While the S&P 500 reaches new all-time highs, credit spreads in the corporate bond market have not rallied to anywhere near the same degree. The average spread in the Morningstar Corporate Bond Index ended last week at +144 basis points, still well wide of the tight level reached in the middle of May.
We think there are two main reasons that credit spreads have not fully participated in the appetite for risk: interest rates have generally been on an uptrend since the beginning of May, and idiosyncratic risk seems to be rising from increased shareholder activism and aggressive share-buyback programs.
While we do not have a strong view on when the Federal Reserve will begin to taper its asset-purchase program, we have long opined that longer-dated interest rates will quickly increase by 100-150 basis points once the Fed makes its intentions known. The Fed, which has been single-largest buyer of Treasury bonds, is unconcerned about gains or losses and has signaled that it is getting increasingly closer to the time when it will begin reducing its purchases. These asset purchases have not been made for investment purposes, but for economic reasons, to purposefully 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, which could take the 10-year Treasury up to 3.50%. As interest rates rise, investors have been looking to reduce duration [a measure of interest-rate sensitivity] to minimize potential losses. So long as rates are rising and the economy muddles along, we think credit spreads will stay in a relatively narrow trading range as portfolio managers avoid longer-dated corporate bonds, waiting for interest rates to stabilize in a new trading range. Once interest rates stabilize, we think credit spreads could resume tightening, assuming the market's general appetite for risk remains.
While we have seen recent patterns of decelerating consumer spending, most companies have been able to meet earnings expectations, albeit many estimates were lowered right before earnings reports. An increase in idiosyncratic risk has had a far greater impact on spreads than underlying financial performance. More and more issuers either raise leverage targets to fund share-buyback programs or acquiescing to activist shareholders who prod companies to take actions that reward shareholders at the expense of bondholders. Adding to the issuers we highlighted last week, Viacom(VIAB) (rating: A-/UR-, narrow moat) recently announced that it was increasing its debt leverage target to a range of 2.75-3.00 times to fund a $10 billion increase in its share-repurchase program. We were surprised by this action, as the firm had consistently reiterated its target leverage ratio of 2.00-2.25 every quarter for the past few years, including the most recent quarter. As another example, we had previously written that we were concerned about ADT's (ADT) (rating: BBB+/UR-, wide moat) lack of commitment to an investment-grade rating. Our fears were justified this past week as the firm raised its target leverage ratio to 3.0 times from 2.0. We suspect management felt pressured to raise leverage as a result of shareholder activism.
- source: Morningstar Analysts
Economic Outlook as Clear as Mud Second-quarter gross domestic product rose 1.7%, surpassing expectations. The two factors that accounted for most of the difference versus estimates were business spending on structures and government spending. Business spending on structures was a significant drag in the first quarter, providing an easy comparison to beat on a sequential basis in the second quarter. After two consecutive quarters of being a significant drag on economic growth, the sequential reduction in government spending appears to have run its course and only reduced second-quarter GDP by 0.1%. For a detailed look into second-quarter GDP and how it affects our outlook for the rest of the year, please see this week's Economic Insights by Robert Johnson, director of economic research.
Even though GDP growth increased to 1.7% in the second quarter from a downwardly revised 1.1% in the first quarter, the Federal Open Market Committee recently reduced its assessment of economic growth to "modest" from "moderate." In addition, the FOMC highlighted that persistently low inflation below its 2% objective could pose risks to economic performance. Considering that the Fed has repeatedly said its decision to begin tapering its asset-purchase program will be driven by incoming data, it appears that the economy may not yet have the self-sustaining momentum to ease off this monetary stimulus. However, the Treasury will issue decreasing amounts of new bonds this fall as the deficit shrinks, and the Fed already owns a significant amount of outstanding long-term Treasuries. On a technical basis, it will become increasingly harder for the Fed to continue purchasing Treasuries at the same rate it has been for much longer.
Adding to the confusion last week, July nonfarm payrolls only grew 162,000, a decrease from last month (which was revised downward) and below expectations; however, even with this weaker number, the unemployment rate still dropped to 7.4%. This employment report was in contrast to the ADP employment report, which showed a gain of 200,000 for July and revised the June payrolls number higher. Among other indicators, the ISM Manufacturing Index rose to 55.4 (its strongest reading in two years) and the PMI Manufacturing Index rose to 53.7 (a reading above 50 represents economic expansion). China's official PMI Index rose to 50.3 in July from 50.1 in June. However, the official report was in stark contrast to the July Purchasing Managers Index compiled by HSBC, which fell to 47.7--its weakest level since August 2012--from 48.2 (a reading below 50 indicates economic contraction). For greater detail regarding our outlook for China, please see the August 2013 Basic Materials Observer. In this report, we outline why we think China's investment-led growth model is exhausted. Moving to a consumption-led economy will be harder and riskier than most expect, and GDP growth in this "rebalancing act" is likely to disappoint, averaging no more than 5%.
Best Idea Celgene Issuing New Notes; Initial Price Talk Looks Cheap (Aug. 1) On Thursday, Best Idea Celgene(CELG) (rating: A, narrow moat) announced plans to issue new 5-year, 10-year, and 30-year notes. Celgene intends to use the proceeds for general corporate purposes, including its internal R&D program and strategic transactions. From a bond valuation perspective, we continue to highlight Celgene's notes on our Best Ideas list due to its attractiveness on an absolute basis and relative to similarly rated peers. Not surprisingly, price talk on Celgene's new issues looks attractive to us at 110, 145, and 165 basis points over Treasuries, respectively, for the new 5-year, 10-year, and 30-year notes. As investors, we would focus primarily on the firm's new 5-year and 10-year notes, as we see too much uncertainty in the 30-year time frame for this issuer, which is reflected in our narrow (rather than wide) moat rating for the firm. For comparison on an absolute basis, the Morningstar Corporate Bond A Index (excluding financials) which has a duration similar to a 10-year bond, is indicated around +100 basis points over Treasuries, or about 45 basis points tighter than initial price talk on Celgene's new 10-year notes. Also, Celgene's new notes appear attractive relative to other A rated pharmaceutical firms, including AbbVie(ABBV) (rating: A, narrow moat) and Gilead Sciences(GILD) (rating: A, narrow moat), which have 2021 and 2022 notes that are typically indicated around +105 basis points over Treasuries. Overall, we see substantial spread-tightening potential in Celgene's notes compared to its peers, as Celgene diversifies with other potential blockbusters. New products ramping up at Celgene include Pomalyst for multiple myeloma (in early commercialization stage), apremilast in psoriasis indications (being submitted for approval this year), and Abraxane for a variety of cancer indications (approved but still seeking additional indications for expansion).
Celgene may use the proceeds from this new debt issuance for many purposes. First, Celgene's recent deal with Morphosys highlights the firm's interest in making relatively small deals and acquiring rights to products that complement Celgene's own offerings. Also, while management has made no comment on the possibility of a bid for Onyx Pharmaceuticals(ONXX) (rating: BBB-, no moat), we think this business would be very complementary to Celgene's hematological and growing solid tumor businesses. Despite the benefits, antitrust concerns might keep Celgene on the sidelines during the Onyx bidding process, and since the potential acquisition of Onyx would probably result in higher leverage at Celgene, not bidding on Onyx would probably be positive for Celgene debtholders. Additionally, while the registration documents for these new notes do not highlight share repurchases as a potential use of funds, the firm remains active on that front and has a new $3 billion share-repurchase authorization.
Ford Motor Credit to Issue Benchmark 10-Year Bonds; Initial Price Talk Attractive (Aug. 1) Ford Motor Credit (rating: BBB-) is offering 10-year senior notes with initial price talk in the low 190s over Treasuries. With positive credit momentum at the parent company and an expectation of ratings upgrades we view fair value at about 180 basis points over Treasuries. This is about 40 basis points wide of where we view fair value at auto-related peers such as the finance sub of Daimler (DAI) (rating: BBB+, no moat) and Johnson Controls(JCI) (rating: BBB+, narrow moat) and clearly more in line with solid BBB credit quality. As we noted in our recent earnings note, Ford reported excellent second-quarter results and we believe the firm is on a multiyear trend in deleveraging as it targets debt and pension liability reduction with solid free cash flow. As such, we view Ford and Ford Credit as solid core holdings which could perform well over the intermediate-term as ratings continue in an upward trajectory. Ford Credit's 5.875% notes due 2021 remain on our Best Ideas list at recently indicated spreads of about +200 versus interpolated Treasuries.
D.R. Horton Offering 10-Year Bonds to Fund Growth; Existing Bonds Look Fair (July 31) Homebuilder D.R. Horton(DHI) (rating: BB+, no moat) is back in the market with a $400 million 10-year bond offering. Proceeds are for "general corporate purposes," which we translate into meaning additional investment in homebuilding operations, as its balance sheet expands with growth in homebuilding operations. That said, the firm retired a $172 million bond in May and has another $145 million due in January. Horton issued $300 million 4.75% 10-year senior notes in February and these are now indicated at 5.27%, providing a spread of 263 basis points over Treasuries. While our credit rating is one notch higher than each of the three major rating agencies, we still see these levels roughly fair. We view fair value on the new notes at about 5.40%. Our primary comps are Toll Brothers(TOL) (rating: BBB-, no moat), whose recently issued 10-year bonds are trading at 5.00% and a spread of +240, and Lennar(LEN) (rating: BB, no moat), whose 10-year bonds issued in November are trading basically on top of Horton. We view Toll as fairly valued and Lennar as rich at these levels.
Horton was beset by weak orders in the third quarter, reported on July 25. Net new orders fell 13% sequentially. Over the past four years sequential order growth has averaged a positive 10%. Orders grew 12% year over year, a marked deceleration from 34% year over year growth in the prior quarter. Horton readily acknowledged that higher mortgage interest rates had a negative effect on demand in the back half of the quarter through July to date (30-year fixed rates rose to 4.6% at quarter-end from 3.4% in early May). We slightly revised down our fiscal 2013 and fiscal 2014 housing sales volumes given the weaker orders in the quarter, but did not change our margin assumptions. We expect buyer demand to resume once prospective buyers digest the large jump in rates, so long as rates do not continue their ascent. Still-strong housing affordability in comparison to rents and very low levels of new home inventory (seasonally adjusted 3.9 months of new home supply versus 50-year average of 6.2 months) should provide support to the home building market over the next couple of years.
WellPoint Issuing New Debt to Tender for Existing Issues, Price Talk Close to Fair Value (July 30) On Tuesday, WellPoint(WLP) (rating: BBB+, narrow moat) announced plans to issue new 5-year and 30.5-year notes. The proceeds will be used to make tender offers for up to $600 million in aggregate principal of existing bonds, including up to $300 million of its 2017s ($700 million outstanding) and 2019s ($600 million outstanding) and up to $300 million of its 2034s ($500 million outstanding), 2036s ($900 million outstanding), 2037s ($800 million outstanding), and 2040s ($300 million outstanding). This refinancing will reduce WellPoint's ongoing interest payments somewhat, but we do not believe it will affect its credit rating.
Initial price talk on WellPoint's new notes look about fair for the risk, offering a modest new issue concession with its new 5-year expected to price around 115 basis points over Treasuries and its new 30.5 year expected to price around 155 basis points over Treasuries. These levels compare favorably to its existing 2018s and 2043s, which are indicated around 104 basis points and 135 basis points over Treasuries, respectively. Overall though, managed care organizations like WellPoint typically trade tighter than we would expect for the risk relative to their credit ratings. For comparison, the Morningstar's Corporate Bond BBB+ Index (excluding financials), which has a duration similar to a 10-year bond, are indicated around 146 basis points over Treasuries, or about 10 basis points wider than WellPoint's 2023s, which are indicated around 134 basis points over Treasuries. However, relative to other firms in this niche, WellPoint's notes are indicated closer to fair value than its peers. We maintain a market weight recommendation on WellPoint's notes. For comparison, we would underweight notes from lower-rated managed-care firms, including Aetna(AET) (rating: BBB, narrow moat), which has 2022s indicated around 117 basis points over Treasuries, and Cigna(CI) (rating: BBB-, now moat), which has 2022s indicated around 123 basis points over Treasuries.
Halliburton to Issue Debt to Finance $3.3 Billion Equity Tender; Initial Price Talk Near Fair Value Halliburton(HAL) (rating: A/UR-, narrow moat) announced Monday that it plans to issue 3-year, 5-year, 10-year, and 30-year notes in benchmark size. Proceeds are to be used to fund the repurchase of shares of Halliburton common stock pursuant to the $3.3 billion tender offer announced late last week. Following the announcement of the tender offer, we placed our issuer credit rating on Halliburton under review with negative implications as a result of the substantial increase in debt. Based on our initial review of the impact of the tender offer, we project at most a one notch downgrade to A-. Initial price talk is a spread of +45 basis points for the 3-year, +65 for the 5-year, +95-100 for the 10-year and +112.5 for the 30-year. We peg fair value for the new notes at +50 for the 3-year, +70 for the 5-year, +100 for the 10-year and +110 for the 30-year.
As the company had only $1.4 billion of cash as of June 30, Halliburton is tapping the debt markets to finance its tender offer, which expires Aug. 22. Assuming the entire tender is debt financed, on a pro forma basis, total debt climbs to $8.1 billion from $4.8 billion. This lifts gross leverage to 1.4 times and net leverage to 1.2 times, from 0.9 times and 0.6 times respectively. In its second-quarter earnings released last week, Halliburton delivered better sequential margin performance compared to competitor Schlumberger(SLB) (rating: A+, wide moat) in the difficult North American market as well as industry-leading international revenue growth of 14% year over year. We also note that during the second quarter Halliburton increased its revolving credit facility capacity to $3 billion from $2 billion and that the firm repurchased approximately $1 billion of shares. The second-quarter share repurchases helped lower the firm's cash position to $1.4 billion from $2 billion at the end of the first quarter.
As a result of the tender offer, we changed our recommendation on Halliburton bonds to underweight from market weight, opining that we now viewed fair value on Halliburton's 3.25% notes due 2021 at 90 basis points above the Treasury curve. For comparison, Schlumberger's 2.40% notes due 2022 recently traded at 81 basis points over the Treasury curve, while Schlumberger's 1.25% notes due 2017 traded at 67 basis points above the Treasury curve, which we view as fairly valued and cheap respectively. Also for comparison, National Oilwell Varco(NOV) (rating: A+, wide moat) 2.60% notes due 2022 traded at 82 basis points above the Treasury curve, while NOV's 3.95% bonds due 2042 also traded at 82 basis points above the Treasury curve, which we view as fairly valued and rich, respectively. Adjusting for the difference in maturity between Halliburton's 2021 notes and the new 10-year, we peg fair value for the new Halliburton 10-year at +100 basis points. Using Schlumberger and NOV as a guide for Halliburton's curve, we arrive at a fair value of +50 basis points for the 3-year, +70 for the 5-year, +100 for the 10-year and +110 for the 30-year.
Kinder Morgan to Issue 5.5-Year and 10.5-Year Notes, Tap 30-Year Bonds; Spreads Are Attractive Kinder Morgan Energy Partners(KMP) (rating: BBB+, wide moat) announced Monday that it is issuing a total of $1.75 billion of bonds, including new 5.5-year and 10.5-year notes and an add-on to its outstanding 5.00% bonds due 2043. Kinder Morgan intends to use the proceeds to repay its commercial paper debt, which stands at $1.15 billion, and for general partnership purposes, which may include the purchase of additional membership units of Copano and the subsequent repurchase or redemption by Copano of a portion of its outstanding 7.125% senior notes due 2021. During the second quarter, Kinder completed its acquisition of natural gas gathering and processing firm Copano Energy for approximately $5 billion. We view pricing of +130 basis points for the 5.5-year and +160 basis points for the 10.5-year as 10-15 basis points cheap, with the 5.00% of 2043 bonds fairly valued at +170 basis points.
Kinder Morgan's credit metrics remain strong despite the increase in total debt resulting from the Copano acquisition. On an LTM basis, gross leverage of 4.1 times was flat sequentially, as was interest coverage at 6.1 times. Debt to capitalization improved to 53.4% from 59.5%, as total partners' capital increased with the Copano deal. Based on our estimates for 2013, we project year-end leverage will be 4.2 times, while interest coverage slips to 5.9 times and debt/capitalization increases to 55.9%.
We view Williams Partners(WPZ) (rating: BBB, wide moat) and Enterprise Products Partners(EPD) (rating: BBB+, wide moat) as fair comparables for Kinder Morgan. Williams' 7.25% notes due 2017 recently traded at 146 basis points above the Treasury curve, its 3.35% notes due 2022 traded at a spread of 178 basis points over the 10-year Treasury, while its 6.30% bonds due 2040 traded at a spread of 215 over the 30-year Treasury. We view the 2017 as fair value, but both the 2022 and 2040 as cheap. EPD's 3.35% notes due 2023 recently traded at 115 basis points over the 10-year Treasury, while its 4.85% bonds due 2043 traded at 139 basis points over the 30-year Treasury. We view EPD as trading close to fair value. Prior to today's announcement, Kinder Morgan's outstanding 3.45% notes due 2023 traded at a spread of 142 basis points over the 10-year Treasury and its 5.00% bonds due 2043 traded at a spread of 167 basis points over the 30-year Treasury. Following Kinder Morgan's second-quarter earnings release, we placed fair value on the 3.45% notes due 2023 at 135 basis points over the 10-year, which is unaffected by the new issuance. Given our moat and credit ratings of Kinder's comparables, and spread levels on Kinder's outstanding debt, we believe fair value is +120 basis points for the 5.5-year, +145 basis points for the 10.5-year, and +175 basis points for the 5.00% of 2043.