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Credit Insights

January Spreads Tightened, but Investors Still Lost Money

Many investors tried to dodge the effects of rising interest rates as demand for shorter-duration bonds increased.

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The average spread in Morningstar's Corporate Bond Index tightened 5 basis points in January to end the month at +135. Credit spreads in the financial-services sector tightened 10 basis points, outperforming the industrial sector, which tightened 2 basis points. In our first-quarter 2013 outlook, we opined that the financials sector would outperform the industrial sector this quarter, and we continue to hold that view. 

Within the industrials sector, basic industries and technology outperformed, tightening 11 and 8 basis points, respectively. As investors poured new money into fixed-income mutual funds and exchange-traded funds and the economy continued its tepid recovery, portfolio managers were overweight with their purchases into these cyclical sectors. The energy sector underperformed in January as it widened 2 basis points, the only sector to widen over the course of the month, mainly because of shareholder activism in the sector.

While credit spreads tightened during the course of the month, corporate bond prices declined as interest rates rose. The 10-year and 30-year Treasury bonds each rose 22 basis points, overwhelming the benefits from tightening credit spreads, resulting in a 0.73% decline in the Morningstar Corporate Bond Index. Based on movements in this index, it appears that many investors tried to dodge the effects of rising interest rates as demand for shorter-duration bonds pushed credit spreads of bonds with maturities under seven years tighter than longer-dated bonds. Bonds with maturities under seven years tightened 8 basis points as compared with a 2-basis-point tightening for bonds in the seven- to 10-year maturity range and 4-basis-point tightening for bonds with maturities over 10 years.

As we highlighted in our first-quarter 2013 outlook, it will be mathematically very difficult to enjoy anywhere near the double-digit returns investors enjoyed in 2012. To reach those types of returns, either credit spreads will have to return to the tightest levels recorded (February 2007) or interest rates will have drop significantly below where they are currently trading, which is already near the lowest on record. Assuming corporate credit spreads tighten modestly and interest rates remain steady, in conjunction with the Morningstar Corporate Bond Index currently yielding 2.40%, investment-grade bonds appear to be poised to return the low to mid-single digits in 2013.

Morningstar's Investment-Grade Best Ideas Index Outperforms Once Again
For the month of January, Morningstar's Investment-Grade Best Ideas Index outperformed our Corporate Bond Index by 19 basis points. During the course of the 30 months since inception, we have outperformed the index in 22 of those months, having outperformed by 340 basis points in 2012 and 532 basis points in 2011. Outperformance has been driven by individual security selection, as the overall characteristics of the Best Ideas Index are very similar to the investment-grade credit market as a whole as represented by our Corporate Bond Index.

Negative GDP Print Shocking, but Not Indicative of Economy
According to Robert Johnson, Morningstar's director of economic analysis, the 0.1% decline in the fourth-quarter gross domestic product report was especially convoluted. Closer examination suggests that the government and overly cautious businesses were largely to blame for an otherwise excellent report. A decline in inventories also played a role in the downside in the report as businesses failed to keep up with consumer spending. Johnson believes these businesses will have to make up for the inventory reductions in the months ahead, providing for further growth. Within the GDP report, consumption grew 2.2%, business investment rose 8%, and housing expanded 15%. The major detraction was in the government segment, which subtracted 1.3% from the GDP calculation. Johnson further highlighted the strength in the revisions in the employment report throughout the fourth quarter, which contradicts the weak showing in the GDP report. For additional detail on his economic assessment, please see his weekly report, "Don't Be Fooled by the GDP Report: the Economy Is Gaining Strength."

Homebuilding Investment Ramps Up
 D.R. Horton (DHI) (BB+),  Lennar (LEN) (BB), and Beazer Homes (BZH) (NR) priced several new multitranche high-yield bond offerings last week with proceeds targeted for general corporate purposes, which we expect will be additional investment in land and building opportunities. As the industry recovers from multiyear lows, the homebuilders are reporting improving results. For example, Horton reported robust first-quarter results including strong increases in sales (up 39%), net sales orders (up 39%), and the value of its backlog (up 80%). In addition, Horton's adjusted gross margins of 18.8% increased 200 basis points. In mid-January, Lennar posted yet another very strong quarter, including double-digit increases in fourth-quarter deliveries (up 32%), new orders (up 32%), and backlog dollar value (up 107%). Lennar continues to post market-leading gross margins, which came in at 23.5% this quarter, up 410 basis points year over year and up slightly versus the third quarter. While Lennar and other builders have experienced raw material and labor cost increases, Lennar's management expects to maintain strong margins based on an ability to selectively raise prices. The firm guided to 2013 gross margins in the 23%-24% area versus 22.7% for 2012. Lennar has also maintained stable leverage and its liquidity remains solid. 

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

New Issue Notes

Carnival Takes Second Cruise in Three Months Into the Debt Market (Jan. 31)
 Carnival (CCL) (CUK) (BBB) is coming to market for the second time in three months, offering $500 million in 3-year notes. Initial price talk of 95 basis points over Treasuries seems fair to us as the firm's recently issued 5-year notes are trading around 107 basis points over Treasuries. Given the short tenor, 95 basis points appears reasonable on the credit curve relative to Morningstar's 10-year BBB index, which is currently at 168 basis points over Treasuries. The travel and leisure sector trades roughly in line with the Morningstar Industrials Index, which we view as appropriate given the improvement in consumer spending. Carnival echoed this improvement on its recent earnings call, pointing to a turnaround in 2013.

While inherently volatile because of the large capital requirements to finance ship builds, Carnival is positioned to produce strong normalized cash flows, in our view, as it generates more operating cash flow than is required to support new ship builds. We estimate free cash flow over the next five years will be close to $9.5 billion, leading to a Cash Flow Cushion of around 1 times, despite the firm's hefty debt and debtlike obligations. However, we also forecast roughly $6.5 billion in share repurchases and dividends over the same period, and we expect Carnival will refinance some debt to carry out these shareholder-friendly activities. Based on our projections, we are confident that the firm is an investment-grade credit, with leverage remaining just under 3 times over our forecast period. 

ADT Credit Metrics In Line With Expectations; Bonds Look Attractive (Jan. 30)
 ADT (ADT) (BBB+) reported fiscal first-quarter earnings today, with total revenue up 2% and EBITDA (before special items) up 6%. The results were generally positive, with average revenue per customer increasing to $39.27, roughly 5% higher than the prior year as the company's higher-priced Pulse offering continues to gain traction. Pulse penetration rates reached 19% during the quarter, including almost 30% in the residential direct channel. EBITDA margin reached 51.5% during the quarter, up 210 basis points from the prior year. Total debt was $2.5 billion and TD/EBITDA was 1.6 times, unchanged from the prior fiscal year-end. However, the company tapped the bond market in January, raising $700 million of 10-year money to help fund its share repurchase program. Pro forma for this offering, TD/EBITDA is 2 times, generally in line with the leverage target the company laid out to investors last quarter, when it expressed its commitment to investment-grade ratings. At that time, we left our credit rating unchanged but noted little flexibility at the BBB+ rating given the higher leverage profile.

On the call, management updated investors regarding its progress on the $2 billion share-repurchase program, which is expected to be completed over a three-year period. To date, the company has repurchased about $100 million worth of shares and expects to buy back an additional $600 million over the next six months pursuant to an agreement recently entered into with Credit Suisse. Recall that management's capital allocation plan calls for fiscal 2013 dividends and share repurchases to total $900 million-$1 billion. With dividends expected to be about $100 million for the year, additional share repurchases of about $200 million should be in the cards later this year.

Although we believe investors in ADT should definitely be compensated for the lingering uncertainty regarding the activist investor Corvex Management situation, we think existing bonds offer value and would overweight the name. ADT's newly issued 2023 bond came to market at a spread of 225 basis points over Treasuries and we're now seeing them quoted tighter, around 200 basis points over Treasuries. Looking across the industrial landscape, spreads for similarly rated names are meaningfully tighter, with  Eaton's (ETN) (BBB+) new 10-year bond quoted around a spread of 110 basis points over Treasuries, which we view as slightly rich.  Roper Industries (ROP) (BBB), which is strongly positioned within its rating, has a new 10-year that was quoted around 126 basis points over Treasuries, which we also view as slightly rich. Within the cable space,  Comcast (CMCSA) (CMCSK) (A-) has a 2022 bond that was recently quoted around 110 basis points over Treasuries. Although we view this as somewhat attractive within the sector, we think cable sector spreads are generally rich. We don't expect ADT spreads to tighten to these levels, but given the company's stable cash flow characteristics and management's commitment to investment-grade ratings, we think an additional 30 basis points of tightening is reasonable.

Initial Price Talk on New Air Products Offering Sounds Slightly Rich (Jan. 30)
 Air Products & Chemicals (APD) (A-) is expected to issue $400 million of 10-year notes, with proceeds likely utilized to fund some 2013 maturities. As we've noted before, 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 was recently quoted around a spread of 90 basis points over Treasuries, which generally seems fair relative to the sector but is about 15 basis points tighter than the A- bucket of the Morningstar Industrials Index. Within the sector,  Praxair (PX) (A), which we rate one notch higher, reflecting higher margins and similar leverage, has a 2022 bond that recently traded around a spread of 68 basis over Treasuries, which we view as rich. Initial price talk on the new deal is mid-80s over Treasuries, slightly inside where we see the existing 2021s quoted, which we view as modestly rich

Lennar and Horton Add Supply to High-Yield Market as Homebuilding Investment Ramps Up (Jan. 30)
On the back of a strong first-quarter print by D.R. Horton, both Horton and Lennar announced new multitranche high-yield bond offerings with proceeds targeted for general corporate purposes, which we view as additional investment in land and building opportunities. Lennar is selling an add-on to its existing 4.75% senior notes due 2022 and a new senior note due December 2018, while Horton is offering $300 million of seven-year notes and $400 million of 12-year notes. Lennar's existing 2022s are indicated just below par and offering a yield of about 4.9%, resulting in a spread of about +290 basis points over Treasuries. We view this as fair value, noting that Horton's 2022s--issued in September--recently traded at just under 4.0%, providing a spread of +206, which we view as rich. Toll Brothers' (TOL) (BBB-) nine-year bonds recently traded at slightly above 4.0%, providing a spread of +224, which we view as slightly cheap. We view fair value on Lennar's new 2018s at around 4.0%, slightly inside of its existing bonds due June 2018. For Horton, we see fair value on the 12-year bond at about 4.75% and for the seven-year bond at about 3.75%. We note that while we view Horton's existing levels as somewhat rich, our credit rating is one to two notches higher than that of the rating agencies.

Horton reported robust first-quarter results, including strong increases in sales (up 39%), net sales orders (up 39%), and the value of its backlog (up 80%). While adjusted gross margins of 18.8% increased 200 basis points, they remain well below those of Lennar and Toll, which are in the low 20s. Horton's net debt/capitalization ratio ramped up to 33% from about 21% in the prior quarter as the firm increased its investment in inventory and land by more than $600 million, driving a homebuilding cash decline of $685 million to $643 million. Homebuilding debt ticked up to $2.4 billion from $2.3 billion. Leverage compares favorably to Lennar's, which has held in the mid-40s, but a bit worse than Toll's, at 24%. We do note that Horton has a $500 million convertible bond due in just over a year which is well in the money and may convert to stock. Horton also has two other bonds totaling $283 million maturing in 2014.

In our Jan. 15 note, we noted that Lennar guided to 2013 gross margins in the 23%-24% area versus 22.7% for its recently ended fiscal 2012. Lennar has also maintained stable leverage, with net debt/capital coming in at about 46%. Liquidity remains solid, with homebuilding cash of $1.1 billion and its $525 million credit facility fully undrawn. The firm ended its fiscal year with total homebuilding debt of $4.0 billion. Lennar's next maturity is its 2.0% converts, which are putable and callable in December 2013. With the stock now trading well above the strike price of $27.64, we expect this $276 million bond to get converted to stock. Maturities are well laddered beginning in 2014 after that through the 2022 issue.

We'd Pass on Netflix's New Bond Deal (Jan. 29)
 Netflix (NFLX) (BB+) plans to issue $400 million in 8-year notes today, and price talk is a yield of 5.375%. The firm will use $225 million of the proceeds to refinance existing debt, and the remainder for general corporate purposes, which could include strategic acquisitions. Netflix has $200 million in 8.5% notes that currently may be redeemed at make-whole, but are callable in November at 104.25.

For a company whose business model's profitability we question over the long term, 5.5% isn't enough to get us interested in the deal. We see fair value north of 6%, as we prefer other high-yield names that yield roughly that amount, such as High-yield Best Idea  Frontier Communications (FTR) (BB) in the telecom space. Frontier appears committed to improving its financial condition, especially important given the generally declining fixed-line business. We expect Frontier's revenue will contract over time, with cost-cutting efforts only partially offsetting lost sales. But we also believe the firm can reduce debt fast enough to bring its leverage to a more favorable level. In addition, Frontier's fixed-line network, which only cable rivals can duplicate, should provide an advantage in retaining customer relationships over time relative to Netflix.

Netflix does have strong cash generation, no near-term debt maturities, and more cash than debt--all indicative of an investment-grade rating. Still, we don't think the company is well positioned for the long run, as digital distribution of content has lower barriers to entry and will probably lead to new competitive threats, which is why we believe the firm merits a high-yield rating. Over time, given the uncertainty surrounding Netflix, we believe there could be downward pressure on our rating. There are few switching costs, and we believe the existing pay TV distributors, who are quickly adding streaming content on an authentication basis, are in a better position to license quality content in the long run. We question the ultimate growth potential and sustainable level of long-term profitability for Netflix, given this increasing competition and potential for content owners to retain most of the economic profits. We think owners of valuable and sought-after content hold the upper hand, as they have the ability to sign shorter licensing deals, which allows them to consistently re-price their content.

The recent Disney movie streaming deal is an example of Netflix having to overpay for content. In December, Netflix announced a licensing deal with Disney to secure the rights to films in the U.S. pay television window starting in late 2016. Disney agreed to this deal early, as its current Starz agreement lasts for movies released through 2015, so common sense tells us it got an offer it couldn't refuse, or perhaps didn't think would be available in the future. Also, given the changing dynamics of the home video window, which occurs before Netflix gets movies, the current perceived value could decline.

Click here to see more new bond issuance for the week ended Feb. 1, 2013.

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