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Credit Insights

Markets Roiled by Fed's Threat to Take Away the Punch Bowl

Corporate bonds suffered a double whammy as interest rates rose and credit spreads widened.

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Corporate bonds suffered a double whammy as interest rates rose and credit spreads widened after Federal Reserve chairman Ben Bernanke insinuated that the Fed would begin to slowly reduce its asset purchase program as soon as this fall. We have previously speculated that once the Fed decides to begin reducing its purchases, it would do so by increments of $10 billion-$15 billion per month. During the question-and-answer period, Bernanke hinted that that the asset-purchase program could be wound down by the middle of next year. 

If the Fed begins to taper as soon as this September, then it appears that the monthly purchases would decline in this range. The markets were also pressured on Thursday by the release of HSBC's Flash China Manufacturing PMI, which registered 48.3, its lowest level in nine months (a reading below 50 indicates slowing activity). Considering that China is the second-largest economy in the world and has been a significant importer of commodities and raw materials, investors are concerned that if its economy slows too much, it could hamper global GDP expansion.

Last week, the average spread in the Morningstar Corporate Bond Index widened 6 basis points on Thursday and another 4 basis points on Friday, ending the week at +159. Year-to-date, our corporate bond index has lost 4.00%. This loss is due to a combination of higher interest rates as the yield of 10-year Treasury has risen by 75 basis points to 2.51%, and credit spread widening as the average spread in the Morningstar Corporate Bond Index has increased by a total of 19 basis points. Within the Morningstar Corporate Bond Index, the industrial sector has suffered slightly more of the losses this year, widening 20 basis points versus 17 basis points of widening in the financial sector. 

Within the industrial sector, the most cyclical sub-sectors including basic industries, energy, and transportation have performed the worst, widening 39, 37, and 21 basis points respectively. The technology subsector has outperformed the most, tightening 1 basis point. Two of the issuers that helped the technology group outperform were  Hewlett-Packard (HPQ) (BBB+, narrow moat) and  Symantec (SYMC) (A+, narrow moat) each of which have tightened 40 basis points since the beginning of the year. Both of these issuers have been on our Investment Grade Best Ideas list since the beginning of the year.

Although credit spreads on corporate bonds are becoming more attractive at these wider levels, we continue to think corporate bond credit spreads are within the range of being fairly valued (albeit at the high end of the range). However, we would consider moving to an overweight opinion if credit spreads continue to widen meaningfully from here and there is no change our underlying fundamental and economic assumptions. 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.

Interest Rates Poised to Rise Further
For the past few months, we have cautioned that once the Fed begins to reduce its asset purchase program, 10-year Treasury bond yields would increase 100-150 basis points in a short amount of time. Now that the Fed's intentions are known, we expect every bond trader and fixed-income portfolio manager in the world will try to front-run the rise in rates, probably compounding how quickly and how far rates will rise. The question fixed-income investors need to ask is: Who in their right mind would want to buy long-duration securities right now? The Fed, which for months has been single-largest buyer of Treasury bonds, is unconcerned about gains/losses and is going to reduce its purchases. These asset purchases have not been made for investment purposes, but for economic reasons, to purposely push interest rates below where they would otherwise belong. Once the Fed is no longer manipulating interest rates, we expect long-term rates to normalize toward historical averages. Historically, the yield on the 10-year Treasury bond has averaged 245 basis points over a rolling three-month average of the inflation rate. Even with inflation registering only 1% last month, on a normalized basis the 10-year would currently yield around 3.50%.

  - source: Morningstar Analysts

Summer Storms Roll Through the Credit Markets
Activity was muted at the beginning of the week and the new issue market was lackluster, as only a few issuers braved coming to the new issue market ahead of the Federal Open Market Committee meeting statement. However, after the question and answer session following the FOMC release Wednesday afternoon, storm clouds appeared on the horizon and markets began to meaningfully turn down. The dark clouds turned into a full-blown summer squall Thursday morning, as traders tried to dodge rising interest rates and wider credit spreads and investors scrambled for cover, looking everywhere and anywhere for bids. As quickly as the storm materialized in the morning, it dissipated in the afternoon as trading activity slowed dramatically. After the morning's frenetic pace, one trader likened investors to a deer frozen in the headlights, wondering what to do next, and Wall Street traders were probably instructed by their risk managers to keep their inventories as low as possible.

The tone Friday morning improved as two-way flow increased, but credit spreads continued to be under pressure as offerings from exchange-traded fund redemptions continued to offer more supply than the Street could digest. One trader even mentioned that he saw many of the same bonds offered by different ETFs. No new issues of any size were priced after the FOMC statement, and investment bankers advised their clients to wait until the dust settles before contemplating pricing a new bond offering. We suspect that with interest rates rapidly rising, those issuers that have been mulling coming to market will do so sooner rather than later. We may see a flurry of activity over the next week or two before heading into a summer slowdown.

Fed to Balance Communication Between Reducing Extraordinary Measures, Maintaining Low Rates
The Fed has a delicate balancing act over the next few months. It needs to guide the market as to when it will begin tapering its extraordinary measures (the asset purchase program), as that news will lead to higher interest rates and probably cause a pullback in risk asset prices. However, the Fed also wants to let the market know that it will continue its easy money policy (that is, 0% short-term rates) for a long time yet to come in order to try to slow the rate of increase in interest rates and reduce the severity of the sell-off in the markets. Bernanke has specified that the Fed will keep short-term rates near zero as long as the unemployment rate is above 6.5%. In addition, so long as inflation and inflation expectations are under control, the Fed would probably keep rates at very low levels even after unemployment dips below 6.5%.

A rise in interest rates reduces that principal value that a homebuyer can afford for an equal monthly payment and increases the monthly payments for auto loans. If interest rates rise too much too quickly, it could impair the nascent housing recovery or trim the number of new-auto sales, both of which have helped the economy rebound. Even with interest rates heading higher, Robert Johnson, Morningstar's director of economic research, continues to expect real GDP growth in the United States to average between 2% and 2.25% this year. In his opinion, market worries about even higher rates are misplaced, and the economy can easily survive rates as high as 3.50%. He further points out that higher rates are not an entirely bad thing for the economy (for example, higher rates increase retiree income, and consumers who have put off purchases that need to be financed may be moved to action by the threat of higher rates). The greater risk to his view is that consumer spending, which is one of the main drivers of economic growth, may be pressured as incomes stagnate.

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

New Issue Notes

Valeant Pharmaceuticals Funding Portion of Bausch & Lomb Deal (June 19)
 Valeant Pharmaceuticals International (VRX) (BB, narrow moat) is in the market issuing $3.2 billion in 8-year and 10-year senior unsecured notes, which will be used to fund a portion of the $8.7 billion Bausch & Lomb deal. Valeant also issued $2.0 billion in new equity on Tuesday to help finance the transaction, and the firm aims to use additional debt to fund the rest of the deal ($3.5 billion). We view Valeant's existing senior unsecured notes as moderately attractive, even when considering their subordination to substantial secured credit facilities. For example, its 6.375% 2020s are indicated at a yield to worst around 5.85% and an option-adjusted spread around 440 basis points over the Treasury curve. Valeant's notes may price close to its existing issues with spreads in the mid-400s, creating a modestly attractive opportunity for investors, in our opinion, since we view fair value at spreads around +400, which is about 40 basis points wider than the Merrill Lynch BB index. Specifically, we think Valeant's 8-year notes would be fairly valued around a yield of 5.75% and its 10-year notes would be fairly valued around a yield of 6.25%. We see other moderately attractive values in the high-yield specialty pharmaceuticals niche. For example, our sector pick,  Endo Health Solutions (ENDP) (BB-, narrow moat) has 2022 notes outstanding (also subordinated to secured credit facilities) that are indicated at a yield to worst of 6.22% and an option-adjusted spread around +477 basis points, which we find attractive for the risk.

While Valeant investors need to be aware of its currently inflated financial leverage (debt/EBITDA around 4.6 times is expected after the Bausch & Lomb deal) and its ongoing appetite for acquisitions, we find Valeant's business model attractive in the specialty pharmaceuticals niche. The narrow moat firm sells more than 400 products worldwide with no product concentration above 10% of sales, which is rare in specialty pharmaceuticals. The firm's management team also has shown a knack for integrating acquired businesses and extracting large synergies to boost profitability after the acquisitions, which is comforting, given management's aggressive acquisition strategy. 

We Would Avoid Mylan's New Issues (June 18)
Top-tier generic pharmaceutical firm  Mylan (MYL) (BB+, narrow moat) is in the market today issuing 3-year (floating and fixed rate) and 5-year (fixed rate) notes. We believe the proceeds will be used primarily to fund its $1.6 billion acquisition of Agila, which is scheduled to close by the end of 2013. Initial price talk on the notes appears rich at 150 basis points and 175 basis points over the Treasury curve for the 3-year and 5-year fixed-rate notes, respectively. The market pricing of Mylan's debt implies a weak BBB rating, anchoring on the agencies' ratings of Mylan at BBB-/Baa3. However, we see more risk at Mylan, which is reflected in our BB+ rating, and urge investors to use caution when assessing these notes. Mylan remains on our Bonds to Avoid list, and we would require more compensation to invest in Mylan's notes than initial price talk. Specifically, our fair values would be about 75 basis points wider for each issue (+225 for the 3-year and +250 for the 5-year fixed-rate notes) to account for the relatively high leverage and capital allocation risks we see at Mylan. For only modestly higher risk in the health-care industry than Mylan, we continue to favor  DaVita HealthCare Partners (DVA) (BB, narrow moat); its 5.75% notes due in 2022 are indicated at a yield to worst of 4.93% and option-adjusted spread of +332.

Fundamentally, we think Mylan's growth will slow substantially around 2015, as patent cliff benefits end in U.S. generics and Mylan starts to lose marketing exclusivity on Epipen. Because of those factors, we believe Mylan's moat trend is negative, and its management team may try to bolster its long-term competitive position through debt-funded acquisitions. For example, Mylan reportedly bid $15 billion for  Actavis (ACT) (BBB+, narrow moat) in a failed merger attempt in May. So while we recognize that leverage currently remains below its target ceiling of 4.25 times debt/EBITDA, we wouldn't be surprised to see Mylan sustain debt/EBITDA well above 3 times in the long run, which we view as too high for an investment-grade rating, and exceed its leverage ceiling to pursue growth-boosting acquisitions if the right target emerges.

Initial Price Talk on O'Reilly's New Bond Deal Looks Slightly Cheap (June 17)
 O'Reilly Automotive (ORLY) (BBB, no moat) is coming to market with $300 million in 10-year notes today. Initial price talk of high 100s to 200 basis points over Treasuries seems slightly cheap, as the BBB portion of the Morningstar Industrials 10-year index is currently at 188 basis points over Treasuries. We believe O'Reilly should trade just inside the index given its more defensive position as an auto-parts retailer. The firm's 2022 notes were recently indicated at 162 basis points over Treasuries, which we believe represents fair value. Other BBB retailers in our coverage list trade much too tight, in our view. Auto-parts retailer peer  AutoZone (AZO) (BBB, narrow moat) and  Macy's (M) (BBB, no moat) both have 2.875% notes due 2023 that were recently indicated at 147 and 137 basis points over Treasuries, respectively.

At the end of the first quarter, O'Reilly's leverage was below its target of 2-2.25 times, and management stated that it planned to issue debt in 2013. The firm's leverage, as calculated by the company, was at 1.8 times. It should be noted that the firm calculated lease-adjusted leverage using a 6 times multiple of rent expense, where Morningstar uses 8 times. Our calculation places the firm at 2.2 times leverage.

Management reiterated its commitment to an investment-grade rating. The firm's leverage target has long since been communicated and it is encapsulated in Morningstar's BBB rating. O'Reilly has solid and stable free cash flow generation, moderate leverage, and minimal near-term debt maturities. The auto-parts industry is generally stable, as it relies on demand for necessity items (such as maintenance and failure auto parts). We view the service element of the business as sticky, given that most customers rely on the retailer's expertise when purchasing auto parts.

Ingersoll-Rand New Issuance Looks Attractive (June 17)
 Ingersoll-Rand (IR) (BBB, no moat) is expected to be in the market today with a benchmark-size three-tranche deal, split among 5.5-, 10-, and 30-year maturities. Proceeds will be used first to refinance $600 million of 6% notes due in August and second to redeem $655 million of 9.5% notes due 2014 and/or cover the costs of the spin-off of the security business, which is expected to close by the end of 2013. Initial price talk on the new issuance looks attractive, with spreads of 210, 225, and 262.5 basis points over Treasuries for the 5.5-, 10-, and 30-year tranches, respectively.

The company has a number of bonds outstanding, although most are either short-dated or relatively small in size. The largest bond is the $750 million 6.875% due 2018. Although it trades infrequently, we recently saw it indicated around a price of 120 and a spread of 170 basis points over Treasuries, which also seems cheap to us. Looking at other similar-rated diversified industrial comps,  Eaton (ETN) (BBB+, narrow moat) has a 2022 bond that was recently indicated around a spread of 112 basis points over Treasuries, which we view as rich.  Roper Industries (ROP) (BBB, narrow moat), which we view as strongly positioned within its rating, also has a 2022 bond that was recently indicated around a spread of 143 basis points over Treasuries, which also seems a bit rich. Factoring in some premium for the presence of activist investor Trian, we would place fair value for the new offering in the area of +160, +180, and +215 for the 5.5-, 10-, and 30-year tranches, respectively.

In March, we downgraded our issuer rating on Ingersoll-Rand from BBB+ to BBB based on the weaker credit profile that will exist following the planned spin-off of the security business (approximately 14% of total revenue) and the implementation of shareholder-friendly initiatives, including a $2 billion share-repurchase program and a meaningfully higher dividend. The moves are in reaction to activist investor Trian's call to increase shareholder value and could stave off a full breakup of the company. If further shareholder-friendly moves are announced, our rating could fall further. Ingersoll-Rand enjoys strong, market-leading brands across its HVAC, construction, and industrial businesses, but has yet to generate meaningful improvement in return on capital. As such, we do not think it enjoys an economic moat at this time.

As part of the plan, management laid out a leverage target of 2.0-2.5 times TD/EBITDA, meaningfully higher than the 2012 actual level of 1.7 times and more indicative of a mid-BBB credit, in our view. Leverage will be driven higher through the loss of the security business earnings as well as a modest increase in total debt. The share-repurchase program is expected to start in the second half of the year, with completion targeted for the first quarter of 2014. Funding is expected to come from free cash flow (2013 guidance of $1.1 billion) as well as the expected dividend from the security spin-off (approximately $1 billion).

Chevron to Issue Debt to Refinance Commercial Paper; Initial Price Talk Looks Cheap (June 17)
 Chevron (CVX) (AA, narrow moat) announced Monday that it plans to issue 3-year fixed- and floating-rate, 5-year fixed- and floating-rate, 7-year, and 10-year notes in benchmark size. Proceeds are to be used to repay a portion of the company's commercial paper borrowings. As of May 31, Chevron had $5.5 billion of commercial paper outstanding. We are hearing a total size of $5 billion. Initial price talk is a spread of +70 basis points for the 3-year, +90 for the 5-year, +120 for the 7-year and +130 for the 10-year. We peg fair value for the new notes at +45 for the 3-year, +55 for the 5-year, +70 for the 7-year, and +90 for the 10-year.

Chevron, along with its supermajor integrated peers, is finding it increasingly difficult to expand production and add reserves as many of the remaining pools of cheap, easily accessible resources large enough to interest the supermajors reside in the hands of governments and national oil companies. As such, we see only modest growth in the next few years. In addition, the company's massive Gorgon liquefied natural gas project in Australia has been hampered by cost overruns. Because of these facts, we award Chevron a narrow moat with a negative trend. Still, the company maintains a rock-solid balance sheet with almost $19 billion of cash compared with just $14 billion of debt, although we expect Chevron to return to a new debt position by 2014 due to a combination of capital spending and continued distributions to shareholders, including $1.25 billion of share repurchases per quarter. Factoring in this use of cash, we still project that Chevron's credit metrics will remain supportive of our credit rating and comparable with its peers. With 70% of total production in the form of liquids, Chevron is well positioned competitively and will continue to generate operating cash flows well in excess of capital expenditures.

Within our coverage universe of supermajor integrated companies,  Royal Dutch Shell (RDS.A) (AA-, narrow moat) and  ExxonMobil (XOM) (AAA, wide moat) are comparable with Chevron. Shell's 1.125% notes due 2017 recently traded at a spread of 45 basis points above the Treasury curve, while its 2.375% notes due 2022 traded at a spread of 85 basis points over the Treasury curve. ExxonMobil's 5.65% notes due 2016 are quoted at a spread of +41, its 5.5% notes due 2018 are quoted at +50, and its 8.625% notes due 2021 recently traded at a spread of +77. For comparison to the initial price talk, which strikes us as very wide, we note that Chevron's 2.355% notes due 2022 recently traded at 70 basis points over the 10-year Treasury before the deal announcement, while large exploration and production firm  Apache's (APA) (A-, narrow moat) 2.625% notes due 2023 recently traded at a spread of 99 basis points above the 10-year Treasury. Based on our rating, Chevron's strong balance sheet, and cash flow generation, offset by the company's intention to use its substantial cash balance for share repurchases, we believe fair value on the new issues is +45 basis points for the 3-year, +55 for the 5-year, +70 for the 7-year, and +90 for the 10-year.

Click here to see more new bond issuance for the week ended June 21, 2013.

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