Credit spreads backed up 6 basis points last week, with the greatest widening occurring Thursday as the Morningstar Corporate Bond Index ended the week at +150.
Investors quickly became sellers as the markets digested another large slew of new issues and headline risk surrounding the fiscal cliff negotiations pressured markets. In fact, we heard from one bond trader that the amount of new issue volume over the past few weeks may have finally soaked up the cash sitting on the sidelines in many investor portfolios. This trader further reported that many clients were selling front-end paper to make room for new issues. While a rising tide has lifted all boats and credit spreads have tightened across the board over the past few months, we generally expect the rate of improvement in credit quality will stagnate as global economies weaken and corporate earnings are pressured. We believe this dynamic--tight spreads and stagnant credit quality--will limit further credit spread tightening and lead to greater differentiation among issuer credit quality over the near term.
Even though the credit market weakened last week, the new issue market provided plenty of volume for investors to choose from. We counted $30 billion worth of deals priced last week among the issuers we cover. This volume slightly surpassed last week's new issue volume, which included the $14.7 billion megadeal for AbbVie.
The new issue markets will be quiet this week as investors take time off for Thanksgiving, leaving only a two-week window for issuers who want to issue debt before the holiday season and year-end hit.
One of the more attractive new issues we saw last week was National Oilwell Varco (NOV) (A+). The company issued bonds to fund the purchase of equipment manufacturer Robbins & Myers. We view its 2012 acquisitions positively and believe that the firm is building upon its dominant position as one of the largest equipment suppliers in the drilling industry. Based on a 2012 year-end pro forma capital structure that includes $1 billion of revolver borrowing and $3 billion of long-term debt, we project leverage of 1.0 times and interest coverage of 22 times. Similar to its rapid deleveraging following its acquisition of Grant Prideco, we assume that National Oilwell Varco will use free cash flow to pay down revolver borrowing, ending 2014 with $3 billion of total debt. In light of the acquisitions, we recently affirmed our A+ rating after reviewing the company on a pro forma basis for the proposed capital structure. Our rating remains one notch higher than those of the rating agencies. Based on our rating and NOV's strong order backlog and dominant position, we believe fair values on the new issuances are +60 basis points for the 5-year, +80 basis points for the 10-year and +85 basis points for the 30-year. As we have posited before, we believe the substantial difference between our fair value and initial price talk is due to the fact that National Oilwell Varco is relatively unknown to corporate bond buyers, as the company's outstanding debt before this latest issuance was $500 million, spread across three issues all with a maturity of less than three years.
Eurozone Officially Enters a Recession
According to Eurostat, GDP fell 0.1% in the euro area during the third quarter. This decline comes on the heels of a 0.2% decline in the second quarter, fitting the standard definition of a recession.
Among the core countries, German GDP rose 0.3% and French GDP rose 0.2%. However, the strength in these nations was not enough to offset declines of 0.2% in Italy, 0.3% in Spain, and 0.8% in Portugal. Business indicators such as industrial production, which declined 2.5% in September, and the purchasing managers index, which fell to 45.7 in October from 46.1 in September (a level below 50 indicates contraction), are continuing to weaken, likely foretelling even greater contraction yet to come. The European Commission lowered its forecast for 2013 GDP growth in the eurozone to 0.1% from 1.0%, a disappointingly low growth rate considering consensus estimates for 2012 are for a 0.4% decline.
As the economies continue to contract, sovereign debt measures are weakening to the point that many countries' credit ratings may be lowered. For example, Moody's is reportedly reassessing its Aaa rating for the United Kingdom as the country's efforts to reduce debt metrics are being hindered by a weak economy. The agency will review its rating at the beginning of next year. As the economies soften, inflation has continued to decline, dropping to 2.5% in October, and the core rate dropped to 1.5%. As inflation subsides this may allow the European Central Bank room to consider actions to improve economic conditions.
Federal Reserve Hints at Changing Policy Guidance
In a speech given last week by Janet Yellen, vice chair of the board of governors of the Federal Reserve, regarding the evolution of central bank communications, she explained the rationale behind potentially changing the content of the Federal Reserve's communication to the public. She posited that the Federal Open Market Committee may begin to include guidance on economic conditions that would need to prevail before increasing the federal funds rate may be appropriate. She further stated that the FOMC could eliminate the calendar date guidance completely.
She highlighted an example from Charles Evans, president of the Chicago Fed, that the FOMC would commit to holding the federal funds rate at its current level at least until unemployment has declined below 7%, provided that inflation over the medium term remains below 3%. She further highlighted the suggestion of Narayana Kocherlakota, president of the Minneapolis Fed, that the thresholds be as low as 5.5% for unemployment and 2.25% for the medium-term inflation outlook. We also saw additional language in the FOMC's October minutes, released last week, that suggests the FOMC is considering changing its communications to incorporate these metrics in its guidance. We would not be surprised to see these changes made sometime over the next few FOMC meetings.
New Issue Notes
National Oilwell Varco to Issue 5-Year, 10-Year, and 30-Year Bonds at Attractive Levels (Nov. 15)
National Oilwell Varco (NOV) (A+) announced Thursday that it plans to issue 5-year, 10-year, and 30-year bonds to fund the purchase of equipment manufacturer Robbins & Myers. Including the August announcement of the purchase of Robbins & Myers for $2.5 billion in cash, National Oilwell Varco has entered into $5 billion of acquisitions in 2012. National Oilwell Varco has a history of successful integrations which help garner the company a wide moat. Thus we view the 2012 acquisitions positively and believe that NOV is building upon its dominant position as one of the largest equipment suppliers in the drilling industry.
Within our coverage universe of major oil services companies, Schlumberger (SLB) (A+), which we rate with a wide moat, and Halliburton (HAL) (A), which we view as having a narrow moat, are comparable to National Oilwell Varco. Schlumberger's 1.25% notes due 2017 are quoted at a spread of +62 basis points over the 5-year Treasury, while its 2.40% notes due 2022 traded at a spread of +83 basis points over the 10-year. Halliburton's 4.50% bonds due 2041 traded at a spread of +98 basis points over the 30-year Treasury. We are hearing initial price talk of +105-110 basis points for the 5-year, +125-130 for the 10-year, and +125-130 for the 30-year. Based on our rating and NOV's strong order backlog and dominant position, we believe fair values on the new issuances are +60 basis points for the 5-year, +80 basis points for the 10-year, and +85 basis points for the 30-year. As we have posited before, we believe the substantial difference between our fair value and initial price talk is due to the fact that National Oilwell Varco is relatively unknown to corporate bond buyers, as the company's outstanding debt before today was $500 million, spread across three issues all with a maturity of less than three years.
Today's bond issuance is a structural shift in the company's capital structure as NOV increases its debt level and extends its term structure. Based on a 2012 year-end pro forma capital structure of $1 billion of revolver borrowing and $3 billion of long-term debt, we project leverage of 1.0 times and interest coverage of 22 times. Similar to National Oilwell Varco's rapid deleveraging following its acquisition of Grant Prideco, we assume that the company will use free cash flow to pay down revolver borrowing, ending 2014 with $3 billion of total debt. In light of the acquisitions, we recently affirmed our A+ rating after reviewing the company on a pro forma basis for the proposed capital structure. Our rating remains one notch higher than that of the rating agencies.
We Think Sealed Air's New Issuance May Present Attractive Value (Nov. 14)
Sealed Air (SEE) (BB) is planning to issue $850 million of senior unsecured bonds maturing in 2020 and 2022 (both bonds are noncallable for life). The company plans to use the proceeds to tender for its existing 2013 bond that carries a coupon of 5.625% and its 2017 bond that carries a coupon of 7.875%. The company's existing 2019 bond is currently quoted around a yield to worst of 6.41%, and its 2021 bond is quoted around a yield to worst of 6.83%, both of which are very attractive compared with peer BB packaging companies such as Ball (BLL) (BB+), Crown (CCK) (BB-), and Silgan (SLGN) (BB+) (whose 10-year bonds are typically trading at yields of roughly 3.5%-4.5%). In addition, the yield to worst on the Merrill Lynch BB Index is 4.97%, much lower than the yields on Sealed Air's existing bonds. If the new bonds price at similar levels to existing bonds, we would strongly recommend investors participating.
We think Sealed Air can be an attractive investment for bondholders. The Diversey acquisition was somewhat disastrous both for the company's balance sheet health and its near-term earnings (Diversey has a large footprint in Europe, and the segment is facing some material operational headwinds given the European recession), which we think is the leading cause for Sealed Air's bonds' wide spread compared with peers. However, there have been a number of significant changes in the executive suite since the Diversey acquisition was made last year.
In June, Carol Lowe was named Sealed Air's new CFO. Lowe was the CFO of Carlisle Companies from 2004 to 2008--a period in which Carlisle reduced its debt/equity ratio from 37% to 25%. This deleveraging experience should be immensely beneficial to Sealed Air. Perhaps more important, we are encouraged by the appointment of Jerome Peribere as Sealed Air's new CEO, starting in March 2013. Peribere is currently Sealed Air's COO during the transition period. Peribere has extensive experience at integrating large acquisitions, as he oversaw Dow Chemical's (DOW) (BBB) successful integration of Rohm and Haas.
We think the moves the new management team has made, including selling Diversey's Japanese unit ($377 million gross proceeds), extending the maturity profile of its debt by this new offering, or potentially unloading other pockets of assets gained from Diversey, bode well for bondholders. We think the company's operations and balance sheet are poised to show improvements.
In addition, we think the downside protection of these new bonds is hedged by the tight covenants in Sealed Air's existing bank facility. Sealed Air has to reach a debt/EBITDA coverage ratio of 4.5 times by the end of 2013, which dictates the company's debt reduction plan for the next one to two years. We think the company is fully capable of reducing debt further to give itself more breathing room. We estimate that Sealed Air will generate roughly $1 billion of EBITDA in 2013, which translates to a maximum of $4.5 billion of gross debt (total debt is $4.9 billion at the end of the third quarter). We expect the company will pay down at least $300 million of debt with the proceeds from Diversey's Japanese unit sale this year. Further, we continue to think Sealed Air's packaging business in the U.S. is a stable cash generator, and we expect the company will generate more than $400 million of free cash flow next year, using part of that to further pay down debt.
Initial Price Talk on Macy's New Deal Is Fairly Valued, but We'd Pass If It Prices Tighter (Nov. 14)
Macy's M (BBB) announced an $800 million debt offering this morning in 10- and 30-year tranches. Initial price talk on the 10-year of 150 basis points over Treasuries is roughly 30 basis points wide of where the firm's existing 10-year is trading, but 30 basis tight of Morningstar's Industrials 10-year BBB Index.
We view the mid-100-basis-point range as fair value for Macy's bonds, based on where comparable retailers trade. However, we expect the deal will likely price tighter than our fair value estimate, at which point we would probably not be interested in the transaction. The BBB rated auto parts retailers, AutoZone (AZO) and O'Reilly Automotive (ORLY), also trade tight to the index, but are slightly wider. AutoZone recently priced a 10-year deal at +120 basis points and currently trades in that area, which we also think is expensive. Looking beyond retail comparables, we find better value in the restaurant sector and would rather own Darden Restaurants (DRI) (BBB) at +174 basis points over Treasuries.
Earlier this month, Macy's announced a $500 million tender offer consisting of four tranches of outstanding notes in the following priority: 5.90% notes due 2016 ($977 million outstanding), 7.45% debentures due 2016 ($123 million outstanding), 7.50% debentures due 2015 ($100 million outstanding), and 7.875% notes due 2015 ($612 million outstanding). The firm stated it plans issue new debt to fund the tender offer, taking advantage of not only low rates and investors' demand for new paper, but also its improving credit quality.
We upgraded our issuer credit rating for Macy's to BBB from BBB- in August based on continued improving leverage. The firm's lease-adjusted leverage now stands at 2.3 times and we expect this number to trend lower by year-end. Previously, Morningstar upgraded Macy's issuer credit rating to BBB- from BB+ in April 2011 due to improvements in the retailer's operating performance and balance sheet. At that time, lease-adjusted leverage was just under 3 times. Moody's and S&P moved their respective ratings higher a quarter or two later. Our current rating is in line with S&P, but a notch higher than Moody's. From our perspective, Macy's is now solidly investment grade after such concerted efforts to strengthen its balance sheet.
The firm has begun to return more cash to shareholders, which we believe indicates that management is happy with its leverage trajectory. The firm reined in dividends and share repurchases in 2008 until it returned to investment-grade in 2011. It plans to repurchase $1 billion of shares in fiscal 2012 and recently raised its dividend.
General Electric Capital to Issue 5-Year Notes; Initial Price Talk Sounds Attractive (Nov. 14)
General Electric Capital Corporation (A) is expected to issue benchmark-size 5-year notes today. Our rating on GECC is influenced by our rating on parent General Electric (GE) (AA-) and the financial support provided through an income maintenance agreement. However, given that the support agreement does not constitute a guarantee of GECC's debt and the majority of GECC's profits are derived from businesses unrelated to GE, we do not believe there is an inextricable link between the two entities. As such, the foundation for our GECC rating is its standalone rating, which falls in the A- category, subsequently adjusted upward for the GE support.
We're hearing initial price talk in the "low 100s," which sounds somewhat attractive, if it holds. GECC has an existing 2017 that was recently quoted around a spread of 90 basis points over Treasuries, which seems fair to slightly rich to us relative to other A rated financials. J.P. Morgan Chase (JPM) (A) has a 5-year bond that was recently quoted around a spread of 105 basis points over Treasuries, which we view as fair. In the 10-year part of the curve, both GECC and JPM trade in the area of +130, which also seems fair. We would be buyers of the new GECC 5-year down to a spread of +95.
BMC Provides Another Opportunity to Pick Up Yield (Nov. 13)
BMC Software (BMC) (A+) plans to issue $400 million of new 10-year notes, its second such offering during 2012. We expect this offering will price attractively despite the fact that BMC's financial profile is deteriorating.
Management is seeking to enhance shareholder value amid rumors that the firm is an acquisition target. The firm recently completed a review of its strategic options and decided to add another $1 billion to its share repurchase program, with plans to execute $750 million of this authorization via an accelerated buyback by the end of the year. BMC ended its fiscal second quarter (September) with a bit more than $600 million in net cash. Net cash has steadily declined in recent quarters as a result of acquisitions and share repurchase and now stands at about half the level of a year ago. BMC now holds less than $500 million domestically versus $825 million in gross debt. With free cash flow running at around $600 million annually, net cash could approach zero at the end of the current quarter, which would be unusual for a software firm. The current debt offering will be used to build domestic cash for the share repurchase program. We like the stable, solid cash flow that BMC produces, but if management doesn't allow cash to rebuild in 2013, our rating would be in jeopardy.
BMC's 4.25% notes due in 2022, issued last February, currently trade at a spread of about 243 basis points over Treasuries. At this level, BMC trades like a BBB- credit based on spreads within the Morningstar Industrials Index. We believe the new notes are attractive down to a spread in the high-100s, a level that would still provide a sizable cushion against future downward pressure on BMC's ratings. For context, rival CA (CA) (A) has tended to carry less net cash than BMC and we generally don't like its business as well. CA's 5.375% notes due in 2019 trade at about 190 basis points over Treasuries. Importantly, the new BMC notes, as with its existing debt, include protection against a change of control.
AK Steel's New Issue May Come Cheap to Compensate Bondholders for Near-Term Uncertainty (Nov. 13)
AK Steel (AKS) (B) is coming to the high-yield market with a $350 million senior secured bond that is not callable until 2015 and matures in 2018. We expect the proceeds to fund the company's pension liabilities and capital expenditure programs in the next two years. Pension funding will be $180 million in 2013 and $240 million in 2014, and we expect annual capital expenditures to exceed $100 million in each year.
We think the deal will price very cheap compared to the Merrill Lynch Industrial High Yield Index with similar ratings, which stood at a yield of 6.43% this morning. AK Steel's 2022 senior unsecured bond is trading at a yield of 11%, which is much cheaper than the prevailing yield with a typical B company. Its 2020 senior unsecured bonds are trading at a yield of 10%. U.S. Steel (X) (BB-) has a 2022 bond that is trading at a yield of 7.5%. We think AK Steel's secured issue should come inside of its existing bonds but cheaper than that of U.S. Steel. We are comfortable owning this secured bond despite the negative fundamental trends and potential downside ratings risk as the downside risk of this bond is somewhat hedged with the collateral and the bond matures ahead of AKS's two senior unsecured notes.
In addition, we are not highly concerned about the company's liquidity position. Despite several quarters of weak operating earnings, AK Steel still has ample liquidity, and we do not think the liquidity situation will worsen meaningfully in the next two years nor do we expect the company to violate any covenants that would reduce the availability on the company's credit facility. As of the end of third quarter, the company's cash stood at $47 million. In addition, the company has $558 million available on its asset-backed revolver. This facility matures in April 2016, about six months behind the date the new secured bond first becomes callable. Combined, we view the existing $605 million of liquidity as sufficient for near-term funding needs including additional cash burn through 2013. However, AK Steel is also issuing 25 million of shares (which we think may generate around $75 million-$100 million in cash proceeds), plus $125 million of exchangeable senior unsecured notes due in 2019. If all these are issued as planned, we expect the company to finish the year with roughly $600 million of cash, in addition to an estimated $500 of undrawn revolver.
That said, the company's credit quality is weak and may face some further downside pressure. AK Steel has been running with operating losses in the past five quarters in a row, underlined by its material lack of pricing power against both its upstream raw material providers and its downstream customers. Existential risks of the company may linger for the next 12 to 18 months. While lower raw material costs may provide some meaningful relief in 2013, we remain concerned about the weak demand and uneven end market recoveries (with the exception of automotive). We think there is a lack of momentum in demand in AK's products and excess domestic steelmaking capacity and global competition is likely to yield a lackluster 2013. If the company can successfully manage until 2015, we think the benefit of upward integration may begin to solve one side of the difficult equation for AK Steel, which, in the long term, may improve the company's sustainable competitive position.
Click here to see more new bond issuance for the week ended Nov. 16, 2012.