First Pullback in Corporate Credit Spreads in 10 Weeks
We continue to view credit spreads as fairly valued, albeit at the tight end of the range that we see as appropriate, given our economic outlook.
The average credit spread in the Morningstar Corporate Bond Index widened 5 basis points to +121 last week. This is the first time that our index has widened on a weekly basis since Nov. 8, some 10 weeks ago. While the basic materials sector weakened a little more than other sectors, credit spreads generally widened out across the board. We continue to view credit spreads as fairly valued, albeit at the tight end of the range that we see as appropriate, given our economic outlook.
Other risk assets fell as well, as the S&P 500 fell 2.6% last week. The S&P attempted to hold its support at 1,800, but once that level was breeched, it was all downhill from there for the rest of the trading session Friday. The equity market's fear gauge, the VIX, soared 32% to 18.1, the highest since last October. As the markets sold off, the 10-year Treasury rose in a flight to safety, sending its yield down 9 basis points to 2.74%, its lowest since last November. Except for a few high-profile companies whose shares rose after reporting earnings, investors have been generally disenchanted with results. Top-line growth has remained sluggish, guidance has been lackluster at best, and a significant part of earnings growth has been low quality (tax changes, addbacks, or share buybacks) as opposed to sustainable improvements in the underlying business. Reporting season kicks up in earnest this week, as about 25% of the companies in the S&P 500 are scheduled to release earnings.
Compounding the disappointment from corporate results, Markit reported that its Flash US Manufacturing PMI Index decreased to 53.7 in January from 55.0 in December. While a reading above 50 still indicates continued economic expansion, the index was below economists' consensus expectations. In addition to a general re-evaluation of the prospects for earnings growth in the United States in relation to expectations and current price/earnings multiples, several factors emanating from overseas have raised the general unease in the markets. For example, China reported 2013 GDP growth of 7.7%, matching 2012's growth rate, but the recent flash HSBC China Manufacturing PMI Index fell to 49.6. This is the first time since last July that measure has been below 50, which is the cutoff between expansion and contraction.
In addition, rumors spread that a Chinese wealth management product may default at the end of this month. WMPs have grown exponentially in China over the past few years, and there are reportedly a couple of trillion dollars' worth of WMPs outstanding. These products are a way for banks to unload loans off their balance sheets into trusts. These trusts then issue short-term debt to retail accounts searching for higher yields than deposits. The loans in these trusts were often made for real estate development, infrastructure projects, and local government financing vehicles with several years to maturity. There aren't any official figures regarding WMPs, but a substantial portion requires the short-term debt to be either rolled over or purchased by new investors. If the debt is not rolled over or new investors are not found, the situation would be akin to the problem seen in the U.S. during the credit crisis when the market for auction-rate securities locked up. The fear in China is that if one or more of these WMPs defaults, it could cause a domino effect as investors lose faith in the product and elect not to roll over their investments.
More Tapering to Come, Even Though Economic Indicators Are Waning
After this week's Federal Open Market Committee meeting, Robert Johnson, Morningstar's director of economic analysis, expects the Fed will cut another $10 billion off its asset-purchase program; but even though he expects fourth-quarter GDP growth, which will be released Thursday, could be over 3%, he is concerned that the economy has been slowing. In addition to the weaker PMI data, Robert highlighted several economic indicators that have him worried, including softer home prices, weaker existing home sales, and an above-average number of disappointments from fourth-quarter earnings reports. Robert is concerned that the reduction in expanded unemployment benefits, higher health insurance premiums, and continued pressure from the reduction in food stamp benefits will hurt the first quarter.
Anheuser-Busch InBev Issues $5.25 Billion to Fund Acquisition; We Prefer SABMiller
Anheuser-Busch Inbev (BUD) (rating: A-, wide moat) issued $5.25 billion of notes across several tranches to fund its acquisition of Oriental Brewery. While debt leverage will increase modestly in the short term, management expects to reach its targeted net debt/EBITDA leverage ratio of 2 times by the end of 2014. The modest increase in debt leverage was not enough for us to consider revising our A- issuer credit rating. To reach its debt leverage goal, we expect the firm will have to significantly reduce its share-buyback program and use free cash flow to reduce debt. While we believe Anheuser-Busch InBev is a well-managed company with a strong credit profile, we believe that for the credit risk, SABMiller (rating: A, wide moat), bonds which we rate one notch higher, are more attractive. SAB's bonds are trading wider than BUD's, as the rating agencies rate SAB upper BBB, but we believe that over time, SAB's bonds will trade in line with BUD's as the credit risk and leverage profile of the two firms are similar. Within the SABMiller capital structure, we find the 5.875% senior notes due 2035 to be the cheapest and have recommended that bond on our Best Ideas list.
Third Point Targets Dow Chemical to Split Up; We're Still Underweight
Activist investor Dan Loeb revealed that his hedge fund, Third Point, has taken a $1.3 billion stake in Dow Chemical (DOW) (rating: BBB, no moat), with hopes that the company will split up some of its varied business lines. Specifically, Third Point wants Dow to explore spinning off its petrochemical business--including both upstream and downstream petrochemical products--into a new entity. Although plans for a smaller-scale divestiture had been revealed by management in early December, the news of a larger transaction caused spreads on the company's 3% senior notes due 2020 to widen 10 basis points to 125 basis points over the Treasury curve. Since putting our underweight recommendation on Dow in November, the firm's bonds have lagged the Morningstar Industrial Index by about 5 basis points. We expect the bonds will widen further as uncertainty surrounding a possible breakup lingers.
Deutsche Bank Reports Weak 4Q; We Continue to Recommend an Underweight
Last week, Deutsche Bank (DB) (rating: A, narrow moat) released fourth-quarter results early, reporting dismal results for the period. For the fourth quarter, Deutsche lost EUR 965 million and reported earnings for the year of just EUR 1.1 billion. Although these results were an improvement from the EUR 2.5 billion loss during the same quarter a year ago and earnings of just EUR 315 million for 2012, they represent the second consecutive year of weak earnings. Results in the most recent quarter included a litigation expense of EUR 528 million, a 16.4% decrease in group net revenue (led by a 27% decrease in DB's corporate banking and securities division due to weak fixed-income trading), a 43% increase in restructuring costs, and a striking 59% increase in provisions for credit losses, all relative to the year-earlier period. For the year, the bank reported a lackluster return on average equity of 1.9% and a weak efficiency ratio of 87%.
Deutsche Bank's Basel III Tier 1 regulatory capital--which compares favorably with most global peers--was unchanged from the sequential quarter at 9.7% due to a decrease in risk-weighted assets; a broader concern to us regarding DB is its high asset leverage. By its own calculation, third-quarter leverage was 19 times compared with an average of 15 times for large U.S. banks. While Deutsche Bank's results are not an immediate cause for concern, they do cause us to question the firm's credit risk relative basis as compared with their global peers. As such, we continue to recommend investors underweight Deutsche Bank's bonds.
New Issue Notes
Amphenol's New 5-Year Notes Likely to Price Very Attractively (Jan. 23)
Amphenol (APH) (rating: A, narrow moat) plans to issue $500 million of 5-year notes, with initial price talk in the range of 115 basis points over Treasuries. We have an overweight rating on the firm's existing bonds and expect the new issue will price attractively as well. Our view on Amphenol results primarily from our narrow moat rating. Our moat rating is based on Amphenol's strong position in the market for circular connectors, which are used in extremely stressful environmental conditions like aerospace equipment, military vehicles, and power generation. This area of connectivity is characterized by comparatively sophisticated design and very stringent quality standards. As a result, Amphenol enjoys high customer switching costs in these higher-end markets, as the very high cost of a component failure makes customers risk-averse to switching suppliers. This competitive position stands in contrast to TE Connectivity (TEL) (rating: BBB+, no moat), which derives a large portion of its sales to industries where switching costs among suppliers are low--computers and cell phones, for example.
Amphenol and TE Connectivity have historically carried similar levels of leverage, though a heavy round of acquisition spending during the fourth quarter has pushed leverage higher at Amphenol. Amphenol ended 2013 with net leverage of 0.9 times EBITDA versus 0.6 times at TE. We would note, however, that both firms have carried leverage in the 0.5-1.0 times EBITDA range over the past couple of years. Amphenol's new notes will probably be used to repay revolver borrowings used to finance the fourth-quarter acquisitions. We generally like Amphenol's acquisition strategy. One key takeaway, in our view, is the recent entrance into the sensor-based instrument market (through Advanced Sensors), which should position Amphenol to take advantage of such secular growth trends as automotive infotainment, which have received plenty of attention (and R&D dollars) over the past few years. Looking beyond this opportunity, Amphenol continues to build a robust portfolio offering and is extending its relationship with key customers.
Despite our relatively favorable view, Amphenol bonds trade in line with TE Connectivity's: Amphenol's 4.0% notes due 2022 were recently indicated at 157 basis points over the nearest Treasury versus TE's 3.5% notes due 2022 at +156 basis points. Given the current trading level on the Amphenol 2022 notes, initial price talk of +115 basis points looks about right for the new 5-year notes. However, the A tranche of the Morningstar Industrials Index trading at +77 basis points at roughly 10-years to maturity, on average. As such, we believe the new Amphenol bonds will probably price very attractively.
Textron Offering $600 Million of Notes to Fund Beechcraft Acquisition (Jan. 23)
Textron (TXT) (rating: BBB-, narrow moat) is in the market with a $600 million offering of 7- and 10-year notes. Proceeds will be used to finance its acquisition of Beechcraft for $1.4 billion, which is expected to close in the first half of this year. Textron had previously said it would use $500 million of bank loans and cash to fund the remainder. For comparables in the 7-year space, we point to defense peer L-3 Communications' (rating: BBB-, no moat) 2021 maturity notes currently indicated at a spread to the nearest Treasury of +172 basis points. We see that as fairly valued considering our stable credit view of L-3 and view fair value for Textron's 7-year at about +155 given potential credit improvement. For the 10-year note we would add about +15 basis points to get to +170. This compares with the broad Morningstar Industrials BBB Index at +155.
Beechcraft will add about $1.8 billion in revenue and $150 million in EBITDA, and management has guided to first-year synergies of another $65 million. Excluding these synergies, we estimate pro forma total debt/EBITDA of about 2.4 times as of Dec. 31. We believe the firm can deleverage quickly to below 2 times in 2015 based on solid guidance for sales and free cash flow, which could allow for steady debt repayment. Management guided to manufacturing free cash flow of more than $500 million after pension contributions for 2014, and the firm ended the year with more than $1 billion in cash versus $1.9 billion of debt. Notably, Textron's unfunded pension liability was also reduced sharply at the end of 2013 to $0.2 billion from $1.3 billion the prior year. In addition to the bank loans used to fund the deal, Textron has a series of bonds maturing 2015-21 that could be paid off with cash.
We view the acquisition of Beechcraft as strategically favorable, as it will materially expand Textron's reach into the general aviation market and complement Textron's Cessna unit, which has recently struggled because of poor demand. The deal will also meaningfully expand Textron's global network of service centers and overall service revenue. We expect Textron's diversified mix of aerospace, defense, and industrial businesses to result in solid mid-single-digit top-line growth and stable margins over our forecast horizon, which could lead to steady deleveraging. Also of note, Textron's previously troubled finance unit is now a nearly 100% captive finance subsidiary that is making positive contributions to the bottom line.
PNC's New 3- and 5-Year Notes Are Attractive (Jan. 23)
PNC Bank (PNC) (rating: A-, narrow moat) is in the market with benchmark-size 3-year and 5-year senior bank-level notes. Price talk on the 3-year notes is the mid-50-basis-point range over Treasuries and the high-70-basis-point range over Treasuries for the 5-year. We consider price talk on both issues attractive as we see fair value on the 3-year at 40 basis points to Treasuries and the low 60s over Treasuries for the 5-year note. PNC Bank's current 3-year note, the 1.15% due in 2016, is indicated at +34 basis points to the nearest Treasury. Regional peer BB&T's (BBT) (rating: A-, narrow moat) senior bank-level notes, the 1.45% due in 2016, are indicated at +39 basis points to Treasuries, which we consider fair value. In the 5-year area, Key Bank's (KEY) (rating: BBB+, narrow moat) senior bank notes, the 1.65% due in 2018, are indicated at +59 basis points to the nearest Treasury, which we consider fair value. Higher-rated regional banking peers Wells Fargo (WFC) (rating: A+, narrow moat) and U.S. Bancorp (USB) (rating: A+, narrow moat) both trade considerably tighter. Although we consider bank-level debt to be structurally senior in a Title II orderly liquidation, Wells' 2.15% senior holding company notes due in 2019 are indicated at +53 basis points to the nearest Treasury, while U.S. Bancorp's 1.95% senior holding company notes due in 2018 are indicated at +40. We consider both of these issues to be fair value for the rating. By comparison, PNC's senior bank notes appear attractive at the price talk.
PNC has emerged from the financial crisis as a larger and better-capitalized company with improving asset quality and profitability. Nonperforming loans ended 2013 at 1.58% of total loans, while 2013 net income increased 40% from 2012. In addition to solid performance, PNC doubled its size, expanded its territory and remaining focused on improving profitability through stronger expense controls (noninterest expense decreased 10% in 2013 compared to 2012) and product cross-selling. With the most recent acquisition of RBC Bank USA (Royal Bank of Canada's former U.S. banking operations) in 2012, the bank expanded its geographical reach into the Southeast. In addition, the bank appears well capitalized with Tier 1 common equity of 12.4%, up 80 basis points from 2012, and Basel III Tier 1 equity of 9.4%, up an impressive 190 basis points from 2012. Both of these ratios compare favorably with regional peers.
General Mills' New 10-Year Bonds Look Cheap (Jan. 21)
General Mills (GIS) (rating: A, narrow moat) is reportedly in the market this morning offering new 2-year floating-rate notes and 10-year bonds. Our issuer credit rating for General Mills is one notch higher than Moody's and two notches higher than Standard & Poor's. We assign a narrow economic moat rating to General Mills, the second-largest producer of ready-to-eat cereals in the United States (behind Kellogg), because of its portfolio of market-leading brands and expansive global network. The firm possesses the number-one ready-to-eat cereal franchise, Cheerios, which maintains about 13% share of the market. In addition, its Pillsbury brand dominates the refrigerated baked goods segment, with nearly 70% share.
Whisper price talk is 25-30 basis points over Libor on the 2-year tranche and +100 for the 10-year tranche. General Mills' existing 3.15% senior notes due in 2021 traded last week at 71 basis points over the nearest Treasury. For General Mills, we think the appropriate 7/10s curve should be between 15 and 20 basis points, placing pricing for the new 10-year between +85 and +90, which we view as cheap based on our view of the credit risk and compared with its peers. For example, the single A tranche of the Morningstar Industrial Corporate Bond Index is currently +77, and Mondelez (MDLZ) (rating: BBB, wide moat) just issued new 10-year bonds at +105 last week. We rate Mondelez three notches lower than General Mills and recommended clients pass on Mondelez's new 10-year, as we thought the spread was too thin for the credit risk. Those bonds have widened out since then and are currently trading around +115. We also prefer General Mill's new 10-year issue over Kellogg's (K) (rating: BBB+, narrow moat) 2.75% senior notes due in 2023, which are indicated at +105. We recently downgraded Kellogg one notch as the firm's margins and credit metrics have underperformed our assumptions since we originally rated the issuer. The General Mills notes also appear cheap compared with Kraft Foods' (rating BBB+, narrow moat) 3.50% senior notes due in 2022, which are indicated at +104 and which we rate as a market weight.
In the food sector, we recommend an overweight position on Campbell Soup's (CPB) (rating: A-, wide moat) 2.50% senior notes due in 2022, which trade closer to 135 basis points over the nearest Treasury. For investors looking for strong, defensive issuers for their portfolios in the consumer product category, we also think Clorox (CLX) (rating: A-, narrow moat) is an attractive value for the credit risk and rate the firm's bonds as an overweight. For example, Clorox's 2022 notes are indicated just inside 100 over the nearest Treasury, which is roughly in line with the A- component of Morningstar's Corporate Bond Index. Given the defensive nature, we think Clorox should trade inside the index and rate the firm's notes as an overweight.
Price Talk on JPMorgan's New Issues Is Generally Fair (Jan. 21)
JPMorgan Chase (JPM) (rating: A, narrow moat) is in the market with a benchmark-size multitranche offering of 5-year, 10-year, and 30-year fixed-rate senior notes as well as a 5-year floating-rate note tranche. Initial price talk on the 5-year notes is around +75 basis points to Treasuries, which we view as fair, while initial price talk on both the 10-year and 30-year is +115 basis points to Treasuries. We consider price talk on the 10-year as fair but would expect additional spread compensation when moving from 10 to 30 years. As a result, we would consider price talk on the 30-year note as unattractive.
After a difficult 2013 for JPM, we see the company fundamentally close to peer Citigroup (C) (rating: A-, narrow moat), and as a result, we would expect the bonds to price similarly. Citigroup's 2.5% senior notes due in 2018 are indicated at +73 basis points to the nearest Treasury, its 3.875% notes due in 2023 are indicated at +120 basis points to Treasuries, and its 4.95% notes due in 2043 are indicated at +116 basis points to Treasuries, which we view as fair. Bank of America (BAC) (rating: BBB, narrow moat) serves as the most recent new issue comparison. On Jan. 16, the bank tapped into its 2.60% notes due in 2019 at +87 basis points to Treasuries and issued 10-year notes at +125 and 30-year notes at +120 basis points to Treasuries. We view all these spreads as fair for the rating. Within the group of global banks, we consider the 30-year spreads as fair, but unattractive compared with 10-year spreads.
Although JPMorgan performed admirably through the financial crisis, it is now paying the price for its missteps, recording legal expenses in excess of $11 billion during 2013, more than double 2012. While we don't expect litigation costs to remain at this level, we do expect legal and regulatory costs to be a drag on earnings. Lower earnings have led capital to appear low, with 11.9% Tier 1 capital compared with Citi's 13.6% as of the end of 2013.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.