firms. The biosimilars approval pathway should remain intact.

The device side was viewed largely as a relative loser when the reform was passed, and the ruling doesn't change much in terms of our assessments of the industry's prospects going forward. We anticipated the additional insureds in 2014 would not significantly contribute to volume because many devices are concentrated among Medicare recipients. For example, an estimated 90%-95% of pacemakers in the U.S. are implanted in Medicare patients. However, there are some particular product lines that do skew somewhat younger, such as spine devices, which are split more evenly between Medicare and non-Medicare patients. Firms that are not highly tied to Medicare reimbursement should see some magnitude of the volume boost, but likely not to the extent of other health-care industries. With the law upheld, it also appears that the 2.3% medical-device excise tax will stand. We already baked that tax into our valuations two years ago, and at the time we said it would cut into the long-term earnings power of medical device firms by 4%-10%, hardly a devastating impact. Also, the effect of the tax is being mitigated by several factors, particularly the sales mix by geography, which generally has been shifting away from the United States.

Medical-device companies also have been preparing for this tax and additional pricing pressure going forward (not necessarily only because of the PPACA), which led to the restructuring of operations and investments in more manufacturing facilities in tax-advantaged locations outside of the U.S. Overall, we think a number of larger regulatory and customer issues--such as changes in the pathway to market and fiscal budget pressures in the developed world--are changing the competitive landscape for medical-device firms, and these changing dynamics should have a more substantial effect on this industry in the foreseeable future than the PPACA.

For other sectors, the impact is also fairly muted. In regard to biotech, we are maintaining our view that health reform has an overall net neutral impact as expanded coverage offsets new fees and drug rebates. However, within the spectrum of our biotech coverage, some firms have fared better than others. Companies like  Gilead (ticker: GILD, rating: A),  Amgen (ticker: AMGN, rating: AA-), and  Roche (ticker: RHHBY, rating: AA-) have seen the largest hits to their businesses due to larger rebates through Medicaid and industry fees from a higher share of drugs reimbursed by Medicare. Those factors may be contributing to attractive valuations at two of our best ideas among investment-grade issuers--Gilead and Amgen. Conversely, reform has had little impact on companies like  Celgene (ticker: CELG, rating: A) and  BioMarin (ticker: BMRN, rating: BBB+) with heavy exposure to orphan drugs that are exempt from the industry fee.

--This section was contributed by the Healthcare Research Team.

New Issue Commentary
Markel: We Like the New 10-Year Notes as Well as the Existing 10-Year (Published June 27)

 Markel Corporation (ticker: MKL, rating: BBB) announced on June 27 that it is issuing $300 million of new benchmark 10-year notes. The proceeds are expected to prefund existing 2013 notes, which have approximately $250 million outstanding. Whisper on price guidance is in the area of 330 basis points above Treasuries, which appears to be about 40 basis points cheap to existing notes. For our rating, we think the existing notes are about 20 basis points cheap, so these new notes would be extremely attractive at prevailing whisper talk, and we would recommend them all the way down to a spread of 270 above Treasuries.

From a credit perspective, we like Markel's excellent risk management in specialty insurance but are wary of its aggressive investment portfolio. By confining its operations to the specialty insurance markets, Markel is able to dodge both competition and regulation. Specialty insurance, primarily excess and surplus lines, is characterized by policies that are complicated to price, or are not accepted in the regulated insurance market. This form of insurance is sometimes perceived to carry higher risk, but Markel has proven that it is able to manage this risk efficiently over the long term. The company consistently seeks to write insurance that it believes will be profitable, often sacrificing top-line growth to achieve this end. While the company has managed claims to a relatively low level, the expenses incurred in the underwriting process are higher than peers, and this has prevented Markel from producing strong underwriting profits. As such, we don't believe Markel possesses an economic moat. Goodwill and intangible assets account for approximately 25% of shareholders' equity. After adjusting for this, we calculate Markel's debt/capital ratio at approximately 33%, which is higher than peers. Also, Markel holds a significant portion of its portfolio (approximately 25%) in common stocks. Both these considerations weaken Markel's financial risk score in our rating model, which ultimately leads to a BBB rating.

Comcast's Debt Issuance Offers Reasonable Value (Published June 26)
 Comcast (ticker: CMCSA, rating: BBB+) is in the market looking to issue 10- and 30-year notes. The firm is one of our favorites in the U.S. telecom sector on the strength of its network assets and the steady pace at which it is taking market share from phone companies like  AT&T (ticker: T, rating: A-). Comcast also has the strongest balance sheet among its cable peers, with consolidated net leverage at 1.9 times EBITDA and 1.8 times within the cable business (which excludes the NBC Universal joint venture). The firm hasn't issued new debt in some time, so this offering is likely to attract strong attention. Comcast generates very solid, consistent cash flow and its use of cash for dividends and share repurchases is very reasonable, in our view. The dividend was increased 44% earlier this year to $1.8 billion annually, but it still totals only about 22% of consolidated cash flow (30% from the cable business). Comcast also plans to repurchase $3 billion of its shares this year. Cash raised from the new issuance likely will be used to repay high-coupon debt--last week, the firm called $575 million of 6.625% notes due 2056.

Comcast's existing debt trades tight relative to the BBB+ portion of the Morningstar Corporate Bond Index. The firm's 5.15% notes due 2020 trade at 155 basis points above Treasuries versus +203 for the index. However, we believe the new Comcast notes offer a reasonable value given the high quality of the firm and its conservative capital allocation policies. Initial price talk is in the area of 170 basis points above Treasuries on the new 10-year offering and +210 on the 30-year notes. At this level, the 10-year offering would sit at about the midpoint between the BBB+ and A- buckets within the Index.

In addition, we believe Comcast offers much better value that peer  Time Warner Cable (ticker: TWC, rating: BBB-). TWC's 5.0% notes due 2020 currently trade at 206 basis points above Treasuries, only about 50 basis points wider than the Comcast notes referenced above. Within the Index, the gap between the BBB+ and BBB- buckets is roughly 100 basis points. In addition, TWC has taken a much more aggressive approach to capital allocation, targeting leverage at 3.25 times EBITDA and returning more cash to shareholders than it generates.

John Deere Capital Expected to Issue Benchmark Floating-Rate and Three- and 10.5-Year Bonds (Published June 26)
John Deere Capital Corp. (Deere Capital, rating: A) is expected to be back in the markets Tuesday with a benchmark-sized offering split between 22-month floating rate notes and three- and 10.5-year fixed-rate tranches. Our credit rating on Deere Capital is directly linked to our rating of  Deere & Co. (ticker: DE, rating: A), based on the strong interrelationships between the two entities. Deere dominates the North American agricultural equipment market, with a share near 50%. Although we think competitors' products have narrowed the quality gap during the last several years, customer loyalty and Deere's solid dealership network have preserved share and have helped the company generate impressive economic profitability, carving a narrow economic moat.

In February, Deere Capital issued 10-year notes that we recently saw quoted around a spread of 110 basis points above Treasuries, which we view as fairly valued within the sector. For comparison, Caterpillar Finance, which we rate one notch lower at A- and maintain an underweight weighting on the bonds, also has a 2022 bond that trades around that same level. Given the slightly longer maturity of the proposed 10.5-year notes, we would put fair value around a spread of 115 basis points above Treasuries and expect the three-year to price about 50 basis points tighter.

For investors looking for a little more yield in the sector, we continue to recommend  AGCO (ticker: AGCO, rating: BBB-), which has a 2021 bond that recently was quoted around 315 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.

Sonic Automotive Issuing $200 Million of Senior Subordinated Bonds to Retire Convertible Bonds (Published June 25)
 Sonic Automotive (ticker: SAH, rating: B+) announced its intent to issue $200 million in new Rule 144a senior subordinated notes, with the proceeds being used to retire all or a portion of its $135 million 5.0% senior unsecured convertible bonds that are putable and callable Oct. 1, 2014. Any remaining proceeds would be used to buy back stock or for general corporate purposes. We would note that the 5.0% converts have a strike price that is currently in line with the stock price and are currently trading at a price of around 130. We expect the firm would have to offer a modest premium to these levels in order to get convertholders to swap their bonds for shares and cash.

While terms of the transaction are unclear at this point, we would note that Sonic's 9.0% senior subordinated bonds due 2018 are currently indicated at a price of about 108, providing investors a yield of about 6.4% to the first call date in March 2014. This generates an option-adjusted spread of 560.  Asbury Automotive's (ticker: ABG, rating: B+) 8.375% senior subordinated notes due 2020 are trading at about 6.6% due to the 2015 call date. Alternatively,  Penske Automotive's (ticker: PAG, rating: B+) 7.75% non-callable senior subordinated notes due in 2016 offer a slightly higher yield (6.9%) and spread (620). Assuming an eight-year non-call 4 structure on new Sonic bonds, we see fair value in the 7% area. The sector trades tight to the high-yield market, with the Merrill Lynch High Yield Master II currently offering a yield of about 7.5% and OAS of 650. However, we believe the fundamentals of this sector will allow it to perform well in a difficult market. With limited opportunities to invest in the sector, we believe this new issue could be a good entry point for investors to establish a core holding.

We remain very constructive on the auto dealer space given its moaty characteristics. We believe domestic auto sales are likely to continue on a steady upward trend and the replenishment of lost inventories from production shortfalls from the Japanese Three manufacturers also should serve to boost the fortunes of the dealers. The follow-on parts and services operations provide steady operating income, leading to narrow moats on our coverage list of dealers. A highly variable operating cost structure allows for further downside protection.

Click here to see more new bond issuance for the week ended June 29, 2012.

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