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Credit Insights

Monetary Largesse Lifts Credit Market

While the market as a whole appears to be driven by monetary policy as opposed to individual fundamental analysis, we advise investors to be cautious in selecting which bond offerings they participate in.

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Summer is over, the window to the new issue market has been thrown wide open, and the credit market is on fire. Portfolio managers continue to report receiving a flood of new money as funds flow into the fixed-income sector. Even with more than $17 billion of investment-grade bonds issued last week, fund investors still seem to have plenty of cash that needs to be put to work.

Credit spreads tightened 6 basis points in the Morningstar Corporate Bond Index as the average spread declined to +167 last week with the preponderance of tightening occurring after the European Central Bank announced its new Outright Monetary Transactions program Thursday morning. Credit spreads have returned to their tightest levels since August 2011 and are slightly tighter than the average credit spread over the past 12 years.

No firm was a bigger beneficiary of the frenzied demand for paper and growing optimism in the European sovereign market last week than  Telefonica (TEF, BBB-). On Wednesday, the firm issued EUR 750 million 5.811% senior notes due 2017 at a spread of +485 over mid-swaps. Two days later, it returned to the market and added another EUR 250 million to the same bond deal and priced those bonds at mid-swaps+390, almost 100 basis points tighter.

On July 26, we had identified Telefonica's bonds as trading at relatively attractive levels--too cheap to ignore, but too tied to sovereign risk to sharply overweight. At that time, the 3.992% notes due 2016 were trading at +650 and have subsequently tightened to +420.

As can be seen in the following chart, Telefonica debt remains closely intertwined with Spanish debt, and optimism surrounding the ECB's actions last week has clearly played a role in the firm's ability to upsize its earlier offering at very favorable rates. At current spreads, we'd be wary of Telefonica bonds in absolute terms, but we continue to view the firm much more favorably than  Telecom Italia (TI, BB+).

We have heard from syndicate desks to expect a deluge of new issues on Monday and Tuesday totaling between $25 billion and $30 billion. It will probably quiet down thereafter as investment bankers will recommend to clients to access the markets before the German Constitutional Court rules on Wednesday and the Fed releases its decision from the September Federal Open Market Committee meeting Thursday. Considering the near-insatiable demand for paper, we expect the new issues will easily be digested by the market, but hope that with such a large calendar, the new issues will offer attractive new issue concessions to existing trading levels.

In a bull market like we are experiencing now, any issuer that comes to market will probably find a warm reception, regardless of its credit quality. Remember when fundamentals used to matter? While the market is focused on monetary policy,  FedEx (FDX) and  Intel (INTC) have reduced guidance for the third quarter. In the past, announcements by such bellwethers would have put the markets into a tailspin; however, there was so much upward momentum in the markets caused by monetary largesse that this news barely registered in the broader markets.

Even the nonfarm payrolls report was analyzed not for the insight it might provide into the outlook for the economy, but for whether it will provide ample cover to the Fed to institute another round of monetary steroids after the FOMC meeting. While the market as a whole appears to be driven by monetary policy as opposed to individual fundamental analysis, we advise investors to be cautious in selecting which bond offerings they participate in, lest they be plagued by buyer's remorse if the market takes a turn for the worse.

ECB Seeks to Enhance Monetary Policy Transmission; Effectively Eliminates Near-Term Sovereign Default Risk
With its new OMT program, it appears that the ECB has begun to morph from a secured lender of last resort to the banking system into an unsecured lender of last resort to sovereign nations. As long as a country formally requests assistance and accepts the conditions attached to a European Financial Stability Facility or European Stability Mechanism, this new plan effectively eliminates sovereign default risk in the near term. This plan will not purchase debt directly from individual countries, but will purchase bonds of up to 3-year maturities to reduce interest rates to levels that the ECB deems appropriate. The EFSF or ESM programs would be used to intervene in the primary markets as needed.

Spain is scheduled to auction bonds several times through the end of October as it needs to raise enough money to fund its deficit and a few large bond maturities. While Spanish bond prices have ripped higher and yields have plunged, it remains to be seen if instituting this new program will entice investors to purchase the volume of new bonds that the country needs to issue, or if Spain will have to formally request aid under this program. We expect that Spain will delay until the last minute requesting assistance under this program in order to negotiate as much leeway under the conditionality provisions as possible. This new program places the European Union/ECB and Spain in difficult negotiating positions as it appears that failure of either party to reach an agreement will bring about an implosion in the eurozone, a form of mutually assured financial destruction.

While the ECB has announced that bond purchases made under the OMT will be pari passu with other existing bondholders, we have doubts. If push comes to shove, we think the ECB would still be treated differently than other creditors. As we've seen in past examples, when governments are involved in restructurings and defaults (think  GM (GM) and Chrysler), not all creditors are necessarily treated equally.

One final concern about this program was that the ECB's decision was not unanimous. Germany's Bundesbank president Jens Weidmann voted against the bond-buying program, with a press release stating, "He regards such purchases as being tantamount to financing governments by printing banknotes." He also argued that this program could take the pressure off struggling countries to institute necessary but painful reforms in the near term as well as transferring credit risk of those nations onto the taxpayers of the other EU member countries. If this program is insufficient to halt the sovereign debt crisis in Europe, this discord may be indicative of the first real cracks evolving among the eurozone members that could lead to further disunity.

One piece of news that has been overshadowed by the OMT program is that the ECB has reduced its forecasts for real GDP growth in the eurozone for 2012 to a decline of 0.2%-0.6% and lowered the midpoint of its 2013 forecast to 0.5% from 1.0%. The ECB also raised its forecasts for inflation by 0.1% to a range of 2.4%-2.6%. As the economies deteriorate, it will place added pressures upon sovereign credit metrics and lead to higher losses among the banks that are already struggling with rapidly increasing nonperforming loans.

Spanish and Italian Bonds Gap Upward
Spanish and Italian bond prices gapped upward across the curve. The yield on Spain's 2-year bond tightened 91 basis points to 2.74% and the yield on the 10-year bond tightened 126 basis points to 5.63%. The yield on Italy's 2-year bond tightened 56 basis points to 2.24% and the yield on the 10-year bond tightened 80 basis points to 5.06%

Headlines on the Horizon: ECB Down, German Constitutional Court and Fed Left to Go
The German Constitutional Court is expected to rule Wednesday whether it will implement an injunction to prohibit Germany from ratifying the ESM. If the constitutional court inhibits ratifying or rejects the ESM, it would take the eurozone back to square one in figuring out a way to finance the deficits and maturing debt of the peripheral countries. On Thursday, the FOMC will release its statement following the September meeting and announce any plans to implement further monetary easing.

Assuming the ESM is constitutional under German law, the market will focus on the plan and structure to bail out the Spanish banks, which continue to increase their borrowings from the ECB as they are essentially shut out of the public capital markets. It's still unclear as to the structure of the bailout offered to the Spanish banks and whether this debt will have to be guaranteed by the Spanish government, which would increase the country's debt/GDP ratio. In conjunction with uncertainty around the impact of Spanish bank bailout on Spain's credit quality, Moody's may conclude its rating evaluation of Spain. Moody's had placed its Baa3 rating under review for possible downgrade in June, and we are approaching the three-month window in which Moody's usually concludes its rating reviews. Also, the ongoing negotiations with Greece to allow the next installment of bailout funds should be concluded in September.

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

State and Local Pensions 101
Contributed by Rachel Barkley, Municipal Credit Analyst

Government pension plans have been in the news often lately, usually attached to dire predictions and inflammatory language. News reports warn about looming unfunded liabilities while many entities are discussing or have implemented pension reforms. In extreme cases, some local governments have filed for bankruptcy or declared a fiscal emergency in order to amend pension benefits.

Pension liabilities represent significant long-term obligations for governmental entities. In recent years many governments have been required to increase their annual contributions substantially to fund these future liabilities, adding additional budgetary pressures to already stressed fiscal profiles. This combination makes pensions an important element to understand when determining an entity's credit quality.

Government actions on pensions also can have a sizable impact on a substantial segment of the national population. According to a recent report from the U.S. Government Accountability Office, more than 27 million employees and beneficiaries are part of state or local government pension plans(1). These plans represent a considerable portion of retirement planning for these individuals.

Despite the importance of pensions on both the governmental and individual level, they are often poorly understood. With this in mind, Morningstar aims to shed some light on pensions and their potential impact on state and local governments.

What are public pension plans? Pension plans provide postretirement monetary benefits for eligible retirees. Benefits are determined by the type of the plan, while actual benefits can vary widely both between plans and within a single plan based on a number of factors. Plans typically are managed by a board of trustees, which is responsible for investment management.

Why do governments offer them? State and local governments offer pension benefits for a variety of reasons. Generally compensation tends to be less than in the private sector during the working years of the employee(2). Generous pension benefits, as well as other postretirement benefits, are used to offset a portion of this wage gap, allowing governments to remain competitive in attracting a skilled workforce. Benefits allow beneficiaries to achieve a measure of financial security in their postretirement years. In some cases, government workers are not eligible for Social Security benefits, making their pension all the more important to ensure they have sufficient revenue for their retirement years.

Why are state pension plans particularly important? State pension plans often have wide-ranging effects. State plans frequently serve as umbrella plans covering employees for local governments. The majority of these local governments are required to make annual contributions to the state plans. Plan contributions are influenced by market returns, actuarial assumptions and methodology as well as the number and type of employees attributable to each governmental participant. The state often dictates required contributions for plan members, either based on annual legislation, statutory requirements, or actuarial projections. These contributions can place budgetary stress on participating governments. Additionally, if the state government does not require adequate annual contributions, the unfunded liability increases leading to what can be a considerable financial pressure to the participating governments in future years.

State pension plans that solely cover state employees can also have a notable influence on local governments within the state. As states provide substantial aid to school districts and other local governments, financial pressure on state governments, including strain stemming from increasing pension costs, can lead to reductions in intergovernmental aid to local governments.

What can be the impact for governments? Many governments have been able to manage their pension liabilities while maintaining adequate fiscal solvency. However, state and local governments have been facing considerable budgetary pressure for the past few years. Labor-related costs, including pension payments, continue to account for a significant portion of total government spending. Required pension payments have escalated in many places as plans have absorbed investment losses associated with the recession, adding further stress to a government's fiscal profile. Investment losses have also increased unfunded pension liabilities, which can create a looming fiscal obstacle that will have to be funded in future years. Failure to adequately manage pension obligations has led to a decline in overall credit quality for some entities.

Why have government pensions been in the news so often lately? Governments across the nation have dealt with rising pension costs and liabilities in a variety of manners. As revenue declined in recent years with the recession, governments were forced to reduce spending and take a hard look at any large cost drivers. This has led to many governments trying to implement changes to their pension plans. Changes typically include anything from increasing the employee contribution rate, adjusting the cost of living formula, or revising the benefit formula. In some cases, the type of pension plan is changed from a defined benefit plan to a defined contribution plan or a hybrid plan.

These measures are frequently required to be voted on by the legislature and are often opposed by government employees. In some areas, agreement from labor unions is necessary for implementation. The combination of the impact on the government's budget coupled with the at-times vocal opposition by affected employees has led to pensions being in the news more frequently over the past few years.

In very rare cases, unsustainable pension costs have led a few local governments to file for Chapter 9 bankruptcy. These cases have been heavily covered by news organizations, intensifying the focus on the issue of pensions.

How does accounting for pension plans work? A governmental entity, usually the employer, and often the employee make contributions to the plan that, combined with investment earnings, are expected to fund future benefits. Contributions are determined by either an actuary or through legislative and/or statutory guidelines. These contributions are then invested with the total of contributions and earnings accounting for the plan's assets. Annual gains or losses on the value of investments are incorporated into total assets depending on the actuarial methodology. Contributions and their respective investment earnings are generally placed in trusts and are irrevocable, with assets dedicated to providing pension benefits to plan members.

Upon retirement, retirees and beneficiaries are entitled to annual payouts, which are determined by plan type (defined benefit versus defined contribution). For defined benefit plans, these payments operate like an annuity, with each employee entitled to a specific annual payment based on a benefit formula. These formulas generally incorporate years of service, salary, and a multiplier variable. Specific benefit formulas vary among plans and often within plans, depending on an employee's start date and/or employee classification (public safety, general, management, and so on). Defined benefit payments can be constant for the life of the payment, adjusted annually for cost of living, or adjusted occasionally for cost of living increases as seen fit by the overseeing party.

To determine the long-term obligations of the defined benefit plan, the plan hires an actuary to conduct a valuation. This is typically done on an annual basis. The actuary considers a number of variables and assumptions that cover three major categories: workforce, demographics, and economics. Workforce data include current and anticipated workforce levels as well as current and projected age of employees. Demographic variables incorporate anticipated mortality and disability rates in addition to projected age at retirement. Economic assumptions involve salary growth assumptions, the expected rate of return for investments, and inflation (cost of living) adjustments over time. The actuary uses this information to come up with the expected long-term liabilities of the plan as well as an annual actuarial required contribution equal to the level of annual funding necessary for projected assets to meet projected liabilities over time.

Participants of defined contribution plans are entitled to payments based on the actual contributions and investment income with no obligation by the government to make set payout amounts.

Endnotes
1. State and Local Government Pension Plans: Economic Downturn Spurs Efforts to Address Costs and Sustainability. U.S. Government Accountability Office. March 2012.
2. Alicia Munnell et al. Comparing Compensation: State-Local Versus Private Sector Workers. Center for Retirement Research at Boston College. September 2011.

New Issue Notes

BNP's New U.S. Dollar 5-Year Looks Fairly Valued (Sept. 7)
 BNP Paribas (BNP, A) announced Friday that it is issuing new 5-year benchmark U.S. dollar-denominated notes. Whisper on price guidance is in the area of 185 basis points above Treasuries. While we are comfortable with the credit in comparison with other European banks, we see these bonds as fairly valued. For comparison,  Citigroup (C, A-) trades approximately 30 basis points wider; while we rate Citigroup one notch lower, we think the increased spread and BNP's greater European exposure make Citigroup's bonds more attractive.

From a credit perspective, we like BNP's sound capital structure, but we are wary of its lower reserves. BNP Paribas was created in 2000 by the merger of Banque Nationale de Paris and Paribas and is the largest publicly traded bank in France, with approximately EUR 2 trillion in assets. Retail banking generates about 35% of the company's pretax income, corporate and investment banking about 40%, asset management about 15%, and corporate center and equipment leasing about 10% combined. While BNP Paribas has operations in 80-plus countries, it considers its two home markets to be France and Italy. By our calculations, BNP is one of the best-capitalized banks in France with a comparatively large cushion of tangible common equity/tangible assets for a European bank. It has a Tier 1 capital ratio of more than 11% based on Basel 2.5 calculations. BNP's customer deposits fund more than 80% of customer loans, and while we'd prefer to see this ratio closer to 100%, we see the current level as reasonable. BNP's exposure to the sovereign debt of troubled European governments like Portugal, Italy, Ireland, Greece, and Spain is manageable and represents less than 30% of core Tier 1 capital.

Air Products' New Offering Will Probably Be Rich (Sept. 6)
 Air Products (APD, A-) is expected to issue $400 million of 5-year notes. Proceeds are likely to be used to repay debt maturing later this year. The industrial gas sector trades relatively tight, given the stable cash flows driven by a high proportion of long-term contracts. These characteristics help earn Air Products a narrow economic moat. Consistent with this pricing view, Air Products has an existing 2021 bond that recently was quoted around a spread of 91 basis points above Treasuries, 45 basis points tighter than the A- bucket of the Morningstar Industrials Index.

Within the sector, we also think Air Products looks rich compared with competitor  Praxair (PX, A), which we rate one notch higher, reflecting higher margins and similar leverage. Praxair has a 2022 bond that was quoted around a spread of 90 basis points above Treasuries, which we view as fair value. Adjusting for the curve and the difference in credit quality, we would place fair value for Air Products' new 5-year offering in the area of 70 basis points above Treasuries, but would not be surprised to see this new deal price well inside that level.

Nissan Motor Acceptance Makes a Rare Visit to the High-Grade Market (Sept. 5)
 Nissan Motor's (NSANY, BBB+) finance subsidiary Nissan Motor Acceptance is in the market with a 5-year medium-term note offering. On Sept. 4, American Honda Finance, a finance subsidiary of  Honda Motor (HMC, A), issued 5-year bonds at 95 basis points above Treasuries, which we viewed as attractive. Meanwhile, the  Volkswagen (VOW, A-) finance subsidiary's U.S. dollar-denominated bonds due 2017 recently were indicated at about 113 basis points above Treasuries, while  Daimler's (DAI, BBB+) 5-year finance sub bonds were at 125. We view the Daimler notes as slightly rich and view fair value on the new Nissan notes at around 135 basis points above Treasuries.

Nissan has held up much better than its Japanese brethren recently because of its more diversified manufacturing and sales footprint, bolstered by its alliance with  Renault (RNO, BBB-). Renault owns 43.4% of Nissan while Nissan owns 15% of Renault. The European crisis has put more pressure on Renault's operations of late, making the volume of product Nissan contributes more beneficial to Renault's plants. However, overall the alliance benefits both companies thanks to cost synergies such as engineering and purchasing.

Nissan recently reported first-quarter operating results that exceeded our expectations, as heavy launch costs on new vehicles did not depress operating income as much as we expected. Despite modest negative free cash flow from manufacturing operations during the quarter, the firm retains a solid balance sheet, including a net cash position.

EOG Resources Issues 10.5-Year Notes (Sept. 5)
 EOG Resources (EOG, A) announced Wednesday morning that it is issuing 10.5-year notes. We expect the proceeds from this issuance will be used to fund EOG's drilling program, which is focused on increasing crude and natural gas liquids production as a percentage of total production. Given EOG's sizable, low-cost positions in some of the best liquids-rich plays in North America and 10 years of drilling inventory, we believe this decision makes sense, as future cash flows and returns should remain healthy.

We are hearing price talk on the new notes of 120-125 basis points above Treasuries. The company's outstanding 4.1% notes due 2021 recently traded at 95 basis points above Treasuries. For comparison,  Apache's (APA, A+) 3.25% 2022 notes traded at 86 basis points above Treasuries, while  ConocoPhillips' (COP, A) 6% 2020 notes are quoted at 94 basis points above Treasuries. On a last-12-months basis, EOG has similar net leverage to Apache and ConocoPhillips at 0.7 times, although EOG produces less crude as a percentage of total production, is smaller in scale, and is currently free cash-flow negative due to its drilling program. Adjusting for maturity, the high dollar prices on the outstanding issues, and EOG's negative free cash flow, we believe fair value on the new EOG notes is about 105 basis points above Treasuries.

Waste Management to Issue 10-Year Notes; Existing Spreads Look Modestly Attractive (Sept. 5)
We're hearing that  Waste Management (WM, BBB+) plans to sell $500 million of 10-year notes and that the deal size is unlikely to grow. Proceeds could be used to pay down some debt maturing later this year. The company's narrow economic moat is derived from its industry-leading landfill network, which provides a competitive advantage that is difficult for other waste services providers to replicate. Only competitor  Republic Services (RSG, BBB+) comes close, with nearly 80 fewer. Since the challenges of landfill ownership create significant barriers to entry because of high fixed operational costs, political opposition, and regulatory hurdles, industry players that control the greatest amount of landfill assets ultimately will command pricing power in the form of tipping fees, leading to outsize returns on invested capital over time as third-party haulers divert additional volume to remaining landfills. These advantages allow the company to keep competitors at bay and gain greater control over the entire waste stream over time.

Waste Management has a 2021 bond that we recently saw quoted around a spread of 140 basis points over Treasuries. Republic Services has a new 2022 bond (issued in May) that's trading in the same area, about 145 basis points over Treasuries for a slightly longer maturity. We think these spreads are modestly attractive for our rating and point to rail comps for support. We think a parallel can be drawn between the two sectors, given the significant barriers to entry in both due to their practically impossible to replicate networks--landfills and rail. In rails, we maintain an overweight rating on similarly rated  CSX (CSX, BBB+), which has a 2021 bond that was recently quoted around a spread of 145 basis points over Treasuries, basically on top of existing Waste Management bonds. For comparison,  Norfolk Southern (NSC, BBB+) has a 2022 bond that we view as rich and quoted around 103 basis points over Treasuries. We would place fair value for a new Waste Management 10-year in the area of 130 basis points over Treasuries and be buyers down to that spread.

Principal Financial Group's New Notes Look Slightly Cheap (Sept. 5)
 Principal Financial Group (PFG, BBB) announced that it is issuing $600 million of 10-year and 30-year debt. Whisper on price guidance is in the area of 215 basis points above Treasuries for the 10-year and 240 basis points for the 30-year. In comparison with other insurance names, and accounting for Principal Financial's more diverse business, which derives a large portion of revenue from asset management, we think the price talk is approximately 15 basis points cheap for the rating. We would recommend buying the 10-year notes down to a spread of 200 and the 30-year notes down to a spread of 220.

From a credit perspective, we like Principal Financial's sound business model, but we are concerned about its leveraged balance sheet. Unlike other life insurance companies, Principal has a differentiated business model that emphasizes retirement products and asset management. Principal has grown from a mutual insurance company into a financial services powerhouse by capturing the retirement business of small and medium-size companies that are largely ignored by larger insurance companies and asset managers. We think the scale advantages and the stickiness inherent to the retirement business give Principal a narrow economic moat. Principal does, however, maintain a leveraged balance sheet where equity represents less than 15% of the investment portfolio.

American Honda Finance to Issue 3- and 5-Year Bonds; Price Talk Is Attractive (Sept. 4)
 Honda Motor's (HMC, A) subsidiary American Honda Finance is in the market again with an offering of 3- and 5-year notes. We view the finance subsidiary similarly to the parent. American Honda Finance issued 3- and 5-year bonds in February at 101 and 124 basis points above Treasuries, respectively. These are now indicated at about 70 and 90 basis points above interpolated Treasuries, respectively.

Price talk on the new deal is 80 and 95-100 basis points above Treasuries, respectively. We view these levels as attractive, and we see fair value at about 15 basis points inside of price talk. In comparison, the 5-year bonds of Toyota's finance subsidiary--issued in May at a spread of 106--are indicated at about 58 basis points above Treasuries, which we view as somewhat rich. We rate Honda and Toyota the same, although we slightly prefer Toyota from a credit perspective and believe a 10-basis-point differential is more appropriate. Going the other direction, the Volkswagen finance subsidiary's U.S. dollar-denominated bonds due 2017 recently were indicated at about 113 basis points above Treasuries, while Daimler's 5-year finance sub bonds were at 125.

Our rating factors in a forecast for a sharp recovery from the challenging 2011 conditions beginning in the current calendar year as production and inventory levels return to normal. Honda's largest end market is North America, where we have a very healthy outlook for sales growth over the next several years. Honda also benefits from some diversification away from autos as motorcycles and other industrial products constitute more than 20% of manufacturing revenue. Finally, Honda continues to sport a strong balance sheet with its manufacturing operations typically in a net cash position, giving the firm strong financial flexibility.

John Deere Capital Expected to Issue Benchmark-Size 3- and 5-Year Notes (Sept. 4)
John Deere Capital is expected to be back in the market Tuesday with a benchmark-size offering of 3- and 5-year notes. Our credit rating on Deere Capital is directly linked to our rating of  Deere & Co. (DE, 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 somewhat during the past several years, customer loyalty and Deere's solid dealership network have preserved share and helped the company generate impressive economic profitability, carving a narrow economic moat.

In June, Deere Capital issued 3-year notes that we recently saw quoted around a spread of 45 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 recently issued 2015 bond that trades about 5 basis points tighter. We would place fair value on a new Deere Capital 5-year about 20 basis points wider than the 3-year. No doubt the sector trades tight, with Deere Capital's 2022 bond trading about 15 basis points inside the spread on the Morningstar Industrial Index. Although it's difficult to get excited about spreads at these levels, if the new deal prices on top of or wide of existing levels, we would view that as fair value for investors looking to add exposure to shorter-dated paper of high-quality issuers.

Vale to Offer New 30-Year Notes; We Expect Bonds to Price Cheaply (Sept. 4)
Iron ore giant  Vale (VALE, BBB+) announced plans to offer benchmark-size notes due 2042. We expect proceeds will be used to fund the firm's massive capital expenditure plans, a large portion of which will go to boosting annual iron ore production toward 400 million tonnes in the next few years from 312 million tonnes in 2011. While we expect the bonds to price cheaply relative to our favorable view of the firm's credit quality, we'd caution that the new bonds can be expected to exhibit substantial near-term volatility, reflecting uncertainty regarding Chinese steel demand and the consequences another leg down in China would have for iron ore prices.

Vale's existing notes have come under pressure in recent weeks as spot iron ore prices plunged from $135.25/t at June 30 to $90.50/t as of Sept. 3 on weaker steel market conditions in China, which consumes roughly two thirds of the world's seaborne iron ore. The company's 4.375% 2022s now trade at 265 basis points over Treasuries, 15 basis points wider than June 30 levels. Over the same period, the average BBB+ industrial constituent in the Morningstar Corporate Bond Index, which has a duration comparable with Vale's 2022s, tightened 44 basis points to 160 basis points over Treasuries.

Provided the new bonds come at levels roughly commensurate with Vale's existing long-dated bonds (the high dollar price 2039s trade at 302 basis points over Treasuries), we'd see very good value and would consider the bonds solidly attractive as tight as 250 basis points above Treasuries. While profitability and credit metrics would weaken and spreads would widen in the event we see mounting troubles in China, Vale's currently robust credit metrics (net debt/TTM EBITDA was 0.9 times at June 30) and low cash operating costs ($36/t) would mitigate the risk to the balance sheet and allow it to weather a sharp and sustained slump in China better than most mining companies we cover.

Generally speaking, we're more comfortable holding very long-dated debt of companies like Vale that possess a structural competitive advantage, or moat, that can be sustained through multiple market cycles. In Vale's case, its moat is embodied in low operating costs and a long-lived reserve base, qualities we expect to underpin its fundamental credit quality for many years to come.

Bank of Montreal's New Benchmark 5-Year Notes: Tight for a Reason (Sept. 4)
 Bank of Montreal (BMO, A) announced Tuesday that it is issuing a new U.S. dollar benchmark 5-year note. No information has been given on price guidance yet. Considering that Bank of Montreal's current 5-year trades with a spread above Treasuries of approximately 80 basis points, and also factoring in a new issue concession, we expect this new deal to price in the area of 90 basis points above Treasuries. As with many Canadian banks, Bank of Montreal trades tight to its rating due in large part to Canada's highly regulated banking oligopoly. These tight spread levels at the 5-year point also can be seen in U.S regional banks. For example,  BB&T's (BBT, A-) newly issued 5-year note also trades with a spread above Treasuries of approximately 80 basis points. In contrast, large U.S. banks, like Citigroup, trade with spreads approximately 120 basis points wider. In the end, investors must decide if the lower spread levels are worth the less volatile business models of the Canadian and U.S regional banks. For investors who wish to sleep well at night, we think the answer is yes. However, for investors who need to outperform indexes, we think the answer is no.

Norfolk Southern to Issue $600 Million of 30-Year Bonds; We See Better Value Elsewhere in the Sector (Sept. 4)
We're hearing that  Norfolk Southern (NSC, BBB+) plans to sell $600 million of 30-year notes and that the deal size is unlikely to grow. We maintain an underweight rating on Norfolk Southern and continue to prefer the bonds of similarly rated CSX, its Eastern competitor. The two have relatively similar leverage profiles and operating ratios wrapped around 70% for the latest 12 months ended June 30. Although credit metrics have improved over the first half of the year, weak coal volume remains a significant headwind for both names because of low natural gas prices.

NSC has an existing 2041 bond that we recently saw quoted around a spread of 130 basis points over Treasuries, roughly 20 basis points tighter than the CSX bonds due 2042. We would view fair value somewhere in between the two or around a spread of 140 basis points over Treasuries. However, with strong demand for new paper, we would not be surprised to see the new NSC issuance price at or inside existing levels. We also prefer  Union Pacific (UNP, A-) to Norfolk Southern. Our one-notch-higher rating on UNP is driven by its slightly better credit metrics and larger top line, and with the UNP 2041s quoted around a spread of 140 basis points over Treasuries, we also see more value in UNP relative to Norfolk Southern.

Click here to see more new bond issuance for the week ended Sept. 7, 2012.

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