Credit Markets Normalizing, but Concerns Remain
Things are slowly improving in the bond market, but many of the issues in Europe that underlie the sovereign debt crisis remain unresolved.
With all the liquidity sloshing around the globe, central banks have succeeded in one of their intended goals, to normalize credit markets. Still, this liquidity has failed to spur the economic growth that will allow central banks to remove liquidity. Among the developed nations, the U.S. economy has performed the best, but it remains mired in a slow-growth recovery, averaging plus or minus 2% real gross domestic product. The eurozone has suffered six quarters of GDP contraction, the longest recession since the eurozone was established. Japan's economy is only just beginning to show signs of life after its quantitative easing program reduced the value of the yen; the yen has dropped 10% versus the dollar since the beginning of April and 17% since the beginning of the year.
While the credit markets have substantially normalized, we remain concerned that many of the issues in Europe that underlie the sovereign debt crisis remain unresolved. For example, Italian banks Intesa Sanpaolo (ISNPY) (BB-, no moat) and UniCredit (UNCFF) (BBB-, narrow moat) reported earnings last week, and while overall the numbers were respectable, the larger story was the increase in nonperforming loans. For Morningstar, our concern surrounding the continual increases in Italian nonperforming loans has been a consistent theme over the past year, and as the economic outlook for Italy remains poor, we suspect that these concerns will remain over the near term.
At Intesa, gross nonperforming loans increased 17% from last year and 3% from last quarter. While the company takes some solace that the rate of increase in nonperforming loans appears to be slowing, it is still seeing increases despite an already high balance of nonperforming loans. Our concerns will not be alleviated until we see an actual drop in the total balance of nonperforming loans. By our calculations, approximately 13% of all the loans on Intesa's books are nonperforming. Nonperforming loans at UniCredit increased 12% over the year and 2% from last quarter. UniCredit's gross impaired loans now constitute approximately 14% of all loans. UniCredit's loan portfolio is more diversified across Europe, compared with Intesa, and Italian loans constitute approximately 35%-40% of the loan book. These Italian loans are the main driver of the nonperforming loan growth at UniCredit. UniCredit's nonperforming loans in Italy grew 17% over the last year, approximately the same rate that Intesa experienced. For both banks, the coverage ratio of reserves/impaired loans is in the mid-40s, which is reasonable on a historical basis. The continuing economic problems in Italy, however, could change that view. As we have seen in other countries, extreme economic stresses can lead to massive liquidations in nonperforming loans. These liquidations, in turn, drive overall loss rates higher, making historically reasonable coverage ratios obsolete.
Prodigious Liquidity Absolves a Multitude of Sins
The Federal Reserve has been flooding the markets with liquidity since the end of 2008. First it launched QE1, accelerated the flow in the second half of 2010 with QE2, began Operation Twist in the fall of 2011, and most recently launched QE3 last December. The European Central Bank has performed its own liquidity injections in Europe, with the most successful being its three-year long-term refinancing operation, started in December 2011. The ECB expanded its easy monetary policy when it recently cut in its short-term rates 25 basis points to 0.50%. At the beginning of April, the Bank of Japan announced its own massive easing program and plans to double its monetary base by the end of 2014. Among other global central banks, easy money abounds as the Reserve Bank of Australia recently cut its interest rate 25 basis points to a record-low 2.75%. Since November 2010, Australia's central bank has cut its interest rate by a total of 200 basis points. South Korea also cut its benchmark rate by 25 basis points to 2.50%, its first interest rate cut since October 2012 and a cumulative decrease of 75 basis points since the South Koreans last raised interest rates in June 2011.
As interest rates decline and the Federal Reserve's asset-purchase program removes Treasury and mortgage-backed securities from the public markets, investors have increasingly been allocating fixed-income investments into the corporate bond market. This demand has pushed the average spread in the Morningstar Corporate Bond Index down to 132 basis points over Treasuries, only 3 basis points higher than its tightest level after the U.S. credit crisis. This deluge of liquidity flowing into the corporate bond market has restored many of the historical relationships in the credit markets that had been distorted by the credit crisis and the sovereign debt crisis.
Financial Sector Continues to Outperform Industrials, but We Think It's Run Its Course
Before the U.S. credit crisis, the financials sector within the Morningstar Corporate Bond Index traded about 50 basis points tighter than the industrials sector. However, this spread compressed by the fall of 2007 and reversed substantially in 2008 as investors began to realize the depths of losses on banks' balance sheets as subprime losses morphed into a full-blown credit crisis. Bondholders feared that banks were woefully undercapitalized and unable to absorb the full extent of losses on their balance sheets, prompting traders to sell bank bonds first and ask questions later. Bank funding holes were filled though multiple equity offerings and a whole host of alphabet soup government programs (TARP, TGLP, TALF, and so on), which began to compress the basis between the financial and industrial sectors. However, before the basis could revert to its historical norm, contagion from the developing Greek debt crisis began to spread to Spain and Italy. As the sovereign debt crisis expanded, investors were concerned that sovereign defaults would bankrupt many European banks and counterparty exposure would cause losses within the U.S. financial system as well. The ECB provided financing to the banks through the LTRO, which halted the immediate solvency concerns. This fear was further alleviated in July 2012 when ECB president Mario Draghi said he would do whatever it takes to preserve the euro. Since then, as the fear abated that insolvency in the European banking system would undermine the credit quality of U.S. banks, the spread between financials and industrials has steadily tightened, and they are currently trading on top of one another.
At the beginning of March, we revised our outlook on the U.S. banking sector to neutral from overweight. Previously, we had been overweight financials since March 2012, but the impetus for changing our view was our increasing concern regarding the continuing growth in nonperforming loans in Spain and Italy. We think the increase in nonperforming loans is likely to lead the markets to once again question the stability of many European banks. Subsequent to the restructuring template in Cyprus, there is a greater risk of bondholder impairment in a bailout situation. Therefore, we expect credit spreads of European banks are likely to widen in response to increasing risk, which may then lead to widening credit spreads among U.S. banks.
European Corporate Bond Index Tightens Inside US Corporate Bond Index
Historically, the average spread in the Morningstar Eurobond Corporate Index has been significantly lower than our US Corporate Bond Index. The spread between the two indexes peaked at about 375 basis points during the depths of the U.S. credit crisis as European corporate bonds held their value much better than their equivalent-rated U.S. counterparts. The spread steadily narrowed to historical norms by the end of 2009 as the U.S. credit markets healed. However, as contagion from the Greek sovereign debt crisis spread throughout the peripheral European countries, the spread inverted. The inverted spread differential peaked in December 2011 and began to narrow after the ECB instituted a three-year long-term refinancing operation, which significantly eased liquidity pressures among European banks. The spread narrowed further after the ECB president Draghi made his famous "whatever it takes to preserve the euro" remark in July 2012. In just the past few weeks, the average spread in our Eurobond corporate index has dropped below our U.S. corporate index and is currently 18 basis points tighter.
Among the peripheral countries, sovereign interest rates have declined from their peaks last fall. The yields on Italian and Spanish 10-year bonds have dropped to 4.00% and 4.20%, respectively, their lowest rates since October 2010. Even beleaguered Portugal, which has effectively been locked out of the long-term public debt markets for the past two years, was able to issue EUR 3 billion of new 10-year bonds the prior week thanks to strong investor demand for yield.
In the high-yield market, the average spread of the BofAML High Yield Index has dropped to its lowest post-credit crisis level and the new issue market remains red hot. High-yield issuers have been able to refinance debt at substantially lower rates and use proceeds from new bond issues to pay dividends to their private equity owners. Issuers that only a short while ago couldn't imagine they would have easy access to the capital markets and pay low interest rates on their debt are now finding eager buyers. For example, several of the most overleveraged 2007-08 vintage leveraged buyouts such as Claire's, First Data, and Univision have all been able to issue new debt in the public markets. Bonds from these issuers were trading anywhere from 25 to 50 cents on the dollar during the credit crisis, yet now these companies are able to issue debt at par.
New Issue Notes
High-Yield Hospital Tenet Issuing New Debt; Underweight Bonds (May 15)
Two days after hospital and rehabilitation service provider Select Medical Holdings (SEM) (B, no moat) issued $600 million in new senior unsecured notes due in 2021 at a yield of 6.375%, another B rated hospital, Tenet Healthcare (THC) (B, no moat) is in the market. Tenet is issuing $1.05 billion in new 8.5-year senior secured notes, which are noncallable. The proceeds from the new notes will be used to tender for the 8.875% senior secured notes that are due in 2019, which have $925 million in principal outstanding. Tenet will pay $1,133.18 per $1,000 in principal tendered and accrued interest through the settlement date, which is expected to be May 30.
We see fair value on Tenet's new senior secured notes around a yield of 4.5%. In general, we believe Tenet's notes are indicated too tight for the risk. The best comparison we have for Tenet's new notes is its 4.5% senior secured notes due in 2021, which were recently indicated at a yield of 4.1% and too tight, in our opinion, for this B rated issuer's secured debt. We think Tenet's new secured debt should be priced meaningfully wider than the Merrill Lynch BB index, which is indicated at a yield to worst of 4.0%. In general, we think the big hospital firms--Tenet and HCA HCA (rating: B+, no moat)--are indicated at levels that are too tight for the risk, which may inform the pricing on this new issue. For example, HCA's 4.75% senior secured notes due in 2023 were recently indicated at 4.24%. While not an apples-to-apples comparison, hospital investors may be able to get more compensation for the risk at other issuers. For example, we view Select Medical's new senior notes as attractive at a yield of 6.375%, since we placed fair value around 5.50%.
Finally, Best Idea Lorillard Coming to Market With New 10-Year Bonds (May 15)
Lorillard (LO) (BBB, wide moat) is in the market with $500 million of new 10-year notes. In our first-quarter earnings note published April 24, we opined that we expected the company to be back in the market this year, and have previously written that Lorillard could issue up to $1 billion of debt while still preserving its BBB rating. Before this offering, our forecast debt leverage for 2013 was 1.5 times, which is at the low end of the company's 1.5-2.0 times leverage target range. This level of debt leverage places Lorillard roughly in line with our 2013 projected debt leverage for Altria Group (MO) (BBB, wide moat), which we rate the same as Lorillard.
In February 2012, Lorillard issued 2.30% senior notes due 2017 at a spread of about 150 basis points over Treasuries. At that time, we opined that those notes were cheap for the credit risk and those notes are now currently trading around 130 basis points over the comparable Treasury bond. Lorillard's 6.875% senior notes due 2020, which have long been one of our Best Ideas, are trading around 218 basis points over comparable Treasuries. We think Lorillard's bonds are cheap for the credit risk, and the credit spread should tighten toward Altria's levels over time. Currently, Altria's 2.95% senior notes due 2023 are trading at about 125 basis points over Treasuries.
Initial price talk on Lorillard's new issue is 200 basis points above Treasuries, but after adjusting for the large dollar premium on their existing 6.875% notes and accounting for the spread curve from the 2.30% notes, we think the new issue should price around 180 basis points above Treasuries. Over time, we think the new notes should tighten further to about 25 basis points over Treasuries behind Altria's bonds once the overhang regarding potential menthol regulation by the Food and Drug Administration is resolved. In addition to being cheap compared with other tobacco issuers, the new notes are attractive compared with the average spread within the BBB tranche of Morningstar's Industrials Corporate Bond Index, which is currently 167 basis points above Treasuries.
The spread on Lorillard's notes trades significantly wider than the other tobacco names, as the firm's revenue is dependent on the menthol category. The FDA has been examining the menthol category to determine if it will impose additional restrictions, or if it should institute an outright ban on menthol products. While the headlines surrounding the release of the panel's decision may sound dire, we think an outright ban is highly unlikely. The scientific evidence is ambiguous, local governments would lose a substantial amount of tax revenue, an underground market for menthol could emerge, thus limiting the FDA's ability to control the category, and 80% of menthol smokers are minorities. We expect the FDA will impose greater restrictions on the marketing and perhaps the availability of menthol cigarettes, which is incorporated in our forecast. Nevertheless, any restrictions imposed on the menthol category are likely to hurt Lorillard more than its more diversified peers. Once the FDA releases its conclusions, and assuming our opinion is correct, we expect credit spreads for Lorillard's bonds to tighten toward Altria's levels.
Merck Issuing Debt for Planned Share Repurchases (May 15)
Merck (MRK) (AA, wide moat) is in the market Wednesday to issue new three-year (floating and fixed rate), five-year (floating and fixed rate), 10-year, and 30-year notes. The proceeds will be used to fund its new share-repurchase program, which was announced in early May. Merck's board recently increased its share-repurchase program by $15 billion, bringing its total repurchase authorization up to $16.1 billion. Management anticipates repurchasing $7.5 billion of that authorization within the next 12 months, which it intends to fund with debt financing and excess cash flow. If Merck decides to fully fund this year's repurchase activity with debt, we would consider a one-notch credit rating downgrade. We will also keep an eye on how it intends to fund the rest of its repurchase authorization, which has no time limit.
Given the potential for downward pressure on Merck's rating due to expected debt-funded share repurchases, we use both AA and AA- rated pharmaceutical firms as key comparisons when determining fair value for Merck's notes. Based on that analysis, we wouldn't be surprised to see initial price talk of the high 30s for the three-year, high 50s for the five-year, low 90s for the 10-year, and the 105 area for the 30-year tighten somewhat before launch. We view fair value on Merck's new issues around +35 for the three-year, +55 for the five-year, +85 for the 10-year, and +100 for the 30-year, which represents the approximate yield curve we see for the AA and AA- pharmaceutical firms in our coverage universe. For example, in the five-year bucket, the average spread on maturities ranging from 2017 to 2019 is 55 basis points over Treasuries. Our analysis includes issues from Eli Lilly (LLY) (AA, wide moat), Merck, Pfizer (PFE) (AA, wide moat), AstraZeneca (AZN) (AA-, wide moat), Allergan (AGN) (AA-, wide moat), Bristol-Myers Squibb (BMY) (AA-, wide moat), Roche Holding (RHHBY) (AA-, wide moat), and Sanofi (SNY) (AA-, wide moat). In the 10-year maturity bucket, we have fewer comparisons, but we view the +77 spread on Merck's existing 2022s as a bit too tight. We believe fair value on Merck's new 10-year notes should be closer to the +87 and +83 basis points spread we're seeing on AA- rated Allergan's 2023s and Bristol-Myers Squibb's 2022s, respectively, than the +78 spread we're seeing on Novartis' (NVS) (AA+, wide moat) 2022s. For the three-year and 30-year maturity buckets, we see similar spread differences (20 basis points between the three-year and five-year and 15 basis points between the 10-year and 30-year) as suggested in the initial price talk.
Current Price Talk on American Express' 5-Year Bond Deal Is Attractive (May 15)
American Express (AXP) (A-, wide moat) announced today that it is issuing new five-year fixed and/or floating- rate notes. Initial price talk is a spread of 80 basis points over the Treasury curve, which we view as modestly attractive. American Express has existing holding company notes due 2018 that trade with a spread of 87 basis points over the Treasury curve. These high-coupon (7.0%) older notes, however, trade at a dollar price well above $120 and are not a good representation of where new issue spreads should price. Instead, investors should compare the American Express notes with other similar-rated financials, such as Fifth Third (FITB) (A-, narrow moat) or BB&T (BBT) (A-, narrow moat). Both Fifth Third and BB&T trade at spreads in the low 70s, so we would recommend the new American Express notes all the way down to a spread of roughly +73 basis points.
Morningstar's credit rating of A- for American Express reflects the company's excellent loan-loss rate and delinquency profile compared with peers, but is tempered by the firm's reliance on funding through the capital markets. Recently, the net write-off rate has dipped below 2.5%, which compares very favorably with the other major card issuers and is a significant improvement over the 10% rate in early 2009. Given the better credit standards for the average customer of American Express, a low loss rate should be expected. The poor performance in early 2009 was surprising because it was in line or worse than peers. American Express' 30-plus-day delinquent loans have also fallen from their peak in 2009 and are below 2%, with the ratio of loan reserves/delinquent loans at approximately 170%. American Express still funds more than 35% of its assets through long-term debt and securitizations, and deposits only fund about 25%. While there has been some improvement in these numbers, we would like to see the funding profile in line with peers.
New DISH Notes Unattractive, in Our View (May 14)
DISH Network (DISH) (BBB-/UR-, narrow moat) subsidiary DISH DBS is looking to raise $2.5 billion, split between 4- and 10-year notes, to fund a portion of its bid for Sprint Nextel (S) (BB-/UR, no moat). The proceeds will be placed in escrow and the firm will redeem the notes if the Sprint deal isn't completed. Investors in these notes face a different but still similar set of potential outcomes relative to existing DISH noteholders, in our view. If the Sprint deal closes, the new notes will roll into the same position as the existing notes, sitting in a challenging place in the new firm's capital structure. However, we believe there is a significant (greater than 50%) chance that the Sprint bid fails, at least in its current form. If we are right, the new notes would probably provide an attractive return over a short period. Existing noteholders would revert to a much stronger position, given DISH's current net leverage profile (about 1.7 times EBITDA) and substantial liquidity, but would remain subject to uncertainty concerning DISH's next move in the wireless business. Given the relatively tight spreads on DISH's existing notes, we can't recommend the new DISH offering unless the bonds are price substantially wider than existing levels.
DISH DBS would occupy a tough spot in the DISH-Sprint capital structure. The entity holds DISH Network's satellite television business, but not the wireless spectrum that DISH Network will contribute to Sprint's network build. The planned debt offering would take DISH DBS' gross debt load up to nearly $17 billion, or about 5.6 times the entity's EBITDA. The offering will also take DISH's cash balance to about $12 billion ($10.5 billion at DISH DBS), leaving about $5 billion in cash still needed to complete the Sprint deal on the current terms DISH has offered. With all of DISH DBS' cash needed to support the proposed DISH acquisition, we would expect DISH DBS noteholders to end up holding paper in a highly leveraged satellite television firm that faces an uncertain future. The television business will probably not get the same degree of management attention as the wireless effort, an unfortunate place that DISH DBS has been in before. DISH Network has said that it expects to receive a high B rating at the pro forma firm, but the rating at DISH DBS could be much lower.
DISH's existing 5.875% notes due in 2022 have traded with a yield around 5.6% since the current debt offering was announced, equating to a spread of about 395 basis points over Treasuries. We believe current spreads are too tight, however, given the downside risk associated with the credit profile DISH DBS will carry should the Sprint offer succeed. We would view fair value for DISH DBS bonds, following the proposed combination with Sprint, at a yield around 7% for a 10-year maturity, or a spread of about 500 basis points over Treasuries. There aren't many good comparable firms to DISH DBS, but we would highlight that Leap Wireless' LEAP (rating: B-, no moat) 7.75% senior secured notes due in 2016 trade at a yield of 5.9% to a May 2015 call date, a spread to worst of +560 basis points. Leap's 7.75 unsecured notes due in 2020 trade at a yield of 7.2%, or a spread of +635 basis points. Also, Advanced Micro Devices' (AMD) (B, no moat) 7.5% notes due in 2022 trade at 7.7%, or 590 basis points above Treasuries.
AES to Issue Additional $250 Million 10-Years for Existing Tender Offer; Bonds Fairly Valued (May 14)
AES (AES) (BB-, no moat) is issuing $250 million of 10-year notes that are noncall 5 notes following its issuance of $500 million on April 25 at a yield of 4.875% (316 basis points over Treasuries). Proceeds from the offering will also be used to fund remaining tender offers of up to $800 million. Based on AES' previously issued 4.875% senior notes due 2023, which currently yield 4.39% (289 basis points over Treasuries), which we believe are about fairly valued, we view fair value on the new issue at 300-310 basis points over Treasuries, including a modest new issue concession. This level appears similar to the BB BAML index yielding 4.6% (311 basis points over Treasuries) as well, which looks like a good comparable given our opinion of AES' improving credit quality as a diversified utility (versus a pure-play independent power producer) following its 2011 purchase of regulated utility Dayton Power & Light, which now accounts for roughly one third of its 2012 gross margin.
AES reported strong first-quarter proportional free cash flow of $352 million, up 50% year over year. This performance was fueled primarily by the termination of Beaver Valley PPA payments, lower working capital requirements in the Dominican Republic, and partially offset by lower hydrology in Brazil. However, even though AES affirmed its 2013 proportional free cash flow outlook of $750 million to $1.1 billion, this level is 38% lower year over year, resulting from increased environmental capital expenditures at AES Generation and IPL, as well as lower DPL operating performance due to lower PJM capacity prices.
Concurrently, AES said it is tendering for any and all of its 7.75% senior notes due 2014 (totaling $500 million) and up to a total of $300 million in aggregate of its 7.75% senior notes due 2015 (totaling $500 million), 9.75% senior notes due 2016 (totaling $535 million), and 8.00% senior notes due 2017 (totaling $1.5 billion). The tender offers are set to expire May 22, unless extended, and include maximum tender amounts of $100 million per series.
Alere Issuing New Senior Subordinated Notes (May 13)
Alere (ALR) (B, no moat)--a leading point-of-care diagnostic and health-management firm--is in the market selling $425 million of senior subordinated notes due in 2020, which are noncallable for three years. The proceeds will be used to tender for its $400 million 9% senior sub notes, which are callable this month at 104.50. Compared with Alere's existing notes and another high-yield comparable in the health-care industry, we view fair value on Alere's new 2020 senior subordinated notes around a 7% yield and 575 basis points over Treasuries. Alere's other senior subordinated notes, its 8.625% due in 2018, are callable in 2014, making them difficult comparables for the new notes since they are indicated at a yield to worst of 4.23% and 404 basis points over Treasuries to the 2014 call date. Therefore, we primarily use another high-yield health-care comparable, Kindred Healthcare (KND) (B-, no moat), to reach our fair value for Alere. Kindred's 8.25% senior unsecured notes due in 2019 (with a worst call date in 2017) were recently indicated at 6.40% and 576 basis points over Treasuries. While representing different business models (Kindred provides long-term care and nursing home services) and maturity profiles, we think Kindred's senior unsecured credit profile would be similar to Alere's subordinated credit profile.
Overall, we remain skeptical of Alere's financial position and business model. The firm's debt/EBITDA on a trailing 12-month basis stood around 7 at the end of March. Management aims to reach 4 times debt/EBITDA in 2015, so debt investors may have an improving credit on their hands, if management can reach that goal. However, we don't have much confidence in that deleveraging story, especially given its lackluster cash flows. For example, over the past 12 months, the firm generated less than $150 million in free cash flow (just over $550 million in EBITDA). With $3.9 billion in debt and capital lease obligations, we are not sure how Alere is going to meet its debt/EBITDA goal in that short amount of time. With only $2.2 billion in market capitalization, tapping the equity markets may not be a viable option to significantly reduce its debt position. Also, we are not sure that Alere's strategy of developing a new frontier in health-management services and point-of-care diagnostics has merit or that Alere has enough sustainable advantages in this business to keep it afloat in the long run. We think managed-care firms may continue to find ways to insource health-management services in the long run, cutting Alere out of the financial equation and creating a big viability risk for its business model. While we see some potential in its point-of-care diagnostics, we don't think those products will be able to make up for potential shortcomings in its other segment. Add high leverage and a big appetite for acquisitions, and we think Alere remains a very risky credit.
High-Yield Issuer Select Medical Issuing New Debt (May 13)
Hospital and rehabilitation service provider Select Medical is issuing $500 million in new senior unsecured notes due in 2021 and noncallable for three years. The proceeds of this new issuance will be used to repay just under half of its $1.1 billion term loans that come due in 2018. Related to this repayment, Select Medical will also extend the maturity date of its $300 million credit facility to 2018 from 2016, lower the interest rate payable for the remainder of its $850 million and $275 million term loans due in 2018, and amend some of the restrictive covenants on its senior secured credit facilities. We see these actions as positive for the firm's credit rating trajectory. However, we do not anticipate changing our credit rating on the firm, for now. Of note, Select Medical's board also recently authorized $350 million in share repurchases, so the story at Select is not all positive, with some excess cash flow likely earmarked for activities that are not friendly to debtholders.
To determine the fair value of Select's new issue, we compare its notes primarily with Tenet's senior unsecured debt, which is also structurally subordinated to a meaningful amount of secured debt. We see these firms as similar credits with Tenet's modestly higher debt leverage (Tenet's leverage is about half a turn higher than Select's leverage on an lease adjusted debt/EBITDAR basis, by our estimates) offset by Select's smaller size (Select is about 3 times smaller than Tenet). Therefore, we see Tenet's 6.75% senior unsecured notes due in 2020, which were recently indicated at a yield of 5.04% and spread of 384 basis points over Treasuries, as a good valuation comparable. Adding another year of maturity along with our view that Tenet's notes are indicated at modestly tight levels, we view fair value of Select Medical's new notes around 5.50%, or about 400 basis points over Treasuries. This pricing level would compare favorably, in our opinion, with HCA's HCA (rating: B+, no moat) 2021 senior unsecured notes, which were recently indicated at a yield of 4.39% and a spread of 288 basis points over Treasuries.
Covidien Issuing New Debt Before Spin-Off (May 13)
Medical device maker Covidien (COV) (AA-/UR-, narrow moat) is in the market issuing $500 million in 10-year notes. The proceeds will be used to refinance a debt maturity in June. Initial price talk on the new notes of 112.5 basis points over Treasuries looks modestly attractive, but we wouldn't be surprised to see that spread tighten substantially before launch. For example, Covidien's 2022 notes were recently indicated around 92 basis points over Treasuries, which we would deem about fair for the risk. We do not see a reason investors would require an extra 20 basis points in spread for an extra year of duration from this issuer. Also, similar-rated Medtronic (MDT) (AA-, wide moat) recently issued notes due in 2023 that are now indicated around 94 basis points over Treasuries. We view the mid-90s as fair value for Covidien's new issue. For better value in the device niche, we think investors should consider St. Jude Medical's (STJ) (AA-, wide moat) notes instead. Like Covidien, St. Jude is rated A/Baa1 by the agencies, but its new 2023s are indicated even wider than initial price talk on Covidien's notes at 124 basis points over Treasuries. St. Jude remains one of our investment-grade Best Ideas, and we prefer its notes over Covidien's new notes, especially if Covidien's spreads tighten from initial price talk.
Our credit rating for Covidien remains under review with a negative outlook, as the firm continues to plan the spin-off its pharmaceutical business. We are still analyzing the spin-off plans, but we have long said that this spin-off probably wouldn't result in more than a one-notch downgrade, if any, meaning Covidien should remain a low-risk credit with the ability to borrow at low rates. In late 2011, Covidien announced a tax-free spin-off of its pharmaceutical business, to be completed within 18 months. We've been expecting Covidien to part ways with its pharmaceutical business ever since the company's separation from Tyco International (TYC) (A-, narrow moat) (management noted that this has been in the works for several years now). After the spin-off, Covidien investors will be left with its medical device and instrument businesses, which we believe provide the foundation for Covidien's narrow moat.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.