Corporate bonds suffered last week as interest rates rose and credit spreads widened out. Morningstar's Corporate Bond Index declined 1.39% last week as the 10-year Treasury rose 25 basis points to 2.83% (its highest yield since July 2009) and credit spreads widened out 2 basis points to +146. Year to date, our corporate bond index has declined 3.95% as the 10-year Treasury has widened more than 100 basis points since the end of last year and credit spreads have widened almost 7 basis points.
We think corporate bonds are likely to struggle during the next few months as investors attempt to anticipate when and how quickly the Federal Reserve will taper its asset purchases and forecast the bond market's reaction. Given the economic improvement (gradual employment growth and inflation returning to targeted levels) and technical reasons (lower deficit provides fewer bonds to purchase and the already high percentage the Fed owns in long-dated bonds), we think the Fed will most likely begin to taper its asset-purchase program after the Federal Open Market Committee meeting Sept. 17-18.
Whether the Federal Reserve begins to taper its asset-purchase program in September or within a few months thereafter, we expect interest rates will rise further. We have long opined that longer-dated interest rates will quickly increase 100-150 basis points once the Fed makes its intention to begin tapering known to the market. The first shot across the bow was during the press conference after the June 2013 FOMC meeting, when the 10-year bond was at 2.18%. In that conference, Fed chairman Ben Bernanke stated that if incoming data was consistent with the Fed's forecast, it would be appropriate to moderate the pace of purchases later in the year. Assuming the economic data after the tapering begins continues to indicate economic expansion, the Fed would end its purchase program by mid-2014. This pace would equate to a monthly reduction of about $10 billion.
The Fed's 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 toward 3.50%. As interest rates have been rising, investors have been reducing duration 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 amid continued economic improvement.
Icahn Takes a Bite of Apple, Sending Credit Spreads Wider
Apple's (AAPL) (rating: AA-, narrow moat) 10-year bonds widened about 10 basis points to about 95 basis points over the nearest Treasury last week after Carl Icahn announced that he had taken a stake in the company and was pressing the firm to front-load and increase the size of its share-buyback program. At the end of the June quarter, Apple was sitting on nearly $147 billion in cash, with about $41 billion held onshore. Domestic cash on hand declined nearly $2 billion during the quarter on the repurchase of $16 billion of stock and the payment of $2.8 billion in dividends, offset in part by the firm's $17 billion debt issuance in May. If Apple were to accelerate or increase its share-repurchase plans, it would probably need to issue more debt to fund such a program instead of incurring the tax liability from repatriating cash sitting overseas. If, for example, the firm maintained a $16 billion quarterly buyback pace, it would probably run out of domestic cash in less than three quarters.
We tend to think, however, that Icahn's investment will be one of his more passive ones in terms of owning a cheap stock, rather than an aggressive, corporate raider-type move to shake up the board or split up the company. Still, we don't doubt that Apple will issue additional debt at some point as it completes the $60 billion buyback authorization that runs through the end of calendar 2015. We expect the firm will essentially collateralize any borrowings with overseas cash on the hope that at some point Congress will pass a repatriation bill, allowing cash to move back onshore with minimal tax consequences. If additional borrowings--or the prospect of additional borrowings--continue to spook the market, enabling investors to pick up A+ like spreads on what we view as a significantly stronger credit, we would load up on Apple bonds.
Federal Reserve's Jackson Hole Conference Will Be a Nonevent This Year
The Federal Reserve Bank of Kansas City hosts an annual conference in Jackson Hole, Wyo., where researchers from the different Federal Reserve districts and academics can present their research to their peers. This year's conference is scheduled for Aug. 22-24. Historically, the chairman of the Federal Reserve has provided the opening remarks. Oftentimes within this presentation, the chairman has addressed current economic topics and outlined the Fed's analysis of those topics. During the past few years, these keynotes have been closely analyzed by the market in order to try to divine the Fed's future monetary policy. For example, in Bernanke's 2008 keynote address, he alluded to the potential for the Fed to purchase securities in the open market, which foreshadowed the advent of quantitative easing a few months later. This year is the first since Bernanke became chairman that he will not be present at the conference, and it will be the first time since 1990 that the chairman of the Federal Reserve will not give a keynote presentation. As such, this year's conference will be a non-event, as no market-moving news or synopsis of the Fed's current thinking will emerge.
Peripheral European Sovereign Yields Continue to Decline
Favorable European economic data and rising confidence are fanning the hope that the worst of the eurozone recession has passed and the economic region may be on the mend. Second-quarter eurozone gross domestic product grew 0.3%, the first positive reading since the third quarter of 2011. Growth was led by Germany and France, whose economies grew 0.7% and 0.5%, respectively. However, while GDP expanded in the northern countries, beleaguered southern countries like Italy and Spain continued to report economic contraction (negative 0.2% and negative 0.1%, respectively), albeit at slower rates of contraction. Although the beleaguered Southern European nations remain stalled in recessions, German industrial production, factory orders, and exports are on the rise and should continue to provide a lift to the rest of the eurozone. In addition, upbeat data out of China, such as stronger-than-expected trade data, also spurred hope that emerging markets would continue to support global economic growth.
Positive macroeconomic economic news and a renewed confidence spurred European investors to drive corporate credit spreads tighter as macroeconomic fundamentals have been the main driver of corporate bond performance in Europe. However, while European credit spreads have tightened, corporate credit markets in the United States have not participated in the move, and spreads have widened slightly for the year. We think there are two main reasons that U.S. credit spreads have not fully shared Europe's appetite for risk: 1) U.S. interest rates have generally been on an uptrend since the beginning of May and, 2) idiosyncratic risks are rising from increased shareholder activism and aggressive share-buyback programs.
Second-quarter GDP in Italy and Spain contracted at their slowest quarterly rates (0.2% and 0.1%, respectively) since the third quarter of 2011, prompting economists to believe that the economic deterioration in both countries may be close to an end. Since the beginning of July, the yield on Italy's 10-year bond has dropped 34 basis points to 4.18%, which is only 42 basis points higher than where yields bottomed out at the beginning of May. This move lower has come despite the fact that S&P lowered its rating on Italy to BBB from BBB+ in July. As the yield has dropped, the additional credit spread that investors required to purchase Italian sovereign bonds as compared to German bonds has tightened to +230 basis points. This is the least amount of additional compensation that investors have been willing to accept for Italian risk since the middle of 2011.
Likewise, since the beginning of July, the yield on Spanish 10-year bonds has declined 36 basis points to 4.36%. The additional credit spread that investors required to purchase Spanish sovereign bonds as compared to German bonds has tightened to +248 basis points. This is the least amount of additional compensation that investors have been willing to accept for Spanish risk since the middle of 2011.
Click to see our summary of recent movements among credit risk indicators.
New Issue Notes
Jersey Central Power & Light to Issue $500 Million of 10-Year 144A Notes at Relatively Cheap Whisper Level (Aug. 14)
FirstEnergy's (FE) (rating: BBB-, narrow moat) regulated utility subsidiary, Jersey Central Power & Light, announced today that it will issue $500 million of 10-year 144A notes. Initial price talk on the new deal is low 200 basis points over Treasuries. We view Jersey Central Power & Light's new issue to be relatively cheap if issued in the low 200s compared with its existing longer-tenor (roughly 14 years) 6.15% 144A notes due 2037, which are indicated at 190 basis points over the nearest Treasury. We estimate the 10/20 differential to be approximately 7.5 basis points. While we do not formally rate Jersey Central Power & Light, in our utility operating company scoring system, we view this entity to be of similar credit risk to KeySpan, a regulated utility of National Grid (NGG) (rating: BBB+, narrow moat). KeySpan's 8% notes due 2030 trade at 192 basis points over the nearest Treasury, albeit with roughly 7 years of longer tenor.
Jersey Central Power & Light's credit qualities include relatively moderate allowed return on equity of roughly 9.75%, an unfavorable New Jersey regulatory environment, average regulatory lag mechanisms, and average management performance. As such, we rank Jersey Central Power & Light as a lower-quartile regulated utility operating company under our coverage. We believe KeySpan ranks very similarly, including relatively moderate allowed ROE of roughly 9.8%, an unfavorable New York (Long Island) regulatory environment, average regulatory lag mechanisms, and average management performance.
On a consolidated basis, FirstEnergy reported flat adjusted second-quarter EBITDA of $901 million versus the year-ago period. FirstEnergy's adjusted EBITDA margin improved 150 basis points to 26% due largely to significantly lower operating and maintenance expenses and higher distribution deliveries to residential customers, up 3%. Second-quarter EBITDA benefited from a 7% increase in contracted sales versus the second quarter of 2012 as retail customers increased 38% year over year (by 700,000 to 2.7 million) and was further supported by government aggregation, up 31%, and structured sales, up 96%. FirstEnergy reported lower PJM capacity revenue resulting from significantly lower capacity prices versus the second quarter of 2012.
McCormick's New 10-Year Bonds Offer Opportunity to Capture Appetizing Credit Spread (Aug. 14)
McCormick (MKC) (rating: A+, wide moat) is issuing $250 million 10-year bonds this morning. Our A+ issuer credit rating is one to two notches higher than the rating agencies, probably due to our assessment that the firm has a wide economic moat. Pricing guidance on the notes is +95 over Treasuries, slightly inside where the firm's existing bonds are marked by the pricing services. McCormick's existing 3.90% senior notes due 2021 are mostly put away with long-term investors and rarely trade. Our pricing service currently marks the existing bonds at 102 over the nearest Treasury, which we currently recommend overweighting. We think fair value for the existing bonds should be closer to +80 and fair value for the new issue should be +85. Comparisons in the food and beverage sector include Brown-Forman's (BF.B) (rating: A+, wide moat), whose 2.25% senior notes due 2023 are indicated at 80 over the nearest Treasury, Hershey's (HSY) (rating: A+, wide moat) 2.625% senior notes due 2023, which are indicated at 75 over Treasuries, and Campbell Soup's (CPB) (rating: A-, wide moat) 2.50% senior notes due 2022, which are indicated at 105 over the nearest Treasury.
As the undisputed leader in the category--and more than twice the size of its next-largest competitor--McCormick possesses a stable of competitive advantages that support our wide moat rating and should ensure the firm remains a leading player in the global spice and seasoning category. We expect sales growth of just north of 7% in fiscal 2013 (incorporating the benefit from the pending WAPC acquisition) and forecast annual sales growth of 5% over the longer term, in the middle of management's long-term sales growth forecast of 4%-6%. In our opinion, cost savings from the firm's efficiency initiatives will lead to some additional margin expansion. However, we expect that the firm will reinvest a portion of these savings back into R&D and marketing support for core brands. Our forecast calls for operating margins to expand to 16.5% during the next five years and debt leverage to gradually decline as EBITDA grows annually in the mid- to upper single digits. We expect that McCormick will continue to enhance shareholder returns through higher dividends and additional share repurchases while pursuing bolt-on acquisitions to build out its network, with a particular focus on expanding in faster-growing emerging and developing markets.
Initial Price Talk on American Tower Debt Issue Looks Fair (Aug. 14)
American Tower (AMT) (rating: BBB, narrow moat) is planning to issue 5.5- and 10.5-year senior notes, with initial price talk around 215 basis points and 240 basis points over Treasuries, respectively. While these levels compare favorably with recent trading activity in the firm's existing notes, we believe initial talk approximates fair value. American Tower's 4.5% notes due in 2018 have traded recently at about 175 basis points over the nearest Treasury, while its 3.5% notes due in 2023 have traded around 208 basis points over the nearest Treasury. However, the BBB- portion of the Morningstar Industrial Index stands at about +237 basis points. Our BBB rating on American Tower encompasses the entire firm but these new notes, like the existing bonds, are junior to roughly $3.5 billion of secured debt, equal to about 1.3 times EBITDA. We believe these notes deserve to trade one notch lower than our entity-level rating.
Still, American Tower's debt load is considerably smaller than its peers', with net leverage at 4.4 times EBITDA on a trailing 12-month basis at the end of June versus about 6.4 and 7.5 times at rivals Crown Castle International (CCI) (rating: BBB-, narrow moat) and SBA Communications (SBAC) (rating: BB+, narrow moat), respectively. American Tower targets leverage at 3-5 times EBITDA, but prefers to keep this ratio between 3.5 and 4.0 times under normal circumstances. Holding leverage down largely offsets the impact of the firm's move to convert its U.S. tower business to a real estate investment trust structure. American Tower has agreed to acquire 2,790 towers in Brazil and 1,666 towers in Mexico for a bit more than $800 million in total. The transaction will increase net leverage to about 4.7 times, well within management's targeted range, while ongoing migrations to next-generation technologies in these regions lays the foundation for sustainable cash flow generation.
American Tower's business offers several advantages that enable it to carry a heavy debt load fairly easily. Long-term contracts with wireless carriers drive recurring revenue growth, and towers have minimal ongoing capital needs after initial construction. As more consumers adopt data-hungry wireless devices, we expect carriers will need to expand the number of sites in their networks, and adding tenants to an existing tower can quickly boost cash flow for the tower owner. The biggest risk facing the tower industry is customer concentration, as the four major U.S. wireless carriers produce more than half of total revenue. American Tower has diversified internationally to a greater degree than its two rivals, but this expansion brings a new set of risks, including currency fluctuations.
Price Talk Around J.P. Morgan's 30-Year Subordinated Notes Appears Fair to Slightly Rich (Aug. 14)
J.P. Morgan Chase (JPM) (rating: A, narrow moat) announced today that it is issuing new 30-year benchmark subordinated notes at the holding company level. Initial price talk is a spread in the 190 basis points area above Treasuries. We view this as fair to slightly rich and ascribe fair value around +195-200 basis points, given comps in the 10-year maturity area and adjusting for the longer duration. Currently the firm's 3.375% senior subordinated holding company notes due 2023 trade at 173 above the nearest Treasury, which look generally fair. Looking at comparable banks, Wells Fargo (WFC) (rating: A+, narrow moat) recently issued 10-year subordinated holdco notes that priced at a spread of +160 but have widened out to +168. We view these as moderately cheap. Citigroup's (C) (rating: A-, narrow moat) 3.50% senior subordinated holdco notes are indicated at +205 to the nearest Treasury, which we view as roughly fair.
Morningstar's credit rating for J.P. Morgan reflects the company's stellar performance and reputation throughout the financial crisis, hampered by some of its mediocre credit metrics. In our view, J.P. Morgan is the best managed of the three money center banks in the U.S., having avoided the risk management missteps that critically injured Citigroup and Bank of America in addition to numerous peers around the world. We see no reason this excellent performance won't continue. J.P. Morgan's regulatory capital levels are sound for a bank of its size, with its Tier 1 capital ratio at 11.6% and its Tier 1 common ratio at 10.4%.
Viacom Issuing Debt to Raise Leverage for Share-Repurchase Activity (Aug. 12)
Viacom (VIAB) (rating: BBB+, narrow moat) isn't wasting any time in taking leverage up to its new target of 2.75-3.0 times, from just over 2 times currently. The firm is coming to market with 5-, 10- and 30-year notes today. Initial price talk of around 150, 187.5-200, and 225-237.5 basis points over Treasuries for the three tranches, respectively, is modestly cheap to existing notes, comparable companies, and the Morningstar Corporate Bond Index for BBB+ rated industrial credits. Viacom's 2023 and 2043 notes are currently trading at 154 and 193 basis points over Treasuries, respectively. Similar-rated media entertainment peer Time Warner (TWX) (rating: BBB+, narrow moat) has 2022 notes that were recently indicated at 144 basis points over Treasuries. The Morningstar BBB+ Index is at 149 basis points over Treasuries. We view the existing notes from both companies as currently fairly valued. Most consumer cyclical companies trade just inside the index, but we believe Viacom should trade slightly wide of the index and similar-rated peers given its recent leverage target change, as investors are likely to be wary of getting into a credit that rewards shareholders at the expense of bondholders. Accordingly, in our opinion, fair value on the 10-year issuance is around 160 basis points over Treasuries.
We downgraded our issuer credit rating for Viacom last week to BBB+ from A- on the firm's announcement that it will increase its leverage target to repurchase more shares. The board authorized an increase to the current share-repurchase program to $20 billion from $10 billion. This announcement came as a surprise to us, as Viacom had consistently reiterated its target leverage ratio of 2.0-2.25 times quarter upon quarter for the past few years, including the fiscal second quarter.
Our rating is based on the new leverage target with the assumption that management funds planned share repurchases with new debt, bringing leverage toward the higher end of the new target range. It also encapsulates our more negative view of management's stewardship of debt capital. Also, it takes into account our ratings on Viacom's entertainment peers, including Time Warner, which has a net leverage target maximum of 2.5 times, and Discovery Communications DISCA (rating: BBB, narrow moat), which has a leverage target of 2.5-3.0 times.
Westar to Issue $250 Million of 30-Year First Mortgage Bonds; Whisper Pricing Sounds Fair (Aug. 12)
Westar Energy (WR) (rating: BBB+, narrow moat) announced today that it will issue $250 million of 30-year first mortgage bonds. Initial whisper price talk is 90 basis points over Treasuries. When compared with existing Westar 4.8% first mortgage bonds due 2041, which trade at 81 basis points over Treasuries, the new issue looks fairly valued to us. Comparing it with similar-rated regulated utility peer Xcel Energy's (XEL) (rating: BBB+, narrow moat) 4.8% senior notes due 2041, which trade at 112 basis points over Treasuries, we believe roughly 25 basis points of additional spread is warranted for Xcel's lack of security. We believe the proceeds from this new issue will partially support environmental capital expenditures at its La Cygne plant. At the second quarter, Westar forecast no changes to its total 2013 capital expenditure forecast of $900 million slated primarily for air quality control and transmission projects. It also reported that all major projects remain on track and on budget. Liquidity at the second quarter stood at roughly $1.0 billion, including $4 million of cash and $983 million of revolver availability.
Westar reported second-quarter EBITDA of $199 million, flat year over year. Top-line growth was fueled by increased tariff and market-based wholesale electric sales volume, up 28%, year over year, partially offsetting retail revenue declines of 3% as cooling degree days were down 33%. Gross margins declined 1% because of weather and lower industrial sales. On the regulatory front, Westar said it has benefited from reduced regulatory lag with its transmission and environmental riders, which were recently updated to include more than $300 million of plant investment in 2012. Moreover, Westar filed an abbreviated rate case in April to recover about half of its La Cygne air quality retrofit reflecting an investment of about $335 million through midyear (total $610 million). La Cygne's expected in-service timeline is targeted for mid-2015.
Virginia Electric & Power to Issue $585 Million of 30-Year Notes at Slightly Rich Whisper Level (Aug. 12)
Dominion Resources' (D) (rating: BBB+, narrow moat) regulated electric utility subsidiary, Virginia Electric & Power, announced today this it will issue $585 million of 30-year senior notes. Initial price talk is in the high 80s basis points over Treasuries. We view Virginia Electric & Power's new issue as slightly rich and view fair value at 90-95 basis points over Treasuries. While we do not formally rate Virginia Electric & Power, in our utility operating company scoring system, we view this entity as of similar credit risk to Georgia Power, a regulated utility of Southern (SO) (rating: A-, narrow moat). Georgia Power's 4.3% notes due 2042 trade at 111 basis points over Treasuries, which we view to be cheap. We also view Virginia Electric & Power as a slightly weaker credit versus Southern's regulated utility Alabama Power. Alabama Power's 3.85% senior notes due 2042 trade at 82 basis points over Treasuries.
Virginia Electric & Power's primary credit qualities include a relatively high allowed ROE of roughly 11.0%, a very favorable Southeastern regulatory environment, strong regulatory lag mechanisms, and above-average management performance. As such, we rank Virginia Electric & Power to be one of the strongest regulated utility operating companies under our coverage. We believe Georgia Power ranks very similarly, including a high allowed ROE of roughly 12.2%, a very favorable Southeastern regulatory environment, slightly weaker regulatory lag mechanisms, and outstanding management performance. Alabama Power is the highest-ranked regulated utility under our coverage. We believe it benefits from one of the best allowed ROEs (roughly 13.8%), exceptionally efficient regulatory lag mechanisms, and outstanding management performance.
On a consolidated basis, Dominion Resources reported improved adjusted second-quarter operating earnings of $355 million, up 5% year over year (versus $337 million). Improved operating earnings were primarily attributable to higher revenue related to gas transmission growth projects and higher rate adjustment clause revenue. Negative factors were a planned refueling outage at Millstone Power Station and lower contributions from unregulated retail energy marketing operations. Virginia Electric & Power reported second-quarter operating EBIT of $254 million, down 9% (versus midpoint guidance of $259 million-$299 million), because of lower regulated electric sales and lower storm and service restoration.
R.R. Donnelley Extends Debt Schedule by Issuing 8-Year Notes, Tendering for Earlier Maturities (Aug. 12)
High-yield credit Best Idea R.R. Donnelley & Sons (RRD) (rating: BB, no moat) is in the market with $350 million in 8-year noncallable notes today. The firm also announced that it is tendering for up to $350 million of the following issues: 1) up to $100 million of its 5.5% 2015 notes, 2) up to $100 million of its 6.125% 2017 notes, and 3) up to $150 million of its 7.25% 2018 notes. R.R. Donnelley also has a roughly $250 million note maturity due in April 2014 that we expect to be paid down through free cash flow as its goal is to deleverage. The firm's leverage goal is 2.25-2.75 times and debt/EBITDA currently stands at 2.9. Free cash flow is expected to be $400 million-$500 million in 2013.
We expect the notes to price attractively, as we view R.R. Donnelley's bonds as undervalued. While the firm continues to post soft results as its end users make the transition toward digital media from paper-related products, it has generated solid free cash flow amid these headwinds by prudently downsizing its cost structure. This has allowed the firm to reduce debt in an attempt to achieve its aforementioned leverage goal.
R.R. Donnelley's outstanding 2021 notes were recently indicated at a yield of 6.6%, which is well wide of the yield on the average BB issuer in the Merrill Lynch index of 4.9%. We believe management's more conservative approach to the balance sheet and copious free cash flow generation will allow bonds to outperform. We would view fair value for the new 8-year notes at around 5.5%, given where other consumer cyclical names in the BB area trade. Carter's (CRI) (rating: BB+, no moat) recently priced an 8-year deal at 5.25%, but the notes have since traded in to 5.1%, which we view as slightly cheap for the stable, yet small clothing retailer. Gannett (GCI) (rating: BB/UR, narrow moat) also recently priced 7-year notes at 5.125%, which we viewed as rich, but they have since traded wider to a more appropriate, but still slightly rich, level of 5.3%. Lastly, Royal Caribbean Cruises (RCL) (rating: BB-, narrow moat) has 2022 notes that we view as very rich at 5.3%; we would place fair value closer to 6%.
Click here to see more new bond issuance for the week ended Aug. 16, 2013.