Large Injection of Monetary Steroids Lifts Credit Markets
In a bull market like we are experiencing now, any issuer that comes to market is likely to find a welcome reception, regardless of its credit quality.
The corporate credit market is on fire. Offers wanted littered Wall Street and the only sellers of paper were the broker/dealers that still had some inventory. Portfolio managers continue to report receiving a flood of new money as funds pour into the fixed-income sector. For issuers for which we provide credit ratings, about $30 billion of new investment-grade bonds were issued last week, yet investors begged for more paper to put cash to work.
In the Morningstar Corporate Bond Index, the average credit spread tightened 12 basis points last week to +155, with the preponderance of tightening occurring after the Fed announced what we are terming QEOE (quantitative easing, open-ended). Credit spreads have returned to their tightest levels since July 2011 and are 22 basis points tighter than the average credit spread (9 basis points tighter than the median) over the past 12 years.
Highlighting investors' desperation to buy anything,
Walgreen's ((WAG), BBB) 4.40% senior notes due 2042, which were issued last Monday at +165, ended the week wrapped around +126, almost 40 basis points tighter! Considering that we recently cut our credit rating to BBB from A-, we find this degree of tightening in such a short time to be astounding. We placed Walgreen on our Bonds to Avoid list as it has the option to purchase the remaining 55% of Alliance Boots within three years. If it decides to fully acquire Alliance Boots, we'd consider another cut to our credit rating, as Walgreen will need to pay about $4.9 billion in cash and assume about $12 billion of the target's existing debt. Another example of a new issue that tightened further than we would expect is Computer Sciences ((CSC), BBB). CSC issued 4.45% senior notes due 2022 at +280 on Tuesday, and those notes tightened 30 basis points by the end of the week to +250.
As the Fed purchases mortgage-backed securities and long-term Treasury bonds, investors will have increasingly fewer fixed-income assets to choose from, which will probably force credit spreads tighter as this new liquidity looks for a home. Unfortunately, this action will further penalize savers as the Fed artificially holds down long-term Treasury rates. Fixed-income securities that trade on a spread basis will trade at levels that are tighter than would otherwise occur in the markets. In a bull market like we are experiencing now, any issuer that comes to market is likely to find a welcome reception, regardless of its credit quality. Remember when fundamentals used to matter? While the market as a whole appears to be currently 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 with buyer's remorse when the market takes a turn for the worse.
source: Morningstar Analysts
Fed to Flood the Markets With More Liquidity
The Fed launched QEOE by pledging to purchase an additional $40 billion of agency mortgage-backed securities monthly. The Federal Open Market Committee placed neither an end date nor a cap on the amount of mortgage-backed securities it would buy, but will continue to make these purchases until the labor market substantially improves. In addition, the FOMC left open the door to making additional purchases of Treasury securities if this program is not enough to affect the labor market. The FOMC also said it expects that a "highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens." The Fed will maintain its policy of extending the average maturity of its holdings and reinvesting principal payments from existing holdings. Altogether, these actions will increase the Fed's holdings of longer-term securities by $85 billion per month. The committee anticipates keeping the federal funds rate at essentially zero until at least mid-2015. Considering that zero interest rate policy was launched in December 2008, that target would entail six and one half years of ZIRP. With inflation ranging from 1.5% to 2%, real interest rates are negative through the 10-year Treasury, resulting in considerable financial repression for savers.
On an annualized basis, $40 billion per month of purchases equates $480 billion of quantitative easing. The Fed did not give a target as to where unemployment would need to fall to before it discontinues these purchases; however, we suspect that the Fed may wish to reach the top of the range for its projection for longer-run central tendency of unemployment. That would equate to a little over 6% and, according to the Fed's projections, could be reached by the end of 2014. Assuming the Fed purchases $40 billion per month during this period, that would equate to about $1 trillion. If it takes until the end of 2015 to reach an unemployment rate of slightly over 6%, then the total amount of purchases could reach about $1.5 trillion. Considering the total amount of outstanding agency mortgage-backed securities is about $7 trillion, the Fed could end up owning about 15% of the total agency MBS market. With such an outsize position, it will be extremely difficult for the Fed to exit its position without significantly influencing the market. Once the market knows the Fed is a seller, it will immediately push bonds prices down, thus pushing mortgage bond spreads wider and effectively making mortgages more expensive.
Market-Implied Inflation Soars
Market-implied inflation expectations soared higher subsequent to the FOMC announcement. Intraday on Friday, the five-year, five-year forward inflation break-even rate spiked as high as 3.01%, before settling at 2.86%, 33 basis points higher since the end of August. We estimate that this intraday peak was the highest market-implied forward inflation rate since the Treasury began issuing Treasury Inflation-Protected Securities. For those not familiar with the five-year, five-year forward inflation break-even rate, it is the average annual inflation rate expectation for five years, five years in the future (that is, years 6 through 10). It is calculated by stripping out the inflationary rate embedded in 5-year TIPS from the inflationary rate embedded in 10-year TIPS.
One aspect of the FOMC's announcement that has been mostly overlooked is that the committee reduced its projections for real GDP growth in the U.S. for 2012 to a range of 1.7%-2.0% from its June projection range of 1.9%-2.4%. The Fed shifted this growth to 2013 and lifted its projection for real GDP growth to a range of 2.5%-3.0%. However, this projection assumes that fiscal policymakers will come to an agreement to mitigate the effects of the fiscal cliff by the end of this year. If the government is unable to formulate and agree to a plan to moderate the fiscal cliff, Bernanke plainly stated that he does not believe the Fed has the tools to fully offset the negative economic impact the fiscal cliff would have in the short term. The Fed also increased its projections for 2012 personal consumption expenditure inflation (its preferred measure of inflation) to a range of 1.7%-1.8% and slightly raised the bottom of its 2013 PCE range by 0.1%, to 1.6%.
German Constitutional Court Allows ESM to Be Ratified
As widely expected, the German Constitutional Court allowed the European Stability Mechanism to be ratified. The combination of the ESM and the European Central Banks's new Outright Monetary Transaction program provides a formidable backstop to eliminate near-term sovereign default risk for eurozone members. However, the focus in the European bond market will probably shift back to 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.
With the ECB's new OMT program, it appears that the bank 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 ESM, 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 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 its needs to raise enough money to fund both 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 be enough to 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 brings about an implosion in the eurozone, a form of mutually assured financial destruction.
Moody's Warns Credit Rating of United States Would Likely Be Reduced if Legislative Action Does Not Stabilize Then Reduce Debt/GDP Ratio
Moody's provided an update regarding the direction of its credit rating assessment of the United States. It warned that if budget negotiations during the 2013 congressional legislative session did not result in specific policies that would stabilize the debt/GDP ratio in the near term and lead to a downward trend over the medium term, then Moody's would probably downgrade its credit rating to Aa1 from Aaa. Moody's further stated that the rating outlook assumes that the statutory debt limit would be increased as it expects the debt limit will be reached by the end of this year. If the government does not raise the limit, available funds to pay expenses would be exhausted within a few months after the limit is reached. That could lead to the same market disruption that we experienced in mid-2011.
Pension Reform in California
Contributed by Beth Foos, Municipal Credit Analyst
Rising pension costs have added stress to many state and city budgets in recent years, and in several cases--such as with the cities of Stockton and San Bernardino, Calif.--have contributed to the decision to file for Chapter 9 bankruptcy protection. On Sept. 12, California Gov. Jerry Brown signed into law comprehensive changes to public pensions in the state that are expected to save taxpayers billions of dollars over the long term. The main bill, the California Public Employees' Pension Reform Act of 2013 (AB 340), will cap benefit payments, raise the retirement age, require equal sharing of pension costs, and eliminate some practices that have inflated payments for some retirees in the past. Although there is more work to be done to alleviate pension pressures, we think this is an important first step in addressing pension issues challenging both state and local budgets in California.
The legislation affects the state's main pension funds: the California Public Employees' Retirement System, a cost-sharing plan serving more than 1.6 million members and 3,000 employers, and the California State Teachers' Retirement System, the nation's largest teachers' retirement fund, which serves more than 856,000 members. Reforms will take effect Jan. 1, 2013, and require new employees to work longer to receive full benefits and contribute at least 50% of normal pension costs. The law also changes the formulas for calculating benefits, establishes a mandatory 36 consecutive month final compensation period, limits pensionable compensation to base pay, and caps pension payments at 120% of the Social Security wage base (or $132,120 in 2012) adjusted annually. For all members, AB 340 limits employment of retirees within the same public retirement system, bars retroactive benefit enhancements, and requires the forfeiture of pension benefits for felony convictions. Importantly, the law also allows a five-year window for local government labor unions to negotiate employee contributions and to impose a 50% contribution on employees that are not paying half of normal pension costs if no deal is reached by Jan. 1, 2018.
These changes are estimated to provide $42 billion-$55 billion in savings for CalPERS and $22.7 billion in savings for CalSTRS over a 30-year period. However, this is rather modest compared with the unfunded actuarial accrued liabilities of $51.3 billion and $56 billion for CalPERS and CalSTRS, respectively, at the end of fiscal 2010. Also, substantial budget savings are not expected to be realized for at least five years because the majority of the reforms affect new employees of the systems. Nonetheless, these changes will create savings and begin to curb rising pension costs for state and local governments throughout California, which will support improved credit quality.
The enacted reforms will apply to nearly all public employers in California. Exempt from the regulations are the University of California system and charter cities and charter counties with their own pension plans. The state and participating local entities are required by law to contribute the actuarially required contribution to both systems annually, and contributions are increasing. The state contributes about $3.3 billion annually for pension contributions, which in 2011 represented nearly 4% of general fund expenditures. As investments returns have fallen short of past growth assumptions, required contributions will probably increase, further stressing budgets throughout the state. By capping benefits and requiring more cost sharing from employees, the longer-term health of the system should be more sustainable.
New Issue Notes
D.R. Horton to Issue 10-Year Bonds as Builders Ramp Up Spending (Sept. 11)
Homebuilder D.R. Horton ((DHI), BB+), which issued $350 million of 4.75% 5-year senior notes in April, is back in the market with a 10-year offering for another $350 million. Proceeds are for general corporate purposes. The resurgence in new issuance among homebuilders probably stems from the solidly improving sentiment in the marketplace and builders' desire to have capital available to make opportunistic purchases of land. With corporate bond yields at or near all-time lows, this makes borrowing and extending debt maturities very attractive. Toll Brothers ((TOL), BBB-) issued $420 million of 5.875% senior notes in the first quarter and followed that up with a $250 million 0.5% convertible bond last week. Lennar ((LEN), BB) printed $350 million of 4.75% 5-year senior notes in July. Lennar's notes are currently indicated at a yield of 4.53%, offering a spread of 381 basis points over Treasuries. Horton's 5-year is indicated at 3.15% and a spread of 254. Toll's 10-year bond is currently indicated at 4.55% and a spread of 296. We view Lennar and Toll as slightly cheap and Horton slightly rich at existing levels and would place fair value on the new Horton notes in the 4.875% area.
In addition to the new bond offering, Horton recently announced a new 5-year $125 million senior unsecured revolver that could expand to $500 million. Horton ended its third quarter with homebuilding cash and securities of $1.1 billion and homebuilding debt of $1.9 billion. The firm does have some meaningful upcoming debt maturities, including $172 million in 2013 and $783 million in 2014. The latter includes $500 million of comfortably in-the-money convertible bonds, which may equitize, however. Horton's net debt/capital ratio was about 18%, somewhat low for our rating. We expect this ratio to trend up over time as management noted that "we transitioned to offense from defense" on its third-quarter call in late July, suggesting more aggressive investment in properties. Horton tends to be one of the more aggressive builders with a significant amount of speculative building. This adds an element of risk to the business model, although we view the management team as strong. Overall we give a slight rating edge to Toll, which carries a narrow economic moat as the only national builder of luxury homes. That said, Toll's leverage has ticked up to about 25%, a bit higher than Horton's. Lennar, on the other hand, typically carries leverage in the mid-40s, putting its ratings below those of Horton.
AstraZeneca Refinancing Existing Debt Through New Issuance (Sept. 11)
AstraZeneca (AZN) announced plans to issue new notes due in 2019 and 2042 to refinance $1.75 billion in notes due Sept. 15 and for general corporate purposes. We do not anticipate changing our AA rating based on this new issuance, and we believe investors should be assured of the repayment of these new notes. However, AstraZeneca appears to be one of the most likely firms in the industry to make a capital allocation decision that leads to spread widening in its notes. In fact, AstraZeneca scores among the worst in all fundamental categories considered in that analysis, including patent exposure, pipeline strength, in-line product strength, and room to cut costs. Even if AstraZeneca's new notes price at a fair level for its risk profile, we'd worry that future capital allocation decisions could cause significant spread widening in these new notes.
In terms of valuation, Merck ((MRK), AA), which scores in the middle-tier of the Big Pharma niche in our spread-widening-potential analysis, just issued notes Monday, creating a decent benchmark for Astra's new notes, in our opinion. Merck's 5.5-year, 10-year, and 30-year priced at 50, 75, and 90 basis points above Treasuries, respectively. If Astra's new notes price at similarly fair levels, we would expect its new 2019s to price around 60 basis points above Treasuries while its 2042s price around 90 basis points above Treasuries.
For investors looking for more income potential, we point to Astra's own equity since its dividend yield (6.1%) may exceed its new 2019 notes' yield by more than 400 basis points. For debt-only investors, we highlight Amgen ((AMGN), AA-) as an alternative to Astra's new notes, especially since we believe the potential for an unfriendly capital allocation event already is worked into the pricing of Amgen's notes. For example, its 2022 notes recently offered a 3.11% yield, or a 149-basis-point spread above Treasuries, which is about 45 basis points wider than 10-year notes from the average A rated firms on the Morningstar Corporate Index. We use that A bucket as a benchmark for Amgen since stripping the cash off its balance sheet through various capital allocation activities would push our rating to that level. In general, that analysis highlights that Amgen's notes offer investors a much wider margin of safety than Astra's notes.
We Would Hold Off on CSC Despite Seemingly Wide Spreads (Sept. 11)
Computer Sciences Corporation ((CSC), BBB) plans to issue $500 million in new notes, split between 3- and 10-year maturities. Based on whisper numbers--spreads of 275 basis points above Treasuries for the 3-year and 340 basis points on the 10-year--it appears that this offering will price in line or a bit rich compared with CSC's existing notes. We wouldn't be enthusiastic buyers of this offering, despite seemingly attractive spreads. We haven't recommended CSC debt during the last year despite the fact that its notes often have traded at massively wider spreads than the typical BBB rated issuer. The firm has faced a bevy of troubles recently, including accounting problems, contract disputes, and weak demand stemming from funding delays in the U.S. government. We also recently lowered our economic moat rating on CSC to none, reflecting our view that the firm will continue struggling to generate decent margins as it competes with rivals that enjoy better cost structures.
CSC is in the midst of a cost-cutting initiative under new CEO Mike Lawrie that has shown signs of progress. The firm also has done well to improve its finances during the past three quarters, generating cash flow of about $800 million and spending nearly nothing on acquisitions or share repurchases. Still, we believe the firm has a long way to go to demonstrate that it can deliver consistent results. The firm also needs the bump in liquidity that this debt offering will provide, as it faces $1 billion of maturities in 2013, roughly equal to cash on hand at the end of the first quarter of fiscal 2013. Raising additional capital will clearly enhance CSC's liquidity position, as it expects to generate only $300 million-$350 million of free cash flow during the year.
CSC's existing 6.5% notes due 2018 currently trade at about 310 basis points above Treasuries. At only 30 basis points wide of this level, the planned 10-year offering looks expensive to us. We'd prefer to see a gap of around 50 basis points between the two bonds. In addition, spreads on CSC debt in general are much tighter than they were as recently as two months ago, when the 2018 notes traded more than 100 basis points wider than currently. The notes traded as wide as 600 basis points above Treasuries earlier this year as CSC's problems mounted. Given the road ahead for CSC as it works to improve its cost structure and to renegotiate troubled contracts, we would like to see a bigger spread cushion to guard against the possibility that the firm again stumbles.
Transocean to Issue 5- and 10-Year Notes at Fair Value (Sept. 10)
As part of a larger slate of news released late Sunday and early Monday, Transocean ((RIG), BBB-) announced that it is issuing 5- and 10-year senior notes in benchmark size. Based on the whisper talk of 195 basis points above Treasuries for the 5-year and 225 basis points above Treasuries for the 10-year, we view the new issues as fairly value at best.
The notes will be issued out of the company's wholly owned subsidiary, Transocean Inc., and will be fully and unconditionally guaranteed by the company. Transocean intends to use the proceeds to fund all or part of the costs of the concurrently announced construction for four new-build drillships. The total estimated cost of the new builds is $3 billion. In conjunction, Transocean announced that it is in negotiations with a major oil and gas firm concerning 10-year contracts for the four new builds, with an estimated backlog value of $7.6 billion, or a day rate of about $520,000. Given that competitors recently have signed contracts with day rates above $600,000, we view this potential contract as reasonable, but not outstanding. The company said it also was considering a joint venture agreement with the customer that would share rig ownership and profits in exchange for the customer providing a portion of the financing required.
To the extent that Transocean does not enter into the drilling contracts with the customer and does not construct the new builds or require the full amount of the proceeds for construction of the drillships, it instead would apply the net proceeds from this offering to the repayment of debt ($750 million of senior bonds come due in 2013) and for general corporate purposes.
Further complicating the funding picture, Transocean said it is considering a secured credit facility in the amount of $500 million-$1 billion to fund a portion of the project. Transocean also announced the hiring of a new CFO, Esa Ikaheimonen, who was previously the CFO of Seadrill ((SDRL), B), a heavily leveraged competitor of Transocean's that makes extensive use of secured credit facilities to finance new builds.
Additionally, Transocean announced the sale of its standard jackup rig fleet for $1.05 billion to a group of private equity firms. As part of the transaction, Transocean will receive $855 million in cash. As the firm is ridding itself of 38 low-quality assets in a single transaction, we view this sale favorably.
Finally, Transocean provided details regarding its ongoing legal issues in Brazil and potential Macondo liabilities with the U.S. Department of Justice. At this time, Transocean does not see any impact to the $2 billion reserve it has taken for Macondo. In Brazil, which currently accounts for 11% of Transocean's revenue, the company faces a potential injunction related to its involvement in the 2011 Chevron spill, which could force it out of the Brazilian market for an indeterminate amount of time.
We are hearing whisper talk on the new issues of 195 basis points above Treasuries for the 5-year and 225 basis points above Treasuries for the 10-year. Transocean's 6% 2018 notes recently were quoted at 221 basis points, while its 6.375% 2021 notes traded at 225 basis points. Adjusting for the high dollar price of the 6% and 6.375% notes and the difference in maturities, the whisper talk on both issues appears to offer little concession to the outstanding issues. Based on the potential shifts taking place in Transocean's capital structure, the slightly low day rate for the new builds, and the update on the Brazil and Macondo legal issues, we view these whisper levels as fair value at best.
Given the strength in the deep-water market that is exhibited by Transocean's announcements, we prefer Ensco's ((ESV), BBB) 4.7% 2021, which recently traded 175 basis points above Treasuries. The one-notch increase from Transocean's BBB- rating is worth roughly 50 basis points, but Ensco has a cleaner story. For additional yield, we prefer Rowan's ((RDC), BBB-) 4.875% 2022, which recently traded at 260 basis points above Treasuries. Rowan is new to deep water, but has seen strong interest in its three new ultra-deep-water new builds and just Monday announced a contract with a shipyard to build a fourth new ultra-deep-water drillship.
Merck Refinancing Notes; Equity Offers Higher Yield (Sept. 10)
Merck (MRK) announced plans to issue new 5.5-year, 10-year, and 30-year notes for general corporate purposes, including the repayment of existing debt maturities. We don't anticipate changing our AA credit rating based on this announcement, and given our view of Merck's credit profile, we believe investors should be assured of the repayment of these new notes. However, we suspect pricing on the notes will be merely fair; we are currently hearing whisper spreads of 65, 85, and 105 basis points over Treasuries, respectively, on its new issues. Also, income-seeking investors may be better served by investing in Merck's equity rather than debt, given the higher dividend yields available. For example, Merck's stock offers a 3.8% dividend yield while its existing 2021 notes only offer a 2.2% yield. For debt-only investors, we'd highlight AA- rated Amgen (AMGN) as an alternative to Merck's notes. Amgen remains a Best Idea and offers much higher return potential in its notes than we'd deem fair for its credit profile. For example, its 2022 notes recently offered a 3.17% yield, or a 154 basis point spread over Treasuries.
Overall, though, our issuer credit rating for Merck at AA is in line with most of its large pharmaceutical peers, and in general, we like established pharmaceutical businesses with their large competitive advantages and high profitability. With many blockbusters coming off patent, the firm decided to strengthen its pipeline and existing product mix by purchasing Schering-Plough in 2009. While it had to take on substantial debt to do that deal, we have been pleased to see Merck's debt position shrink substantially since then; its debt/EBITDA position currently stands around 1.0 times. With its enhanced new product prospects through that transaction and its highly manageable debt position, we think Merck's ability to repay debtholders remains quite safe.
Dominion Resources' 10- and 30-Year New Issues Look Moderately Rich (Sept. 10)
Dominion Resources ((D), BBB+) announced Monday that it plans to issue $1.05 billion of five-, 10-, and 30-year senior unsecured notes at the parent company. We have not heard whisper levels on these new issues, but Dominion's existing 10-year 4.45% 2021 bonds trade around 120 basis points above Treasuries and its 30-year 5.25% 2033s trade around 170 basis points above Treasuries. Should Dominion's new issues price in these ranges, we would view them to be moderately rich when compared with the utilities subsector of the Morningstar BBB+ 10-year index, which currently trades around 170 basis points above Treasuries. Moreover, Duke Energy (DUK), one of Dominion's closest, albeit regulated, BBB+ peers, has 10- and 30-year parent company bonds that trade at roughly 134 and 180 basis points above Treasuries, respectively. We would be buyers of Dominion's new issue notes at 20-25 basis points on top of Duke Energy's respective notes.
Dominion recently moved to sell its remaining coal-fired merchant power generation fleet and expects to lift regulated or semi-regulated earnings to 80%-90% of consolidated earnings. Despite its shrinking exposure to power markets, Dominion continues to have more commodity exposure than its fully regulated utility peers, justifying, in part, relatively wider spreads.
Room for Credit Spread to Tighten on Clorox's New Issue (Sept. 10)
Clorox ((CLX), A-) is reportedly bringing a $600 million, 10-year bond offering to market this morning. Before the announcement, Clorox's existing 3.80% senior notes due 2021 were trading in the upper 140s over Treasuries. We highlighted that we thought there was substantial upside when those notes were issued last November at 196 basis points over Treasuries. We continue to believe that there is additional upside in Clorox notes--albeit less than when Clorox came to market last November--as the notes should tighten over time to levels more commensurate with similarly rated comparables in the consumer sector. We have heard that the whisper number on the new issue is around 160-165 basis points above Treasuries, which we consider to be cheap, and expect the official guidance will be reduced from there closer to where the existing 3.80% notes are trading.
We think Clorox notes continue to trade wider than we would expect for two main reasons. First, our credit rating is one notch higher than the rating agencies as we view the firm's credit risk more favorably. We accord Clorox a narrow economic moat based on its strong brands and market shares, as more than 80% of the firm's portfolio consists of number-one and number-two brands, and we further believe the firm's credit is supported by its consistent sales and moderate debt leverage. Based on our projections, Clorox's debt leverage ratio averages 2 times and interest coverage averages more than 10 times over the next five years. Second, the firm was targeted by shareholder activist Carl Icahn last year. Icahn attempted to force the firm to either sell itself or be subject to leveraged buyout bid by him. Icahn was unsuccessful in prompting a change in control, withdrew his slate of nominees for the board, and has exited his equity holding in the company.
We think Clorox's notes should trade closer to comparables like General Mills (GIS, A) 3.15% senior notes due 2021, which are indicated at 116 basis points over Treasuries, or HJ Heinz ((HNZ), A-) 2.85% senior notes due 2022, which are indicated at 106 basis points over Treasuries. To the upside, Estee Lauder ((EL), A) recently issued 2.35% senior notes due 2022 are indicated at 80 basis points over Treasuries, and Kimberly-Clark ((KMB), A) 2.40% senior notes due 2022 are indicated in the mid-60s over Treasuries. We think the notes are cheap compared with the broader market, based on our assessment of the firm's issuer credit rating, as the A- segment of the Morningstar Corporate Bond Index is currently at 134 basis points over Treasuries.
We'd Avoid Walgreen's New Debt Issuance, Which Will Fund the Alliance Boots Investment (Sept. 10)
Walgreen (WAG) announced plans to issue 18-month, 2.5 year, 5-year, 10-year, and 30-year debt to fund its planned $6.7 billion investment in Alliance Boots (representing a 45% stake). We had estimated that Walgreen would need to issue about $3.5 billion of debt to fund the deal for its expected closing before the end of September. Based on those assumptions, we recently cut our credit rating for Walgreen to BBB from A- and placed Walgreen on our Bonds to Avoid list in August.
Walgreen has the option to purchase the remaining 55% of Alliance Boots within three years. If it decides to fully acquire Alliance Boots, we'd consider another cut to our credit rating, as Walgreen will need to pay about $4.9 billion in cash and assume about $12 billion of the target's existing debt. This investment would cause a big change in the balance sheet. At the end of May, Walgreen only held a $405 million net debt position; if this deal fully closes, Walgreen anticipates holding an $11 billion net debt position in 2016.
Given its increasing leverage, we believe Walgreen's notes will be priced too tightly for the risks. For example, Walgreen's only long-dated bonds, its 2019s, trade around 165 basis points above Treasuries. For a similar spread, investors interested in the drug supply chain should consider Express Scripts ((ESRX), A-), in our opinion. Recently, Express Scripts' 2022s traded around 160 basis points above Treasuries, but we rate Express Scripts two notches higher than Walgreen, meaning investors are getting similar rewards for lower risks by investing in Express Scripts, in our opinion. We also expect Express Scripts to continue deleveraging after the Medco merger, creating spread-tightening potential. Additionally, 10-year notes from BBB rated firms in the Morningstar Corporate Index trade around 210 basis points above Treasuries. We'd deem that level about fair for Walgreen's 10-year notes, given the firm's absolute and relative risk levels. But given recent trading trends and strong demand for corporate bonds in recent weeks, we suspect Walgreen's new notes will be priced inside that benchmark.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.