Credit Spreads Grinding Tighter, Still Have Further to Go
So long as the Fed's asset-purchase program is running full speed ahead, it will provide a ceiling on how much long-term rates can rise and will help push credit spreads tighter over time.
Corporate credit spreads continued their slow grind tighter as the average spread in the Morningstar Corporate Bond Index tightened 1 basis point to +134. Interest rates increased modestly as the yield on the 10-year Treasury bond rose 4 basis points to 2.75% and the S&P 500 rose 0.4%, reaching a new high of 1,804.
Economic data released last week was generally positive. Considering that economic data over the prior few weeks has been dour, director of economic analysis Robert Johnson said this week's data made him feel better about the overall economic outlook. Specifically, Johnson cited stronger retail sales reports and a rebound in Markit's Manufacturing Purchasing Managers' Index.
We expect credit spreads will continue to grind tighter and by the end of the year should reach +129, which was the tightest level that spreads reached earlier this year in mid-May. Based on Federal Reserve vice chair Janet Yellen's testimony and her responses to questioning at her confirmation hearing in the Senate, we don't expect the Fed to begin tapering its asset-purchase program anytime in the near future. With the Fed continuing to purchase mortgage-backed securities and long-term Treasury bonds, investors have increasingly fewer fixed-income assets from which to choose. This decrease in supply is becoming even more pronounced as the U.S. government's deficit is shrinking and requiring less new debt issuance. This has positively affected the demand for corporate bonds as the supply of available fixed-income securities constricts and the new Fed-provided liquidity looks for a home. So long as the Fed's asset-purchase program is running full speed ahead, it will provide a ceiling on how much long-term rates can rise and will help push credit spreads tighter over time. As such, we expect that credit spreads will continue to grind tighter.
New Issue Market Mostly Fairly Valued, but We Recommend Avoiding Mylan's Bonds
The new issue market was busy as issuers looked to price bond deals before the Thanksgiving holiday. For the most part, we thought most of the deals were priced at levels that fully reflected the underlying credit risk, with only a few transactions that we thought were cheap. O deal that stood apart from the rest was Mylan's (MYL) (rating: BB+, narrow moat) $2 billion transaction, which was equally split across 3-, 5-, 10-, and 30-year maturities. Those issues were priced at +80, +125, +155, and +165, respectively. As opposed to the Baa3/BBB- ratings assigned to Mylan by the rating agencies, we view Mylan's credit risk as BB+, which is below investment grade. Julie Stralow, our health-care senior credit analyst, believes that fair value for the bonds should be significantly wider, with fair value closer to +175, +225, +250, and +270, respectively.
While we view Mylan's Business Risk, Cash Flow Cushion, and Solvency Score as near average to slightly below average, we project that leverage will remain well above the firm's 3 times goal for the foreseeable future. In the pharmaceutical industry, we view 3 times leverage as one of the financial metrics that roughly delineates investment grade versus non-investment grade. In addition, we remain skeptical about the firm attaining its revenue and earnings goals through internal means, given the pending end of the U.S. patent cliff, pricing concerns in Europe, and generic competition risks on EpiPen in 2015. At its investor day in August, management provided guidance of 13% revenue and 16% earnings per share annualized growth through 2018. Given our cautious view of Mylan's internal prospects--we estimate annualized growth in sales and earnings in the midsingle digits during that period--we believe debtholders should expect significant share repurchases and debt-funded acquisitions, if management intends to reach its lofty goals. Both of those activities could pressure Mylan's credit profile. Even if our credit assessment is overly conservative, we still think the notes are too tight compared with the agency's investment-grade ratings. For example, the new 10-year bonds are indicated around +152, or about 70 basis points tight of the BBB- tranche of the Morningstar Industrials Corporate Bond Index.
New Issue Notes
Apache Announces $850 Million Cash Bond Tender; Tender Levels Look Attractive (Nov. 22)
Apache (APA) (rating: A-, narrow moat) announced that it is tendering for up to $850 million aggregate principal amount of five series of its outstanding notes. The offer includes a tender acceptance priority in the following order; 2.625% notes due 2023, 3.25% notes due 2022, 3.625% notes due 2021, 4.75% notes due 2043, and 4.25% notes due 2044. The notes will be tendered at a spread of +65 basis points, +50 basis points, +15 basis points, +100 basis points, and +100 basis points, respectively. The reference Treasury for the 2023, 2022, and 2021 notes is the 2.75% Treasury due Nov. 15, 2023, and the reference Treasury for the 2043 and 2044 notes is the 3.625% Treasury due Aug.15, 2043. The tender offer is set to expire Dec. 19, 2013, while the early tender offer expires Dec. 5. The early tender offer includes an additional payment of $30 per $1,000 principal amount of bonds tendered. The tender spreads are about 20 basis points inside our fair value estimate, which is 95 basis points over the nearest Treasury for Apache's 2.625% notes due 2023. We recommend that investors tender their bonds. Even though Apache is reducing total debt more than anticipated, we are not changing our fair value estimate nor our market weight recommendation on the bonds.
In May, Apache increased its guidance on asset sales to $4 billion from $2 billion and announced that the proceeds would be split equally between debt reduction and share buybacks. The company has outstripped its guidance with more than $7 billion of sales year to date, but did not explicitly state that proceeds over the $4 billion amount will also be used to reduce debt and buyback shares equally. As of Sept. 30, Apache held $1.25 billion of cash and had reduced total debt by $1.8 billion, to $10.9 billion from $12.8 billion at the end of the second quarter. Debt reduction was achieved through the retirement of $400 million of bonds due in September and by paying down the entire outstanding commercial paper balance of $1.43 billion. In addition, the sale of a 33% interest in Apache's Egyptian assets, which was announced in August, closed in November, providing Apache with nearly $3 billion of cash.
Price Talk on KeyCorp's New 3-Year Notes Is Fair (Nov. 21)
KeyCorp (KEY) (rating: BBB+, narrow moat) is in the market with benchmark-size 3-year senior bank-level notes. Price talk on the notes is in the range of the mid- to high 60s basis points over Treasuries. We consider 65 basis points over Treasuries fair value. This week has seen two of Key's peers issue 3-year notes at the bank level: Fifth Third Bancorp (FITB) (rating: A-, narrow moat) issued $2 billion at +60 basis points to Treasuries on Nov. 18 and BB&T (BBT) (rating: A-, narrow moat) issued $500 million at +52 basis points to Treasuries on Nov. 19. The Fifth Third issue is now indicated at +58, which we view as fair value, while the BB&T issue is indicated at +50, which we consider expensive. Another regional banking peer, PNC Financial Services Group (PNC) (rating: A-, narrow moat), has 3-year bank notes indicated at +53 basis points to the nearest Treasury, which we view as expensive.
Key's performance has been solid recently, with third-quarter earnings up 8.5% from the year-earlier period. Noninterest income grew 7% while interest income was roughly unchanged from the year-earlier period at $584 million. Net interest margins declined, falling 12 basis points to a still-respectable 3.11% as earning asset yields fell faster than cost of funds.
Credit quality again improved as charge-offs fell to just 0.28% of average total loans. The nonperforming loan ratio also improved, falling to 1.01% of period-end loans from 1.23% in the previous quarter. The allowance to nonperforming loan ratio improved to 160% from 134%. The reported tangible common equity ratio remained healthy at slightly under 10%, slightly ahead of its peers.
AT&T Remains Our Favorite Investment-Grade Telecom Credit; New 5-Year Notes Attractive (Nov. 20)
AT&T (T) (rating: A-, narrow moat) is in the market looking to issue 5-year fixed- and floating-rate notes. We continue to view AT&T as the most attractive of the big three U.S. investment-grade telecom firms: AT&T, Verizon Communications (VZ) (rating: BBB, narrow moat), and Comcast (CMCSA) (rating: A-, wide moat). AT&T's existing 1.4% notes due in 2017 are currently indicated at 76 basis points over the nearest Treasury, while Verizon's 1.1% notes due in 2017 are indicated at 84 basis points and Comcast's 5.7% notes due in 2018 are indicated at 69 basis points, with a high dollar price. Given our view that AT&T's credit quality is on par with Comcast and stronger than Verizon's (once the Verizon Wireless deal is complete), we would favor the AT&T bond. With initial price talk on AT&T's new 5-year fixed rate notes at 115 basis points, the issuance appears very attractive.
AT&T bonds have widened sharply over the past couple months in sympathy with Verizon, reflecting the belief that AT&T, having seen the success of Verizon's record $49 billion debt sale, will now do something, either domestically or internationally, to take advantage of the wide-open credit markets. We don't think this view is accurate. On the domestic front, AT&T has said that it doesn't believe regulators are willing to allow a market to consolidate from four to three players, meaning that it would face a tough road in acquiring a satellite television firm. In Europe, AT&T continues to maintain that its interest is primarily based on valuations. We believe the fact that AT&T hasn't moved on a transaction in Europe, more than a year after initially indicating its interest, demonstrates that management is taking a disciplined approach to any investment on the Continent. More broadly, AT&T management remains committed to the 1.8 times leverage target it put in place last year. During AT&T's third-quarter earnings call, CFO John Stephens used the word "flexibility" several times in reference to the balance sheet and said the firm will strive to maintain an A credit rating. We believe the firm values its ability to ramp up investment periodically to maintain its network leadership and ward off competitors, such as the Project VIP enhancements initiated last year.
While we expect Verizon will reduce leverage over the next several years, AT&T already has metrics worthy of an A- rating. We estimate Verizon will end 2013 with pro forma net debt of about $110 billion, putting net leverage at about 2.7 times estimated 2013 EBITDA. By contrast, we expect AT&T will maintain net leverage at about 1.8 times EBITDA through 2014 as it continues to repurchase shares. We then expect leverage will begin to tick down toward management's previous long-term target of 1.5 times, hitting that level in 2016.
Wesco Offering New Senior Notes to Replace Term Loans (Nov. 20)
Wesco International (WCC) (rating: BB+, narrow moat) announced an offering of $400 million 144A senior notes due 2021 through its operating subsidiary Wesco Distribution. The parent will guarantee the obligations. The company intends to use the proceeds to repay a portion of its $820 million senior secured term loan due 2019, which the firm entered into to fund the 2012 EECOL acquisition. We view fair value on the new notes in the 5.625% area, which considers roughly 2 turns of secured leverage ahead of the bonds in the capital structure. Peer distributor Anixter International's (rating: BB+, narrow moat) 5.625% notes of 2019 are indicated at a yield of 4.70%, providing a spread of 317 basis points over the nearest Treasury. We view this as modestly cheap given our rating. Despite similar issuer-level ratings, we believe WCC investors should demand a premium due to Wesco's higher leverage compared Anixter's (3.6 times TTM versus 2.4 times TTM) and subordinated position in the capital structure. Given that and a longer duration, we peg fair value closer to 335 over Treasuries, resulting in a yield of 5.625%. This compares with the Merrill Lynch BB Index at 4.58% and an option-adjusted spread of +310.
Wesco has delivered on its commitment to reduce leverage, repaying about $150 million in debt in fiscal 2013. Pro forma debt/EBITDA was 3.6 times as of September 2013, down from almost 4 times as of December 2012, putting the firm close to its targeted range of 2-3.5 times. Wesco commented that its construction and CIG end markets (43% of revenue) turned positive during the quarter--the first time in 12 months--while October sales trends were at the high end of its expectations.
We expect that Wesco will conserve cash for future tuck-in acquisitions, given the fragmented nature of the industrial distribution industry, so we don't expect substantially more deleveraging. Still, we project free cash flow will average around $300 million per year over the next five years, which should enable the firm to meet its debt commitments.
Mylan's New Issue to Fund Agila Acquisition and Share Repurchases; Avoid Bonds (Nov. 19)
Mylan is in the market issuing new 3-, 5-, 10-, and 30-year bonds. We had previously highlighted the likelihood of new issuance, and proceeds will be used to fund a portion of the Agila acquisition ($1.6 billion value), refinance existing credit facilities ($1.0 billion outstanding), and repurchase shares ($500 million program). Initial price talk looks too rich in our opinion around 100, 150, 175, and 195 basis points, respectively, over Treasuries for the new bonds. Given where Mylan's existing notes are trading, we believe these notes will price close to initial price talk. However, we believe fair value for Mylan's new notes should be closer to 175, 225, 250, and 270 basis points, respectively, over Treasuries, which would better reflect Mylan's borderline-status on the investment-grade/non-investment-grade divide. As such, Mylan remains on our Bonds to Avoid list.
We believe Mylan's debt/adjusted EBITDA will stay above its goal of 3.0 times for the foreseeable future. That leverage goal remains on the border of investment- and non-investment-grade territory in the pharmaceutical industry, in our opinion, so with Mylan unlikely to cut its debt leverage beneath that goal for an extended period, our rating remains on the opposite side of the divide as the agencies, which are at BBB-/Baa3. Even considering those ratings, we believe investors should require more compensation from Mylan's bonds. For example, its 2023s are indicated around 170 basis points over the nearest Treasury, or about 55 basis points tight of the BBB- Morningstar Industrials Index. We believe Mylan's bonds should trade closer to injectable pharmaceuticals and device manufacturer Hospira (rating: BBB-, narrow moat), which the agencies are split on at BBB-/Ba1. Like Mylan, we also see Hospira on the divide of investment-grade and non-investment-grade territory, and Hospira's 2017s, 2023s, and 2040s are indicated around 200, 255, and 285 basis points, respectively, over the nearest Treasury.
At its investor day in August, management provided an outlook of 13% revenue and 16% earnings per share annualized growth through 2018. We remain skeptical about the firm attaining those goals through internal means because of the pending end of the U.S. patent cliff, pricing concerns in Europe, and generic competition risks on EpiPen in 2015. Given our cautious view of Mylan's internal prospects--we estimate annualized growth in sales and earnings in the midsingle digits during that period--we believe debtholders should expect significant share repurchases and debt-funded acquisitions, if management intends to reach its lofty goals. Both of those activities could pressure Mylan's credit profile and bonds, and we believe bond investors should focus their attention elsewhere.
BB&T New Notes Look Fair (Nov. 19)
BB&T is in the market today with a $500 million 3-year senior bank-level offering expected to be split between 3-year fixed-rate and 3-year floating-rate notes, both of which are issued at the senior bank level. Initial price talk is a spread in the mid-50s basis points over Treasuries for the fixed-rate notes, which we view as fair. On Sept. 4, BB&T issued $750 million 3-year bank-level notes at +60 basis points to Treasuries. That issue is now indicated at +53 basis points to the nearest Treasury. On Nov. 15, peer Fifth Third Bank issued $2 billion 3-year bank-level notes at a spread of +60, which we view as fair value. PNC's most recent 3-year year bank-level notes are indicated at +43 basis points to the nearest Treasury, which we consider expensive.
Although third-quarter profits at BB&T were hurt by resolving an unusual tax item, pretax income increased 12.8% compared with the year-earlier period. Net interest income dropped a modest 4% while net interest margin fell 26 basis points to a still impressive 3.68%. The company managed a 6% decrease in noninterest income despite a 45% drop in mortgage banking. It has also been successful managing expenses, as noninterest expenses were down 4% compared with the year-earlier period. Provisions for credit losses were down 62.2% during the period, which aided results.
We were pleased to see credit quality continue to improve. Net charge-offs fell to 0.48% of average loans and leases from 0.74% in June and 1.05% in September 2012. Nonperforming assets dropped to 0.72% of total assets from 0.80% and 1.10% in the 2013 second quarter and the 2012 third quarter, respectively. The loan-loss allowance fell to 1.59% of loans and leases held for investment, down 5 basis points sequentially and 21 basis points year on year. BB&T's Tier 1 ratio continued to improve, moving to a relatively solid 11.3% from 11.1% in the June quarter and 10.0% a year earlier. Similarly, tangible common equity/tangible assets has improved 10 basis points to 6.9% compared with the year-earlier period.
T-Mobile US' 8- and 10-Year Notes Attractive, but We'd Look at Sprint First (Nov. 18)
T-Mobile US (TMUS) (rating: BB-, no moat) is looking to raise $2 billion through the issuance of senior notes due in 2022 and 2024. The debt offering follows closely on the heels of last week's equity issuance, which netted the firm $1.8 billion. T-Mobile's plan for the incremental $3.8 billion of capital isn't totally clear at this point, but management stated on its third-quarter earnings call that fund-raising would be for the purpose of opportunistic acquisitions of additional wireless spectrum, particularly low-band spectrum. The firm could use the capital to participate in the Federal Communications Commission's nationwide H-block auction, which is scheduled to begin in January. In a surprise move, Sprint S (rating: BB-, no moat) recently indicated that it is not planning to bid on the H-block, which could clear the way for T-Mobile to pick up the spectrum at relatively lower cost. However, DISH Network (DISH) (rating: BB+, narrow moat) has committed to the FCC to bid at least $1.6 billion for the H-block as a condition of additional rule changes it is seeking pertaining to its existing spectrum holdings. T-Mobile could also be interested in Verizon Wireless' unused spectrum holdings in the 700 MHz A-block, which cover about half the country and cost the firm about $2.4 billion in 2008.
The T-Mobile USA bonds that Deutsche Telekom (DTEGY) (rating: BBB-, no moat) recently sold to the public provide the best indication of current levels on T-Mobile US debt. T-Mobile USA 6.731% NC-4 notes due 2022 have traded recently with a yield to worst of 6.0% to a 2020 par call date, or 410 basis points over the nearest Treasury. Assuming 25% volatility in interest rates, these bonds trade with an option-adjusted spread of about +394 basis points. T-Mobile USA 6.836% NC-5 notes due 2023 have traded recently with a yield to worst of 6.2% to a 2021 par call date, or 421 basis points over the nearest Treasury. Similarly, the bonds trade with an option-adjusted spread of about +394 basis points. The new T-Mobile US bonds will rank equally with the T-Mobile USA bonds above and contain similar call provisions. Based on the option-adjusted spread on the existing notes, we would expect the new 2022 and 2024 notes to price with yields of about 6.3% and 6.6%, respectively. We view these levels as attractive. For comparison, the Merrill Lynch BB and B indexes currently carry option-adjusted spreads of +315 basis points and +419 basis points, respectively. We would peg fair value at about +350 basis points based on these index levels, putting the fair value yield on the 2022 and 2024 notes at about 5.9% and 6.2%, respectively.
T-Mobile's need to raise additional capital to pursue spectrum assets reflects our negative view on its current competitive and financial position. Larger rivals Verizon and AT&T don't face the same financial constraints in pursuing network investment, including the acquisition of additional spectrum. T-Mobile carries a heavy debt load, with net leverage at 3.0 times EBITDA at the end of the third quarter, excluding its tower lease obligation. Adjusting EBITDA to reflect favorable accounting treatment of the firm's phone leasing program relative to the accounting for the traditional phone subsidy model, net leverage would be about 4.0 times. T-Mobile is also burning cash as it works to upgrade its network to the latest technology.
While T-Mobile US' new bonds may price attractively relative to the index, Sprint's bonds present better value yet. Sprint's 6.0% notes due 2022 and 7.875% notes due 2023 have traded recently at yields of 6.3% and 6.9%, with only make-whole call provisions.
TRW's New 10-year Senior Notes May Price Slightly Cheap (Nov. 18)
TRW Automotive Holdings (rating: BBB-, no moat) is in the market with $400 million of 10-year 144A senior unsecured notes. Initial price talk is in the low 200s over Treasuries. We view fair value at about +200. The firm's 2021 maturity senior notes are indicated at 228 basis points over the nearest Treasury. In our Oct. 29 earnings note, we highlighted the potential for the company to tap the bond market to refinance upcoming maturities, given the recently increased share repurchase mandate. Proceeds from the new issue are specifically targeted at retiring the notes maturing in March 2014, which totaled $462 million at the end of September. In addition, the firm has $205 million of 8.875% notes callable next month. Assuming these get called, the firm would effectively be reducing its total debt from $1.9 billion to $1.6 billion. We do not expect any further debt issuance at the company for the foreseeable future, as cash and free cash flow (approximately $500 million-$600 million annually) should be sufficient to meet the $1.47 billion of authorized share repurchases expected to be executed over the next three years. Pro forma gross leverage is about 1 times, with pro forma cash at about $700 million. With most of the TRW news on the table and debt levels potentially lower than we envisioned, we now see the firm as more strongly positioned in the rating category, supporting a spread level inside the Morningstar BBB- index of +225. Other comps include Ford Motor Credit's (rating: BBB-, no moat) recent 10-year bond recently trading in the 150 area over the nearest Treasury, which we view as somewhat rich despite a potential rating upgrade as it moves towards its middecade financial targets. We continue to prefer Delphi Automotive (DLPH) (rating: BBB, narrow moat), whose 2023 maturity notes are indicated at a yield of 4.29%, providing an option-adjusted spread of +200.
Sabine Pass Liquefaction to Issue $1 Billion of Senior Secured Debt; Fair Value 6.25%-6.50% (Nov. 18)
Cheniere Energy Partners (CQP) (rating: B+, wide moat) announced it is issuing $1 billion of senior secured notes due 2022 out of its wholly owned subsidiary, Sabine Pass Liquefaction, which we do not separately rate. Although the company's natural gas liquefaction facilities will not begin to generate revenue until late 2016 at the earliest, we view Sabine Pass Liquefaction as a wide-moat business based on the fact that Cheniere has signed 20-year contracts for 90% of SPL's capacity. As a result of our wide moat view and the fact that SPL's assets guarantee the debt, we have a similar opinion as the rating agencies that SPL's credit rating is higher than that of Cheniere Energy. SPL intends to use the proceeds from the offering to pay capital costs in connection with the construction of the first four liquefaction trains at its facility in Cameron Parish, La. The proceeds will be used to reduce planned borrowing under SPL's four credit facilities, which total $5.9 billion. When we initiated our credit rating on Cheniere, we anticipated that SPL would draw against its committed credit facilities to help fund construction. As this issuance is pari passu with SPL's four credit facilities and its outstanding senior secured notes due 2021 and 2023, it essentially replaces the planned draw on the credit facilities and extends the maturity date by two years.
Despite the fact that SPL has $3 billion of senior secured notes outstanding, the notes are highly illiquid; the last trade in either issue was in July. SPL is a very unique asset and will be the first liquefied natural gas facility to begin operations in the United States, which severely restricts the number of comparable companies. Sabine Pass Liquefaction's 5.265% notes due 2023 are indicated at a yield to worst of about 6.25%. For comparison, the Merrill Lynch BB index is indicated at a yield to worst of 4.63%. Although Cheniere and SPL should deleverage rapidly as the four facilities enter service between late 2016 and 2018, SPL faces construction risk and counterparty risk. Thus we believe that SPL's debt should trade wide of the Merrill Lynch index and peg fair value at 6.25%-6.50%.
Our B+ issuer credit rating for Cheniere Energy reflects the significant funding already secured to finance construction of the Sabine Pass Liquefaction facility offset by the significant amount of debt amassed to fund the construction, the risk of construction delays, and the counterparty risk of Cheniere's customers. Cheniere has already secured the nearly $9 billion of debt necessary to fund the construction of four natural gas liquefaction trains, each with a nominal production capacity of approximately 4.5 million metric tons per year. Bechtel, the construction contractor, has built one third of the world's LNG facilities, which limits construction risk. In addition, Bechtel's contract has financial incentives in place to meet target start dates. Cheniere's 20-year take-or-pay contracts provide a highly visible stream of fee-based cash flows that eliminates commodity price risks for the firm, should liquefied natural gas or natural gas prices shift dramatically. Customers (like BG Group and Centrica) instead bear the risk of finding LNG trading profits over this period. Cheniere's take-or-pay capacity contracts are essentially tolling agreements, in which customers pay the firm a margin on top of market gas prices for services of transportation, liquefaction, and storage. With about 90% of capacity contracted and pricing based on a Henry Hub gas-linked formula, Cheniere does not face serious risk from competition or commodity prices until it resets contracts in 20 years. Cheniere's counterparties all have investment-grade credit ratings, with roughly 65% of counterparty volumes rated A or higher.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.