The average spread in the Morningstar Corporate Bond Index rallied more than 12 basis points last Thursday to +143. This rally was in response to Federal Reserve chairman Ben Bernanke's assertion that he expected the Fed would continue its highly accommodative policy for the foreseeable future.
While the media hype sent the markets higher, we don't think there is any substantive change in his policy stance since the Q&A session following the Federal Open Market Committee meeting June 19. We think Bernanke has been crystal clear that the Fed would begin to taper asset purchases as early as this fall and end all purchases by next summer if the economy and the unemployment rate develop as the Federal Open Market Committee expects. According to the meeting minutes, it appears that the opinion to begin tapering the asset-purchase program sooner rather than later is gaining traction as "several members judged that a reduction in asset purchases would likely soon be warranted." In addition to the strength or weakness of economic and unemployment metrics in the second half of this year, technical factors in the bond market may force the Fed's hand to begin tapering. The government's monthly deficit has been declining as a result of increased tax revenue, reduced spending increases from sequestration, and dividend payments from Fannie Mae (FNMA) and Freddie Mac (FMCC). As such, the Treasury will not need to issue as much debt in the second half of this year and there will be less debt issued for the Fed to monetize. Considering that the Fed already owns a substantial amount of long-dated Treasuries, it will become increasingly harder for the Fed to source bonds, causing even greater problems in the Treasury repo market.
The Fed has left itself a way to get out of tapering in the second half of this year--if the economy does not progress as it forecasts. In conjunction with the FOMC's statement June 19, the Fed released its updated economic projections. The increased forecasts surprised Bob Johnson, Morningstar's director of economic analysis, who wrote, "I suppose the only real surprise is that the Fed outlook for the economy is remarkably more bullish--too much so, in my mind. Its forecast for 2013 GDP growth is 2.3%-2.5% compared with my forecast of 2.0%-2.25%. For 2014 it is even more bullish, estimating 3.0%-3.5% growth compared with my forecast of 2.0%-2.5%. The Fed also lowered its inflation forecast and significantly lowered its expectations for the unemployment rate, one of the announced key drivers of Fed policy."
New Issue Market Testing the Waters
A few issuers came out of the woodwork to access the bond market last week, but for the most part, it was relatively quiet in the new issue market. New issue concessions indicated in the whisper numbers started off at attractive levels around 20-25 basis points, but tightened to 10-20 basis points in official price talk and tightened further to 5-15 basis points by the time the deals were launched. One example was Oracle (ORCL) (rating: AA, wide moat), which issued both U.S. dollar- and euro-denominated debt. The original whisper talk on the 10-year tranche of the dollar notes was indicated at +125, about 25 basis points wider than where the firm's existing 2022 notes were trading before the deal announcement. Official price talk was tightened to +115 and the final pricing on the notes was +110, just 10 basis points wide of the existing 2022 notes. We still view this as attractive and believe fair value is closer to 90 basis points over Treasuries. We believe Oracle holds one of the strongest competitive positions in the software industry, thanks to the very high switching costs around its database and middleware products. In addition, we expect the firm will successfully navigate the transition to cloud computing as it offers customers hybrid solutions that mix cloud and on-premise products.
Best Buy (BBY) (rating: BB-, no moat), which we rate one notch lower than S&P but four notches lower than Moody's, issued $500 million of 5% senior notes due 2018. The notes will refinance the firm's $500 million July maturity. We would still avoid Best Buy's longer-dated bonds, but given decent cash flow expectations in the near term, we are less concerned about the company's liquidity in the near term. However, this yield simply isn't high enough to get us interested for the credit risk involved. We forecast that Best Buy's earnings will continue to deteriorate concurrent with our pessimistic expectation for the consumer electronics retail industry. Best Buy and its peers face a number of challenges, including the inability to defend market share against Amazon, mass merchants, and key vendors like Apple. Margin compression, coupled with weaker sales, has pushed lease-adjusted leverage to above 3 times, where we expect it will remain because of softer earnings.
Assuming the 10-year Treasury stays range-bound and credit spreads hold their gains, we expect the volume in the new issue market should pick back up. Based on the market volatility since the FOMC meeting and the Fourth of July holiday, we suspect there is a strong backlog of issuers that have held back and are waiting for calmer waters. Considering there are only two and a half weeks until the seasonal August slowdown in the corporate bond market, we expect those issuers that have held off, along with the typical new issue volume, may make for a couple of busy weeks.
Forecasts for Global Economic Growth Continue to Deteriorate
The International Monetary Fund reduced its forecast for global GDP growth to 3.1% from 3.3% last April and cut its projections for economic growth in the emerging market to 5.0% from 5.3%. Supporting the IMF's reduced projections, China released a greater-than-expected drop in June exports of 3.1% due to weak global demand. This drop comes on top of a soft 1% growth rate last year. Recent comments from several Chinese government officials appear to be trying to talk down the markets' expectations for second-quarter GDP. Consensus estimates call for 7.5% year-over-year growth in the second quarter, slower than the 7.7% in the first quarter and 7.9% in the fourth quarter of 2012. However, many economists are revisiting their assumptions as it appears that Chinese policymakers may be more tolerant of slower growth in the near term in order to wring out speculative excesses in the real estate market. Considering China is the second-largest economy in the world, slowing growth will have a domino effect across the globe, especially in the resource-rich nations that have supported their own economies by exporting raw materials to feed China's ravenous appetite.
ECB Holds Short-Term Rates Low; Evaluating Other Monetary Programs
The European Central Bank held its short-term lending rate at 0.5% in July, indicating that it would keep rates low for an extended period. The ECB also wouldn't rule out extending a new round of loans to the banking system if growth weakens or liquidity tightens. In an interview last week, ECB board member Joerg Asmussen from Germany remarked that the ECB may keep its short-term rate low beyond 12 months. When even the Germans (who are culturally opposed to even a hint of inflation) are advocating extended low rates, you know easy money policies are here to stay. We continue to think that the ECB is evaluating other economic support measures such as securitized small-business loan pools or asset purchases, but that it is holding these potential programs in reserve in case the debt crisis returns in Europe. For now, so long as yields on the peripheral sovereign bonds and credit spreads for the banking system remain contained, the ECB will be content to use language to prod economic recovery as opposed to instituting new monetary programs.
Peripheral Sovereign Yields Holding Steady
Even though S&P lowered its rating on Italy to BBB from BBB+, the yield on the country's 10-year bond only increased a few basis points to 4.44%. This level is currently near the midpoint of its trading range since the beginning of the year. Considering the lack of spread movement in Italian bonds and that the spread between Italian and German bonds is +286 basis points (closer to levels appropriate for high-yield issuers), this highlights to us the lack of credence that the market attaches to the agencies' sovereign bond ratings. Spanish 10-year bonds are currently trading at a yield of 4.80%, only slightly higher than the midpoint of their trading range since the beginning of the year and a spread of +317 basis points over German bonds.
Click to see our summary of recent movements among credit risk indicators.
New Issue Notes
Yield on Best Buy's New 5-Year Deal Not High Enough to Interest Us on This Bond to Avoid (July 11)
Best Buy is coming to market with $350 million in 5-year notes. The firm has $500 million in bonds due next week. Initial talk indicates a yield of 5.25%-5.375%, which seems too low, in our view, given the firm's declining fundamentals and comparison with similar-rated consumer cyclical companies.
We forecast that Best Buy's earnings will continue to deteriorate concurrent with our pessimistic expectation for the consumer electronics retail industry. Best Buy and its peers face a number of challenges, including the inability to defend market share against Amazon, mass merchants, and key vendors like Apple as well as the dilutive impact that digital distribution will have. Margin compression, coupled with weaker sales, has pushed lease-adjusted leverage above 3 times, where we expect it will remain because of softer earnings.
Still, our near-term concerns have been allayed. We estimate Best Buy's cash position to be strong thanks to the estimated $733 million in proceeds from the sale of its 50% stake in Best Buy Europe to Carphone Warehouse, announced in April. We forecast that Best Buy will end fiscal 2014 with nearly $3 billion in cash. Accordingly, with an estimated Cash Flow Cushion that exceeds 1 times our base-case expense and obligation forecast in each year over the next five years, we are not overly concerned about Best Buy's ability to repay its near-term notes. However, exacerbated pricing pressures from mass merchants and Amazon or failure to reinvigorate the online platform or execute turnaround efforts could negatively affect our cash flow forecasts.
On a relative value basis, we do not believe Best Buy's new notes offer investors value. L Brands (LTD) (rating: BB+, narrow moat) and Best Idea R.R. Donnelley & Sons (rating: BB, no moat) have 2019 and 2018 bonds that currently yield 5.3% and 6.2%, respectively. Royal Caribbean Cruises (RCL) (rating: BB-, narrow moat) has 2018 bonds that yield lower at 4.5%, but we have long believed these bonds trade rich as the market is pricing in the firm's desire to attain investment-grade status--an event that we do not believe will happen for at least five years. While we would still avoid Best Buy's longer-dated bonds, due to decent cash flow expectations in the near term, we would be interested in the firm's new 5-year bonds, but the yield would have to be closer to 7%, given that the Merrill Lynch High Yield Index is currently at 6.5%.
Bank of Montreal New 3-Year Appears Fairly Valued on Price Talk (July 11)
Bank of Montreal (BMO) (rating: A, narrow moat) announced today that it is issuing new 3-year, dollar-denominated fixed- and/or floating-rate notes. Initial price talk for the fixed-rate note is a spread in the area of high 70 basis points over the Treasury curve, which we view as fairly valued. Yesterday, Bank of Nova Scotia (BNS) (rating: A+, narrow moat) priced a 3-year note at a spread of +72, which we also viewed as fairly valued. We rate Bank of Nova Scotia one notch higher and, although pricing these sometimes illiquid 3-year deals can be difficult, we think about 7-10 basis points seems right between these two deals. If the new Bank of Montreal prices much tighter, we would recommend investors switch to the new Bank of Nova Scotia notes, assuming the notes are at the same level after Fed chairman Ben Bernanke's comments yesterday. Although we view both banks similarly, Bank of Montreal's lower rating is due mostly to lower efficiency and its stagnant Canadian bank operations.
Price Talk on Bank of Nova Scotia's New 3-Year Looks Attractive (July 10)
Bank of Nova Scotia announced today that it is issuing new 3-year, dollar-denominated fixed- and/or floating-rate notes. Initial price talk for the fixed-rate note is a spread in the area of 80 basis points over the Treasury curve, which we view as attractive. Bank of Nova Scotia issued a 3-year note in March, and that illiquid bond appears to trade with a spread of 60 over the Treasury curve, which we view as fairly valued. For reference, yesterday General Electric Capital Corporation (rating: A) priced a 3-year note at a spread of +83. Considering we rate GECC one notch lower, and GECC is a U.S.-based nonbank finance company, we think Bank of Nova Scotia should price at least 10 basis points tighter and we would recommend these new notes all the way down to a spread of +70.
As with other major Canadian banks, we are positive on Bank of Nova Scotia from a credit perspective as a result of Canada's highly regulated banking oligopoly. Bank of Nova Scotia's regulatory capital, however, is below average compared with other Canadian banks, as its Basel III common equity Tier 1 ratio is 8.6%. Our rating for Bank of Nova Scotia, much like the other Canadian banks, is one to three notches lower than the rating agencies' as we take a more critical view on the overall credit status of financial companies and the overleveraged status of the Canadian consumer.
New Oracle Issues Look Attractive (July 9)
Oracle is planning a benchmark-size offering of 5.5- and 10-year notes. Initial price talk looks very attractive at 110 basis points over Treasuries for the 5.5-year notes and +125 basis points for the 10-year offering. We would view fair value for the 10-year notes in the +90 basis points range. We believe Oracle holds one of the strongest competitive positions in the software industry, thanks to the very high switching costs around its database and middleware products. In addition, we expect the firm will successfully navigate the transition to cloud computing as it offers customers hybrid solutions that mix cloud and on-premise products. Oracle has plenty of financial flexibility to navigate future technological developments as it carried $32 billion in cash against $18 billion in debt at the end of fiscal 2013. The firm also issued EUR 2 billion of notes earlier this month. Oracle recently doubled its dividend to about $2.2 billion annually, but this payout still consumes less than 20% of annual free cash flow.
Initial price talk on the new 10-year issue is significantly wider than spreads on Oracle's existing debt. The firm's 2.5% notes due in 2022, issued last October, are indicated at about +100 basis points. Spreads on Oracle debt also compare favorably with other wide-moat technology firms. For comparison, International Business Machines' (IBM) (rating: AA-, wide moat) 1.875% notes due in 2022 currently are indicated at 72 basis points above Treasuries and Google's (GOOG) (rating: AA, wide moat) 3.625% notes due in 2021 are at +87 basis points. Apple's (AAPL) (rating: AA-, narrow moat) recently issued 2.4% notes due in 2023 also are indicated tight to Oracle at around +72 basis points.
PPL to Issue $350 Million of 30-Year First Mortgage Bonds; Initial Price Talk Appears Cheap (July 8)
PPL (PPL) (rating: BBB, narrow moat) announced today that it will issue $350 million of 30-year first mortgage bonds. Initial price talk on PPL's new 30-year issue is roughly 120 basis points above Treasuries. We believe Westar Energy's (WR) (rating: BBB+, narrow moat) 30-year first mortgage bonds due 2042, which recently traded at 86 basis points over Treasuries, is the most relevant comparison given Westar's utilities' comparable allowed returns on equity (roughly 10.3%), above-average recovery mechanisms, and moderately constructive regulatory environment. Given our opinion that PPL is of slightly weaker credit quality than Westar, we believe fair value for PPL's 30-year bonds is 100-105 basis points over Treasuries.
PPL has benefited from a growing contribution of regulated earnings following recent acquisitions. We expect PPL's regulated operating companies in the U.S. (Kentucky Utilities and LG&E & KU) and the United Kingdom to contribute roughly 85% of PPL's total EBITDA in 2013. As such, we view PPL to be more similar to a regulated utility than a diversified utility, given its relatively higher percentage of stable regulated EBITDA. Moreover, PPL's U.S. regulated utilities benefit from better-than-average cost recovery mechanisms encompassing environmental projects, fuel adjustments, and demand-side management recoveries. On the other hand, we continue to expect weak operating performance in the short run at PPL Energy Supply, given margin declines resulting from low power prices as well as lower free cash flow at PPL due to an ambitious five-year capital expenditure program totaling $17.4 billion.
Click here to see more new bond issuance for the week ended July 12, 2013.