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Credit Insights

What a Difference One Economic Data Point Makes

As soon as the employment number was released Friday morning, everyone immediately became a buyer of corporate bonds.

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What a difference one economic data point makes. All week long, every investor in the corporate bond market was a seller, but as soon as the employment number was released Friday morning, everyone immediately became a buyer. With payrolls coming in at 175,000--little higher than consensus--and the unemployment rate weakening slightly to 7.6%, investors could read into the report whatever they were already predisposed to believe. As the prices of long-term Treasury bonds and commodities (especially precious metals) fell, those investors were probably heeding the predictions of the economists who purport that the payroll report supports tapering of the Fed's asset purchase program this summer. Considering the S&P 500 rose 1.3% on Friday, it appears equity investors are in the camp that the employment report was strong enough to support continued economic growth, but not so strong as to prod the Fed into tapering its quantitative easing program.

Credit spreads widened all week long, as the average spread of the Morningstar Corporate Bond Index rose 10 basis points, reaching +147 at the close Thursday, its widest level thus far this year. However, corporate bond spreads tightened on Friday, sending the index to +145 by the end of the week. Since we changed our view on the corporate bond market to neutral from overweight last fall, the average credit spread has ranged between +130 and +155, averaging +140. We continue to view the corporate bond market as fairly valued, although we acknowledge that the near-term momentum will probably push credit spreads tighter early this summer toward the low end of the aforementioned range.

As investors looked to reduce risk during the week, the yield on the 10-year Treasury bond declined, but never breeched the 2% barrier. After the employment report Friday, the risk-on trade resumed in full force and the yield on the 10-year backed up to 2.16%, essentially the same yield at which it began the week. We have cautioned investors numerous times that once the Fed announces its intention to begin tapering, interest rates will probably rise 100-150 basis points in a relatively short period. Historically, the yield on 10-year Treasury bond averages more than 200 basis points greater than the inflation rate. Even at the currently low rate of inflation of about 1%, the yield on the 10-year Treasury could easily increase another 100 basis points.

We have not heard any indications as to the size of the new issue forward calendar for this week, but it could be sizable. Many issuers that had planned to tap the capital markets last week probably held off because of market weakness. However, now that spreads have tightened and traders are once again scrounging for paper, those issuers are likely to hit the market before the window potentially closes again. In addition, any other issuer that has been planning on accessing the bond market at some point this summer may decide to accelerate its capital market plans to beat any further rise in interest rates and tap the market while it can, rather than risk another bout of potential market weakness that could close the new issue window.

It's always amazing to see just what a short memory Wall Street has. Both The Wall Street Journal and the Financial Times have reported that some asset managers have begun to examine investing in synthetic collateralized debt obligations. These investment vehicles are pools of credit default swaps that are then tranched into differing layers of loss protection. With corporate bond yields near their historical lows, investors who are desperate for yield and willing to accept heightened credit risk will buy the lowest tranche of these investment pools. Many of these vehicles did not perform as advertised during the credit crisis and some had to be unwound at significant losses.

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

New Issue Notes

Baxter Funding Gambro Acquisition With New Notes (June 4)
 Baxter International (BAX) (A+, wide moat) is in the market on Tuesday to issue new 18-month floating-rate notes and 3-year, 5-year, 10-year, and 30-year fixed-rate notes. The proceeds will be used to finance its acquisition of Gambro (total consideration for the deal including acquired debt is $4 billion) and for general corporate purposes. Initial price talk on the 3-year, 5-year, 10-year, and 30-year in the high +50s, high +80s, +120, and +132, respectively, looks wider than we would anticipate, especially given where existing Baxter issues are indicated. We see fair value on these new issues around 50, 70, 100, and 115 basis points over Treasuries, respectively, which is much closer to where Baxter's existing issues are indicated. Also, of note last week,  Pfizer (PFE) (AA, wide moat) came to market with 3-year, 5-year, 10-year, and 30-year notes that priced at 45, 50, 88, and 100 basis points over Treasuries, respectively. While not a perfect comparison due to Pfizer's higher credit rating, this recent new debt issuance in the pharmaceutical industry helps inform our view of Baxter's new issue yield curve.

The planned Gambro acquisition was announced in late 2012 and caused us to increase our moat rating to wide. Our wide-moat rating for Baxter reflects the ongoing advantages associated with existing Baxter injectable therapies and the firm's stronger position in renal therapy with Gambro, which will bring Baxter in line with current renal leader  Fresenius Medical Care (FMS) (BB+, narrow moat) in terms of dialysis equipment scale. Even with debt financing for that deal, we estimate Baxter's net debt position will increase by just half a turn due to the deal. At the end of March, Baxter's debt/EBITDA on a trailing 12-month basis stood at an estimated 1.5 times. Baxter's low-risk credit profile hinges on its scale and intangible assets in injectable therapies, which allow it to remain remarkably profitable in a tough industry. Because of those advantages, we expect Baxter to sustain adequate profitability to repay debtholders in the long run.

Even With New Issue Concession, Allstate's 10-Year and 30-Year Price Talk Unattractive (June 4)
 Allstate (ALL) (BBB, narrow moat) announced today that it is issuing new 10-year and 30-year senior notes. Initial price talk is a spread in the area of 112 basis points over the Treasury curve for the 10-year and a spread of +133 for the 30-year. While the price talk is considerably wider than where existing bonds are trading, we view the credit spreads on the existing bonds as too tight compared with our view of the credit risk. Allstate's 7.45% 2019 notes, which are 6-year notes at this point, trade with a spread of +85 to the Treasury curve and Allstate's current 30-year, the 5.20% 2042 notes, trade with a spread of +100 to the Treasury curve. Allstate is rated by the agencies in in the A- range, and this pricing is comparable to that type of rating for an insurance company. Morningstar, however, takes a dimmer view on the credit as Allstate's balance sheet is more leveraged than a standard property and casualty insurer's and more closely resembles that of a life insurance company. Within the insurance sector, we recommend investors look to our investment-grade Best Idea,  W.R. Berkley (WRB) (BBB+, narrow moat), whose 10-year notes trade with a spread of +165 to the Treasury curve for a one-notch better rating, or
 Markel (MKL) (BBB, no moat) which we rate as overweight, whose 10-year and 30-year notes trade with spreads of +160 and +180, respectively.

Short-Term Disruptions in Japan Give Us Pause on Aflac's New Deal (June 3)
 Aflac (AFL) (A-, narrow moat) announced today that it is issuing new 10-year senior notes. Initial price talk is a spread in the area of 160 basis points over the Treasury curve. While this spread talk is optically attractive, given that many of the insurance companies with similar ratings trade with spreads considerably tighter, we still recommend investors pass on this deal. Aflac is heavily tied to the fortunes of Japan, where it derives 80% of its profits, and current economic policy in Japan is in nothing short of an upheaval as prime minister Shinzo Abe is attempting to jump-start the economy through aggressive central bank policy. Abe's policies could have severe short-term detrimental effects on Japanese government bonds and Aflac's investment portfolio is composed of approximately 35% of these bonds. Instead, we recommend our investment-grade Best Idea, W.R. Berkley, where investors can pick up approximately 50 basis points in spread for just a one-notch lower rating.

While there are near-term questions surrounding Aflac's investment portfolio, our credit rating reflects our long-term outlook on the company. A unique distribution model and first-mover advantage in Japan provide Aflac with an enviable competitive position. By focusing on supplemental insurance products, Aflac has been able to consistently generate excess returns for shareholders, a rarity for a company linked to the hypercompetitive life insurance industry. Rather than targeting individuals through sales agents as most life insurers do, Aflac offers its products at the workplace. Aflac markets its products to companies as a way to improve their benefit lineups at no additional cost. Premiums are deducted from employees' paychecks and Aflac pays cash benefits if a policyholder contracts a specified disease. Aflac's unique distribution model yields low costs, allowing it to price below competitors.

EMC Debt Issuance Looks Attractive, but We'd Prefer NetApp (June 3)
 EMC (EMC) (A+, narrow moat) plans to issue 5-, 7-, and 10-year notes to replace convertible notes maturing later this year. These new issues will also provide the financial flexibility needed to carry out an accelerated share-buyback plan and support its recently initiated dividend. Initial price talk on the notes looks attractive, in our view, at 85-90 basis points, 110-115 basis points, and 115-120 basis points over Treasuries for the three tranches, respectively. The typical A+ issue in the Morningstar Industrials Index trades at +89 basis points with an average of about 10 years to maturity. While the new EMC issuance looks attractive versus the broader market, we would prefer rival  NetApp (NTAP) (A+, narrow moat). NetApp also recently issued bonds to replace convertibles in its capital structure, initiated a dividend, as well as a more aggressive share repurchase plan. Specifically, we view EMC as a slightly stronger credit thanks to its larger size and ownership stake in VMWare, but we don't believe the difference between the two warrants a differential in rating. NetApp trades well wide of the initial talk on the EMC issue, as its 2% notes due in 2017 and 3.25% notes due in 2022 currently trade around 130 and 175 basis points over Treasuries, respectively.

We expect that both EMC and NetApp will continue to benefit from the unrelenting growth in the amount of data that corporations, governments, and individuals need to store. We believe both firms enjoy similar competitive advantages that stem from their large respective customer bases and the significant switching costs involved in moving to rival technologies. We further believe that both firms will need to continue to make tuck-in acquisitions to augment internal research and development while maintaining large cash balances to take advantage of opportunities as they arise. Each firm currently sits on about $7 billion in cash (EMC's cash balance excludes cash held at VMWare). EMC plans to repurchase $6 billion of its shares through 2015, including $3 billion in buybacks over the next 12 months, while generating about $3 billion in free cash flow annually, excluding VMWare. In addition to buybacks, EMC also repurchases shares of VMWare to maintain its ownership stake. NetApp plans to repurchase $3 billion of its shares over the next three years, roughly on par with the rate at which it has generated free cash flow over the past few years.

Buckeye Partners to Issue $500 million of 10-Year Notes; Price Talk Looks Cheap (June 3)
 Buckeye Partners (BPL) (BBB, wide moat) announced Monday that it plans to issue $500 million of 10-year senior notes due 2023. Initial price talk is a spread of 212.5 basis points above the 10-Year Treasury; we peg fair value for the new notes at +190 basis points. Buckeye intends to use the proceeds to repay its $300 million July 2013 bond maturity and for general corporate purposes. As of March 31, Buckeye had $510 million drawn on its $1.25 billion unsecured revolving credit facility.

Following a number of large acquisitions, primarily in the crude oil and refined products terminals space in which Buckeye paid high multiples, the company was left with a strained balance sheet in 2012. There were questions about whether or not Buckeye would violate the covenants in its revolving credit facility. The company addressed its balance sheet concerns by issuing $360 million in new units in January of this year, which it used to reduce revolver borrowing. As cash flows from its acquisitions have improved, our concern about the revolver covenant have dissipated as we project that year-end 2013 leverage will be 4.6 times, below the 5.0 times covenant.

Buckeye's 4.875% notes due 2021 recently traded at a spread of 179 basis points above the 10-year Treasury.  Magellan Midstream Partners (MMP) (BBB+, wide moat) and  Plains All American Pipeline (PAA) (BBB-, wide moat), which is a strong credit for our BBB- rating, are comparable with Buckeye. Magellan's 4.25% notes due 2021 recently traded at 77 basis points over the 10-year, which we view as rich given the company's capital needs in 2013. Plains' 2.85% notes due 2023 recently traded at 130 basis points above the 10-Year, which is close to fair value given our outlook for Plains. Based on these trading levels and Buckeye's strained yet improving balance sheet, we believe that fair value on this new issue is 190 basis points above the 10-year.

Click here to see more new bond issuance for the week ended June 7, 2013.

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