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Credit Insights

Fundamentals Returning to the Forefront

Although financial reports continue to show that companies are struggling to increase the top line, they have still generally been able to meet earnings expectations.

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Credit markets were soothed by Fed chairman Ben Bernanke's commentary that the Federal Reserve would be flexible in its monetary policy and respond to incoming economic data. The average spread in the Morningstar Corporate Bond Index tightened 7 basis points last week to +145 and has recaptured about half of the spread widening the market has experienced since its tightest level this year of +129 was reached May 15. 

We still don't think there is any substantive change in the Fed's policy stance since the Q&A session following the Federal Open Market Committee meeting June 19, as the chairman has been 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 FOMC expects.

During the next two weeks, the market's attention will turn back to fundamentals, as earnings season has begun in earnest and the next FOMC policy statement will not be released until July 31. While financial reports continue to show that companies are struggling to increase the top line, they have still generally been able to meet earnings expectations (though we acknowledge that earnings estimates have been lowered during the past few weeks). For example,  Rockwell Collins (COL) (rating: A, narrow moat) reported healthy third-quarter results despite the soft defense spending environment as its commercial aerospace business was strong. We maintain our market weight opinion and that the company will seek to access the public debt market in the near future to refinance debt.  CSX (CSX) (rating: BBB+, narrow moat) reported second-quarter results that showed modest improvement in revenue and profitability despite continued weakness in coal and agricultural products. We maintain our overweight rating as we still think CSX bonds look modestly attractive.

Companies that have been able to buck the trend of middling revenue growth include  Dover (DOV) (rating: A, narrow moat), which reported strong second-quarter results; sales and EBITDA were up 9% and 14%, respectively, driven by strong performance in the refrigeration and printing and identification businesses. We think the company's bonds look attractive and recommend investors overweight this issuer. Medical device maker  St. Jude Medical (STJ) (rating: AA-, wide moat) reported second-quarter results that showed improving trends in its operations. Sales grew 2% in constant currency, up from a 3% decline in constant currency during the first quarter. From a bond valuation perspective, St. Jude's notes offer significantly more compensation than competitor  Medtronic (MDT) (rating: AA, wide moat). For example, St. Jude's new 2023 and 2043 notes were recently indicated at 132 and 146 basis points over Treasuries; Medtronic's new 2023 and 2043 notes are indicated at much slimmer spreads of +96 and +99 basis points, respectively. Given their similar credit profiles, we view St. Jude's notes as more attractive relative to Medtronic's notes.

Among the issuers we cover undergoing catalysts,  Kinder Morgan Energy Partners (KMP) (rating: BBB+, wide moat) reported second-quarter results. Kinder Morgan's credit metrics remain strong despite the increase in total debt resulting from the Copano acquisition. As we have a positive opinion of the deal from a strategic standpoint, we believe Kinder Morgan spreads should outperform and we maintain our overweight recommendation on its debt as the company recognizes the benefits of the acquisition.

Could 2Q GDP Be Negative?
Bob Johnson, Morningstar's director of economic research, is forecasting second-quarter GDP growth of 0.5%; however, based on recent economic indicators, he is becoming increasingly worried that GDP growth may have been even slower. Robert expects that consumption growth may have slowed to 1.5% from 2.4% in the first quarter. Further pressuring GDP growth, net export growth is likely to be more negative and the contraction in government spending may be as much in the second quarter as it was in the first. Based on weak revenue and earnings reports from the technology sector thus far and ongoing poor construction data, the lack of business investment spending may also detract from economic growth. Combining these metrics along with falling inventories and declining utility demand could result in a negative GDP print for the quarter. For greater detail, please see Johnson's July 20 weekly economic insights, "U.S. Economy Looking a Little Accident Prone."

New Issue Market Quieter Than Expected
The new issue market was quieter last week than we had expected. For those bond deals that were brought to market, underwriters continued to bait and switch investors. Whisper talk generally started off at attractive levels with new issue concessions of 20-25 basis points, but tightened to 10-20 basis points in official price talk and tightened further by the time the deals were launched. For example,  Kroger (KR) (rating: BBB, no moat) issued 10-year and 30-year bonds in which the original whisper talk was +160 and +185, respectively. These levels were compelling compared with the trading levels of Kroger's existing 3.40% senior notes due 2022, which were trading around +130 to the curve, and the 5% senior notes due 2042, which were indicated around +160. However, official guidance was tightened to +137.5 and +160, and the bonds were priced at +132.5 and +155. Considering that Kroger needs to come to market later this year with a sizable offering to fund the Harris Teeter acquisition, we thought the new issue should be priced with a decent concession.

Assuming the 10-year Treasury stays range-bound and credit spreads hold their gains, we expect volume in the new issue market should pick up. Based on the market volatility since the FOMC meeting and the July Fourth holiday, we suspect there is a strong backlog of issuers that have held back awaiting calmer waters. Considering there is only one and a half weeks until the seasonal August slowdown in the corporate bond market begins, we expect those issuers that have held off, along with the typical new issue volume, may make for a busy rest of the month.

Detroit Files Bankruptcy
Detroit filed for bankruptcy, marking the largest Chapter 9 filing in U.S. history. While the city will continue to operate police, fire, water, sewer, and public works, an automatic stay will be placed on most of its bills including its unsecured debt (such as certain bonds and contractual agreements). It is expected that Detroit will continue to pay what it considers secured debt, such as water and sewer bonds, as those creditors have the ability to seize assets if they are not paid in a timely manner. Because Chapter 9 filings are rare, there are few precedents to gauge how Detroit will work its way through the bankruptcy process. Morningstar published a primer on the situation last month that addressed many of the questions surrounding this situation, as well as identified potential implications for bondholders and the municipal bond market in general. Please see this commentary from Morningstar municipal credit analyst Elizabeth Foos.

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

New Issue Notes

Kroger Issuing Bonds to Refinance Debt; More New Issues to Come to Fund Harris Teeter Acquisition (July 18)
Kroger is reportedly issuing $850 million of 10-year and 30-year bonds this morning. The original whisper talk of +160 and +185 for the 10-year and 30-year, respectively, was compelling compared with the trading levels of Kroger's existing 3.40% senior notes due 2022 which were trading around +130 to the curve and the 5% senior notes due 2042, which were indicated around +160. However, official guidance was released at +137.5 and +160, and the size of the order book is rumored to be $11 billion. If the order book is that oversubscribed, the bonds will probably be priced even tighter, completely taking any upside out of the notes. Considering Kroger needs to come to market later this year with a sizable offering to fund the Harris Teeter acquisition, we thought the new issue should be priced with a decent concession.

On July 9, Kroger announced its intention to acquire Harris Teeter supermarkets for $2.5 billion and will fund the acquisition through debt. Pro forma for the acquisition, we expect leverage will increase by about a half turn, but we do not expect to change our rating from this modest increase. Management has publicly stated its commitment to reduce leverage over the next 18-24 months and retain its mid-BBB rating. On the company's conference call that morning, CFO Michael Schlotman said, "Finally, I'd like to outline the financial elements of the proposed merger. We will finance the deal with debt. Kroger also intends to assume Harris Teeter's outstanding debt of approximately $100 million. We expect to access the capital markets in the next few weeks to refinance the bonds that matured earlier this year and then closer to closing issue debt at different maturities to finance the merger. This will allow us to set up our capital structure to have exposure at various points along the yield curve and to balance our fixed- and floating-rate exposure. We have a bridge loan commitment in place to provide us the liquidity to fund the transaction." At the earliest, we expect that this transaction could close toward the end of the third quarter, but more likely will close in the beginning to middle of the second quarter.

Currently, within the Morningstar Corporate Bond Index, the average spread for a BBB industrial issuer is +197. While a consumer defensive name such as Kroger should trade tighter than the index, we think Kroger's bonds are fully valued at these levels and this offering highlights how cheap Safeway SWY (rating: BBB, no moat) notes are trading. Safeway's 4.75% senior notes due 2021 are priced at +212 to the curve. Kroger is a better-run company and has better credit metrics, in our opinion, but we believe the current spread differential is too wide for the difference in credit risk. Safeway released its second-quarter results this morning and the stock is currently up about 3%. Management mostly held its 2013 guidance steady as it released its expectations for pro forma 2013 EBITDA to range between $1.70 billion to $1.73 billion as compared with $1.74 billion in 2012. After adjusting for discontinued operations, the Blackhawk IPO, and tax issues, EPS guidance was slightly decreased to the low end of the previously provided range of $2.25-$2.45. However, Safeway notes are not for the faint of heart. While we continue to rate Safeway BBB, subsequent to the announcement that Safeway is selling its Canadian operations, Moody's lowered its rating to Baa3.

Bank of America: 10-Year Price Talk Suggests Decent New Issue Concession but Still too Rich (July 18)
 Bank of America (BAC) (rating: BBB, narrow moat) announced today that it is issuing new benchmark 10-year notes. Initial price talk is a spread in the area of 170 basis points over the Treasury curve, which we view as rich. Bank of America's current 10-year trades with a spread of 155 over the Treasury curve, which we view as very rich. For investors looking at large U.S. money center banks, we recommend  J.P. Morgan Chase (JPM) (rating: A, narrow moat), whose 10-year trades with a spread of +132. By going with J.P. Morgan, investors give up about 20 basis points in spread from B of A's existing 10-year and less than 40 basis points of spread from the price talk on B of A's new 10-year, but pick up three notches of rating. For investors looking to stay in the financial sector but not necessarily money center banks, we recommend  Morgan Stanley (MS) (rating: BBB, narrow moat). Morgan Stanley's 10-year trades with a spread of 183 over the Treasury curve, so investors can pick up 14 basis points of spread from B of A's new 10-year price talk for the same rating. Overall, we think fair value on B of A's new note is a spread of 180 over the Treasury curve. Our rating on B of A is driven in large part by our conservative estimates around the extent and timing of the company's return to "normalized" earnings.

Mosaic Reports 2013 Results and Confirms Plans for New Debt Issuance (July 16)
 
Mosaic (MOS) (rating: BBB+, no moat) reported fourth-quarter and full-year results this morning that met our expectations. While sales volume for potash (up 26% year over year) and phosphate (up 2% year over year) increased in the quarter, the gains were more than offset by price declines. Phosphate prices sank 8% compared with the prior-year period, and potash prices dipped 21% year over year. Despite weaker potash prices, which are consistent with our long-term thesis, the company generated strong operating cash flows that continue to support our very good Cash Flow Cushion rating.

During the call, management confirmed its inability to reach a share-repurchase agreement with the principal shareholders. As a result, it is now planning to execute a general market program sometime after the November restrictions expire. Management has been transparent regarding plans to issue new debt in support the buyback, stating that it expects to opportunistically issue bonds in the second half of 2013 to fund a 2014 repurchase program. Management remains committed to maintaining its debt leverage at no greater than 1.5 times, which given current operating performance provides as much as $3 billion of new issue capacity. The company also remains committed to maintaining a solid liquidity cushion of greater than $2 billion of cash and short-term borrowing capacity. We believe Mosaic has sufficient balance sheet capacity to support the outlined program and note that these plans are fully consistent with the assumptions used in assigning our BBB+ rating.

Click here to see more new bond issuance for the week ended July 19, 2013.

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