Declining Interest Rates Help Investors Recuperate Losses
Interest rates have declined since the Fed announced it was holding its bond-buying program steady and will probably continue to trend lower in the near term.
Last week, corporate-bond investors continued to recuperate some of their losses from earlier this year. The Morningstar Corporate Bond Index rose 0.48% after having risen 1.14% the prior week. The gains in corporate bonds were due to declining interest rates as the 10-year Treasury bond fell 13 basis points to 2.62%. At this yield, the 10-year has retraced about 25% of the 140-basis-point increase from the lowest yield reached this year in May to the almost 3% yield the 10-year hit in September.
The average credit spread in our corporate-bond index widened 2 basis points to +146 as the market finished digesting the huge serving of Verizon Communications (VZ) (rating BBB, narrow moat) bonds served to it in mid-September as well as a significant amount of new issues brought to market last week. In the secondary trading market, portfolio managers finished selling positions to make room for the new Verizon bonds as well as window-dress their portfolios for quarter-end. Other traders bulked up on the Verizon bonds in anticipation that the fixed-income index funds will need to purchase those bonds as they enter the indexes on Oct. 1. Many index funds have already been buying Verizon bonds in anticipation of their increased weighting in the corporate-bond index, but there may still be some more room for the bonds' credit spreads to tighten until these funds match the increased weighting.
Interest rates have declined since the Federal Reserve announced that it was holding its bond-buying program steady and will probably continue to trend lower in the near term. Over the long term though, interest rates will rise toward normalized spreads over inflation and inflation expectations once the Fed begins to reduce its asset-purchase program. As such, the belly of the curve (around the 5-year maturity) appears to provide the best risk/reward trade-off between capturing additional yield from extending out the yield curve and benefiting from roll-down while the Fed keeps short-term rates near zero for the foreseeable future. This point in the curve also keeps duration short enough to limit losses from potential increases in long-term rates. For example, a 5-year bond bought today will only be a 3-year bond in 2015 when the Fed forecasts that the federal-funds rate will begin to rise and will only be a 2-year bond in 2016 when the Fed estimates that the federal-funds rate will be about 2%. Corporate credit spreads are fairly valued within the current trading range; however, with the continuation of easy money policies, the market may push credit spreads back toward the bottom of the +130-167 basis point range where they have traded over the past year.
Holiday Sales Outlook Muted
We began warning investors several weeks ago that political fights over the debt ceiling and continuing spending resolutions to fund federal expenditures would begin to heat up in earnest. While these issues will sway the bond market in the near term, a more important issue for the corporate-bond market over the medium term will be regarding this year's outlook for holiday spending. Approximately 20% of annual retail sales (and as much as 40% for some retailers) take place during November and December. Considering that 70% of GDP is driven by the consumer, holiday sales will affect both the economic and jobs outlook. R.J. Hottovy, director of consumer research, wrote the following: "We anticipate a modest deceleration in comparable-store sales for most retailers during the fourth quarter of 2013, owing to macroeconomic and political uncertainty, payroll and income tax increases, mixed consumer confidence signals, and a calendar shift (there are only 25 shopping days between Black Friday and Christmas this year, seven fewer than in 2012, as well as an earlier start to Hanukkah that may pull promotional activity forward). We anticipate average comparable-store sales growth of roughly 2%-3% across our coverage universe. This compares with average comparable-store sales growth of approximately 3% in 2012 and 4% in both 2011 and 2010. We believe that both in-store transactions and the average transaction size will experience a deceleration, the result of a more cautious consumer and aggressive promotional activity." As retailers gear up for the holiday sales traffic, payrolls expand with temporary workers hired to help the onslaught of shoppers and keep store shelves stocked. However, if retailers' holiday sales outlook are muted, the industry may pull back on the amount of temporary hiring. For additional detail on the current trends and outlook for this year's holiday season, please see the consumer cyclical section of Morningstar's recently published market outlooks.
New Issue Notes
Reynolds American's New Issue Talked With Plenty of Concession to Our Fair Value Opinion (Sept. 12)
Reynolds American (RAI) (rating: BBB, narrow moat) filed a prospectus to issue 10-year and 30-year notes this morning. Initial price talk is reportedly +210 and +240, respectively, which includes an attractive new issue concession to where the firm's existing debt is trading. Reynolds' existing 3.25% senior notes due 2022 are trading at 175 basis points over the nearest Treasury and its 4.75% senior notes due 2042 are trading at +200, which we view as fairly valued based on our assessment of the firm's credit quality.
Gannett Leveraging Up Further to Fund Purchase of Belo; Price Talk Appears Fair (Sept. 26)
Gannett (GCI) (rating: BB/UR, narrow moat) is currently in the debt market with $1 billion in notes split equally in two tranches: 6NC3 and 10NC3. The current price talk on the two tranches is an expected yield of 5.375% and 6.50%, respectively, which in our opinion is fair value. The yield of Merrill Lynch's BB index is currently 5.09%, and we expect a new deal from Gannett to price wide of this level, given the pending acquisition of Belo, which is will raise leverage. Pro forma for the acquisition, this transaction, and $500 million in debt that was issued earlier this year, we estimate total debt/EBITDA will increase to over 2 times, up from 1.3 times at the end of last year. Price talk also looks fair relative to other consumer cyclical names such as business services company and Best Idea R.R. Donnelley & Sons (RRD) (rating: BB, no moat) and cruise line operator Royal Caribbean Cruises (RCL) (rating: BB-, narrow moat). R.R. Donnelley's 2019 notes currently yield 5.81%, which we think is cheap and would place fair value around 5.50%, and Royal Caribbean's 2022 notes yield 5.62%, which we think is slightly rich and would place fair value closer to 6%.
While Gannett's issuer credit rating is under review as we assess the implications of its transformative acquisition of Belo, any downgrade would probably be limited to one notch lower than the existing rating. The $1.5 billion acquisition implies a 9.4 times average 2011-12 EV/EBITDA multiple, and will be funded entirely by debt and will include the assumption of $715 million in debt. In conjunction with the acquisition, management reiterated its commitment to repurchase $300 million in shares over the next two years as well as maintain its dividend (around $180 million annually).
At first blush, the deal would appear to be a clear negative from a credit perspective, given the planned increase in debt. However, from an operational standpoint we believe the acquisition will provide Gannett with more cash flow stability as it diversifies away from print media. Our updated credit rating will take this factor into account, as well as the pro forma capital structure. Management estimates that leverage will be 2.3 times, less than a turn higher than Gannett currently carries, and said it plans to deleverage swiftly. We estimate that the company will slowly reduce leverage to 1.4 times by the end of 2017.
Ford Motor Credit to Issue Benchmark 5-Year Bonds; Initial Price Talk Looks Fair (Sept. 26)
Ford Motor Credit (rating: BBB-) is offering 5-year senior notes with initial price talk of 145 basis points over Treasuries. We view fair value at about +140 based on the current trading levels of finance company 5-year paper of other auto OEMs including: Nissan (NSANY) (rating: BBB+, no moat), whose recently issued notes are indicated at +121, which we see as fair; Daimler (DAI) (rating: BBB+, no moat), whose 5-year notes issued in August are indicated at +104, which we view as rich; Volkswagen (VOW) (rating: A-, no moat), whose notes due in November 2017 are indicated at +84, which we view as fair; Honda (HMC) (rating: A, no moat), whose notes due February 2018 are indicated at +81, which we view as fair; and Toyota (TM) (rating: A, no moat), whose notes due in January 2018 are indicated at +55, which we view as rich.
Ford recently provided greater detail on its capital allocation strategy which reiterates gross manufacturing debt of $10 billion by middecade and cash of around $20 billion. Reduction of its pension liability remains another key initiative. Further, the company, which recently got upgraded out of junk by the final rating agency, wants to maintain investment-grade ratings throughout the cycle, which we believe can result in further ratings upgrades.
Recent monthly auto sales have been encouraging as well. Ford's sales grew 12.4% year over year in August excluding the discontinued Ranger and Crown Victoria. It was the best retail sales month of any month for Ford since August 2006. The company also announced fourth-quarter North American production plans of 785,000 units, up 7% from the fourth quarter of 2012. Car sales rose 15%, utilities grew 16%, and trucks increased 30%. The Fusion midsize sedan had its best ever August. Ford's small cars also did very well with a 30% increase and 44% of that growth from the C-MAX hybrid. The Fiesta subcompact increased sales 61.5% for a record August. Management described inventory as tight on certain key models such as the Fusion, Focus, Explorer, and Escape, but a new Fusion assembly line in Michigan adds 100,000 units of annual Fusion capacity. More good news came from the F-Series truck, which sold more than 70,000 units for the second time this year, which had not happened since 2006. The vehicle's sales grew 22.2% in August with essentially flat incentives, which bodes well for pricing contributions in third-quarter results.
Bank of Montreal's New 5-Year Bond Looks Slightly Cheap Based on Initial Price Talk (Sept. 25)
Bank of Montreal (BMO) (rating: A, narrow moat) announced today that it is issuing 2-year floating and 5-year fixed U.S dollar-denominated notes in benchmark size. Initial price talk on the 5-year notes is a spread of 105 basis points over Treasuries, which we view as slightly cheap. As with other major Canadian banks, we are positive on BMO from a credit perspective due to Canada's highly regulated banking oligopoly. BMO's Tier 1 capital ratio is around 11%, while low-cost deposits represent roughly 70% of the firm's total funding. However, we give BMO a lower rating than the agencies due mostly to its lower efficiency and its stagnant Canadian bank operations.
The existing BMO 1.45% senior notes due 2018 are indicated at a spread of 67 basis points over the nearest Treasury, suggesting a substantial new issue concession. Toronto-Dominion Bank (TD) (rating: AA-, narrow moat) issued 5-year notes Sept. 5 also at a decent concession. Those 2.625% notes due 2018 are now indicated at a spread of +75, which we view as roughly fair. Bank of Nova Scotia's (BNS) (rating: A+, narrow moat) 2.75% notes due 2018 are indicated at 96 over the nearest Treasury, which we view as somewhat cheap. Based on those levels and our modestly lower credit rating at BMO, we see fair value for the new 5-year notes closer to +95.
Wal-Mart's New Deal Looks Attractive (Sept. 25)
Wal-Mart Stores (WMT) (rating: AA, wide moat) is issuing new 5- and 30-year notes today and we view initial price talk of 60-65 and around 105 basis points over Treasuries on the two respective tranches as attractive relative to both existing bonds, which we view as undervalued, and comparables. Wal-Mart's existing 2018 and 2043 notes were recently indicated at 46 and 93 basis points over the nearest Treasury, respectively. Also, lower-rated apparel manufacturer, Ralph Lauren (RL) (rating: A, narrow moat), priced a 5-year deal earlier this week at 68 basis points over Treasuries, making initial price talk on Wal-Mart's new notes look relatively attractive for the risk compared with that lower-rated firm. Another consumer name, more-cyclical restaurant chain McDonald's (MCD) (rating: AA-, wide moat), has 2018 and 2043 notes that were recently indicated at 57 and 79 basis points over the nearest Treasury, respectively, which we also view as slightly rich. We believe Wal-Mart's bonds should trade inside McDonald's levels and would place fair value for Wal-Mart's new 5- and 30-year bonds at around 40-45 and 85-90 basis points over the nearest Treasury, respectively.
Wal-Mart recently reported sluggish second-quarter comparable sales growth (down 0.3% at Wal-Mart U.S. but up 1.7% at Sam's Club), as several headwinds are challenging the firm. The higher payroll tax continues to weigh on year-over-year growth in consumer spending, while low food inflation also pressured the top line. Still, Wal-Mart is a solid and stable credit thanks to its wide economic moat, moderate credit metrics, and robust Cash Flow Cushion. The firm has maintained lease-adjusted leverage below 2 times despite a steadily increasing debt load, which has funded share repurchases and acquisitions.
Enbridge to Issue 3- and 10-Year Notes; Initial Price Talk Looks Fair (Sept. 25)
Enbridge (ENB) (rating: A-, wide moat) announced that it is issuing new 3-year and 10-year notes. Enbridge intends to use the proceeds for capital expenditures and general corporate purposes. Initial price talk is in the area of +130 basis points, which we view as fair value.
Within our coverage universe of C-corp pipeline companies, Spectra Energy (SE) (rating: A-, wide moat) is the lone issuer with outstanding 10-year debt. We view Spectra as very weakly positioned in the A- category because of its recently announced plans to drop down all of its U.S. natural gas storage and transmission assets into its master limited partnership, Spectra Energy Partners. Spectra will also transfer all of its liquids business by dropping down its 50% interest in the Express-Platte pipeline and its interests in the Sands Hills and Southern Hills natural gas liquids pipelines. Several months before the dropdown announcement, Spectra issued 3.30% notes due 2023 at a spread of +148 basis points. The 3.30% notes are now quoted at a spread of 214 basis points above the nearest Treasury, which we view as close to fair value following the deterioration in credit quality due to the dropdown. Also for comparison, the Morningstar Corporate Bond A- Industrials Index is quoted at +123 basis points. Based on Enbridge's network of energy assets that transport and store oil and natural gas throughout Canada and the United States, which firmly positions Enbridge in the A- category, and its superior credit quality compared with Spectra, we believe fair value on the new 10-year notes to be about +130 basis points.
Ralph Lauren Tapping U.S. Debt Markets to Refinance Euro Bond; Price Talk Appears Fair (Sept. 23)
Ralph Lauren (RL) (rating: A, narrow moat) is coming to the debt market with $300 million in 5-year paper today to refinance its $271 million euro bond due next month. Initial price talk is in the high 70s over Treasuries, which appears fair. We believe the retail manufacturer should trade slightly wide of similar-rated retailers. Target (TGT) (rating: A, no moat) and Home Depot (HD) (rating: A, wide moat) have 2018 notes that trade around 60-65 basis points over the nearest Treasury.
Ralph Lauren is a solid credit thanks to its moderate lease-adjusted leverage and healthy free cash flow generation. The firm continues to generate solid cash flow from operations, carries minimal leverage, and is well positioned to internally fund future expansion. Over the past 40 years, Ralph Lauren has evolved into an iconic brand, with a well-diversified product offering and strong global presence. The firm is a leading player in the competitive retail marketplace, delivering 10% revenue growth on average the past five years and performing extremely well amid a modestly improving macroeconomic backdrop. Lease-adjusted debt is around 2 times EBITDAR. Free cash flow has averaged 10% of sales for the past five years, and we expect the firm to use cash generated primarily on share repurchases and dividends, as near-term debt maturities are modest. Accordingly, our five-year Cash Flow Cushion is healthy at almost 2 times our base-case expense and obligation forecast. Ralph Lauren spent more than $800 million on acquisitions over the past five years, a trend that we expect to continue, given management's ongoing strategy of acquiring licensees. Still, few signs suggest that any potential acquisitions will saddle the firm with significant leverage, so we project similar debt levels going forward.
BP to Issue 5-Year and 10-Year Debt; Initial Price Talk Looks Cheap (Sept. 23)
BP (BP) (rating: A, narrow moat) plans to issue 5-year fixed- and floating-rate notes and 10-year notes in benchmark size. Initial price talk is a spread in the area of +90 basis points for the 5-year and +140 for the 10-year. We peg fair value for the new notes at +70 basis points for the 5-year and +125 for the 10-year.
Within our coverage universe of supermajor integrated companies, BP is unique because of the liabilities remaining from the Gulf of Mexico oil spill, but Total (TOT) (rating: A-, narrow moat) and Statoil (STO) (rating: A-, narrow moat) are comparable in terms of issuer credit rating. Total's 2.125% notes due 2018 recently traded at a spread of 59 basis points above the nearest Treasury, while its 3.70% notes due 2024 traded at a spread of +97. We view Total's 5-year notes as 10 basis points rich to fair value, while its 10-year is fairly priced. We currently rate Total market weight. Statoil's 1.20% notes due 2018 recently traded at a spread of 53 basis points above the nearest Treasury, while its 2.45% notes due 2023 traded at a spread of +86. We view both Statoil issues as trading rich to fair value and rate Statoil underweight because the company has issued debt to fill the funding gap between its operating cash flow and its dividend and capital spending program. Also for comparison, BP's outstanding 1.375% notes due 2018 traded at 68 basis points above the nearest Treasury and its 2.75% notes due 2023 traded at +110.
We currently rate BP underweight due to the uncertainty regarding its Gulf oil spill liabilities. We believe these liabilities will have more impact on its longer-date debt. As a result, we would be willing to purchase the new 5-year notes about 10 basis points wide of the comparable Total notes, or at +70. We would require a bit more premium on the 10-year notes, placing fair value at +125.
Concerns about Macondo-related costs have increased as BP has recently disclosed further revelations about the cost overruns that are occurring in it its business/economic loss settlement. We recently published "BP's Still in Great Shape to Handle Macondo Costs," in which we concluded that BP's financial health was unlikely to be impaired even if remaining aftertax cash outflows are steep (that is, $35 billion). Rising settlement costs are clearly a negative development, but they do not change the fact that $50 billion of divestments have left BP's balance sheet in excellent shape. There are two reasons we are confident that Macondo liabilities won't impair BP's balance sheet a second time: 1) Future settlements will have multiyear payment terms, spreading cash outflows over many years, and 2) BP can appeal any adverse legal rulings, which provides it with optionality to delay many of the remaining cash outflows potentially for many years into the future. So long as oil prices remain around $90-$100 per barrel, BP will be able to weather significant financial stress, such as the $26 billion of Macondo cash outflows that we project.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.