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Credit Insights

Pace of Rising Interest Rates Should Moderate

As the 10-year Treasury approaches 3%, the pace at which interest rates are rising will slow, but the Fed could begin to taper its bond-buying program after its September meeting.

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In May, we opined that as soon the Fed intimated to the markets that it would begin tapering its asset-purchase program, interest rates would rise by 100-150 basis points. In the Federal Open Market Committee's May statement, it added the following new language: "The committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes." This provided the market with its first hint that the FOMC was contemplating reducing its asset-purchase program, precipitating the recent rise in interest rates. 

Later in the month, in response to questioning from the Joint Economic Committee, Federal Reserve chairman Ben Bernanke was more specific, saying the FOMC could begin reducing asset purchases as soon as a few meetings from May. Soon thereafter, the FOMC released the minutes from the April 30-May 1 meetings. These minutes highlighted the fact that a number of members believed the current asset-purchase program should have been decreased as early as the June meeting (with one participant recommending beginning decreasing purchases immediately).

Since the beginning of May, the 10-year Treasury has risen 120 basis points and is nearing the bottom of the range that we think reflects a normalized level. Interest rates continued to rise last week, with the 10-year hitting an intraday high of 2.92%, before Treasury bonds rallied Friday after poor new-home sales data was released. As the 10-year approaches 3%, we think the pace at which interest rates are rising will moderate. One of the reasons we believe this is that the Fed has committed to keep short-term rates near zero until unemployment decreases to 6.5% or inflation increases over 2.5%. As such, shorter-term interest rates have not risen at the same pace as longer-term rates. While the 10-year Treasury has risen sharply, the 2-year bond has risen much more slowly, leading to a significant increase in the steepness of the yield curve. 

On average, since the mid-1970s, the spread between the 2-year and 10-year Treasury has been 90 basis points. Currently, the spread is 250 basis points, which is only 40 basis points from its widest point (which occurred in February 2011) and about 2.5 standard deviations higher than average. In addition to the steepness of the curve, as the market prices in a higher probability that the Fed tapers its asset-purchase program in the near term, inflation expectations have moderated. For example, the five-year, five-year forward (the market implied average annual inflation rate expectation for five years, five years in the future) has decreased to 2.40% from 2.80% at the beginning of the year. As the yield curve has steepened and forward-looking inflation expectations have moderated, investors should be willing to extend out the curve to pick up additional yield and benefit from the roll down in the curve over time.


source: Morningstar Analysts

We think corporate bonds will probably continue to struggle over the next month as investors attempt to anticipate the timing of when and how quickly the Federal Reserve will taper its asset purchases and forecast the bond market's reaction. Given economic improvement (gradual employment growth and inflation returning to targeted level) 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 September FOMC meeting (Sept. 17-18).

Tech Sector Earnings Fail to Live Up to Equity Market Expectations, but Credit Quality Largely Unaffected
A number of off-cycle tech companies reported earnings over the past couple of weeks, including  Cisco Systems (CSCO) (rating: AA, wide moat),  Hewlett-Packard (HPQ) (rating: BBB+, narrow moat),  NetApp (NTAP) (rating: A+, narrow moat), and  Dell (DELL) (rating: UR-, no moat). Results have, on the whole, left investors, especially shareholders, wanting. We believe the poor equity market reactions to earnings largely reflect the huge runup in share prices and rising earnings expectations many tech firms have enjoyed this year. For example, before releasing earnings, HP's and Cisco's shares had risen 80% and 36% year to date, respectively. Still, there is no doubt global IT demand is sluggish: Cisco and NetApp, which both have heavy exposure to relatively strong corners of the industry, forecast revenue growth of only 3%-5% and 1%-8%, respectively, for their upcoming quarters. Cisco plans to cut or reassign 4,000 employees as it looks to deliver on its profitability targets in fiscal 2014.

The PC market remains the biggest weak spot across the IT market. Dell and HP, which have heavy exposure to PCs, have fared the worst among the group. HP was the standout underperformer on a revenue basis, with third-quarter revenue down 8% year over year on a 12% drop in PC sales and an 11% decline in server revenue. Dell managed to hold revenue flat year over year. Dell's PC sales fell 5%, whereas server revenue actually increased 10%. Dell has resorted to aggressive price competition to gain share as it prepares to become a private company, taking a bite out of HP's hide. The result is that Dell's margins have been crushed--operating income declined 60% year over year. However, we've been impressed by HP's ability to maintain profitability and cash flow, which it has steadily directed to repaying debt. From a credit perspective, the fiscal third quarter was solid. HP generated about $1.8 billion in free cash flow during the quarter, essentially none of which was used for share repurchases or acquisitions. As a result, total net debt dropped $1.9 billion during the quarter to $11 billion, less than half the level hit following the 2011 Autonomy acquisition. Net "operating company" debt, which excludes debt and cash assigned to HP's financing unit, declined $1.7 billion, to $1.2 billion. HP is nearing its goal of zero net operating debt. The firm plans to announce revised capital-allocation goals at an investor day in October, but we expect the painful experience of rebuilding the balance sheet over the past two years will keep HP committed to holding leverage at very modest levels.

Ultimately, we expect that the success of HP and Dell will depend on their ability to build proprietary technologies that meet evolving customer demands rather than maintain share in commodity markets like PCs. With a superior competitive position today and a rapidly improving, rather than deteriorating, balance sheet, this is a fight we believe HP can win. 
Contributed by Michael Hodel, CFA.

Retail Earnings Highlight Polarized Spending Patterns
Nearly a dozen retailers reported earnings last week, posting mixed results. Over the past quarter, consumer spending appears to be becoming more polarized between higher-end consumers with disposable income to spend and middle- to low-income consumers who continue to be squeezed by higher prices and stagnant incomes. Home-improvement superstores  Home Depot (HD) (rating: A, wide moat) and
 Lowe's (LOW) (rating: A, wide moat) benefited from consumers with the financial wherewithal to move to larger homes or purchase new housing. These issuers' earnings outperformed expectations as the housing market continues to rebound and new and move-up homebuyers furnish and renovate their new homes. Best Buy's turnaround continued to take shape during the second quarter, with top- and bottom-line results coming in ahead of the market's and our internal expectations.

As an indication of the squeeze being felt by middle- to low-income consumers,
 Target (TGT) (rating: A, no moat),  Sears Holdings (SHLD) (rating: B-, no moat), and  J.C. Penney (JCP) (rating: CCC, no moat) each reported disappointing earnings last week, and  Wal-Mart Stores (WMT) (rating: AA, wide moat) reduced its full-year guidance the week before. These retailers generally highlighted pending pressures brought about by elevated unemployment levels, higher payroll taxes, and limited income growth. Benefiting from the woes of the department stores, comparable-store sales rose 4% at  TJX Companies (TJX) (rating: A, narrow moat) as middle-income consumers shifted their spending to discount chains, which have historically catered to lower-end consumers. Small businesses are also feeling the effects of weak economic growth. For example, Staples' total revenue fell 2.2%, with North American stores and online, which cater to individual consumers and small businesses, down 2.0%, and debt leverage rose. 

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

New Issue Notes

DTE Energy to Issue $400 Million of 10-Year Notes at Slightly Rich Guidance Range (Aug. 20)
 DTE Energy (DTE) (rating: BBB+, narrow moat) announced today that it plans to issue $400 million of 10-year notes, which we assume will be at the parentco. The guidance range is low 90s over Treasuries, which we think is slightly rich for parentco debt. When compared with similar-rated parentco peers such as  Duke Energy (DUK) (rating: BBB+, narrow moat), whose 3.05% notes due 2022 trade at 109 basis points over the nearest Treasury, as well as  Xcel Energy (XEL) (rating: BBB+, narrow moat), whose 4.7% notes due 2020 trade at 111 basis points over the nearest Treasury, we believe DTE's fair value is likely in the low 100s.

Management discussed the impact of Detroit's Chapter 9 filing on its second-quarter call; we believe this event could create moderate headwinds for DTE. On the positive side, DTE will take over a substantial portion of the city's meters, which will generate as much as $300 million in new investment opportunities for DTE over the next five to seven years. On the downside, DTE does have significant receivables from the city that, in a worst-case scenario, could go unpaid if the emergency manager is unable to justify the expense, given other senior creditors' claims on cash flows, which are at present enormous. It would be a surprise to us if DTE escaped from Detroit's bankruptcy process without any negative impact, but we do expect that any possible haircut to receivables would be minor and have no impact on valuation.

Entergy Louisiana to Issue $325 Million of 10-year FMB at Cheap Initial Price Talk (Aug. 19)
 Entergy's (ETR) (rating: BBB, narrow moat) regulated electric utility subsidiary, Entergy Louisiana, announced today that it will issue $325 million of 10-year first mortgage bonds. Initial price talk is 130 basis points over Treasuries. We view Entergy Louisiana's new issue as cheap and believe fair value to be around 100 basis points. While we do not formally rate Entergy Louisiana, in our utility operating company scoring system, we view this entity as of similar credit risk to Consumers Energy, a regulated utility of  CMS Energy (CMS) (rating: BBB-, narrow moat). Consumers Energy's 2.85% first mortgage bonds due 2022 trade at 68 basis points over Treasuries, which we view to be rich. Moreover, we view Entergy Louisiana also to be of similar credit risk to Xcel's regulated utility, Public Service Company of Colorado. Public Service Company of Colorado's 2.5% first mortgage bonds due 2023 trade at 75 basis points over Treasuries, which we view to be slightly rich.

Entergy Louisiana's primary credit qualities include relatively high allowed return on equity of roughly 10.25%, a moderately favorable regulatory environment, relatively moderate regulatory lag mechanisms, and fair management performance. As such, we rank Entergy Louisiana as average risk relative to other regulated utility operating companies under our coverage. We believe Consumers Energy ranks very similarly, with relatively high allowed ROE of roughly 10.3%, a moderately favorable regulatory environment, relatively moderate regulatory lag mechanisms, but above-average management performance. Public Service Company of Colorado also benefits from a relatively above-average allowed ROE (roughly 10.0%), moderate regulatory lag mechanisms, and fair management performance.

Click here to see more new bond issuance for the week ended Aug. 23, 2013.

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