Our sector-by-sector take on the corporate credit markets, plus top bond picks.
Credit Sector Roundup
In our last quarterly update, we predicted some banks would begin to return capital to shareholders in the new year, and only a few minutes after the Federal Reserve announced the completion of its Comprehensive Capital Analysis and Review (CCAR), a few of the strongest banks we cover--including J.P. Morgan Chase (JPM, rating: A+), Wells Fargo (WFC, rating: A+), US Bancorp (USB, rating: A+), and State Street (STT, rating: A-)--raised their dividend payouts and announced share repurchases.
While we expect continued earnings improvement at these banks as the economy improves, we think even more capital will be paid out to shareholders as payout ratios and absolute levels of net income increase, limiting the benefits to bondholders. The same holds true for some relatively weaker credits, like KeyCorp (KEY, rating: BBB) and SunTrust (STI, rating: BBB), both of which are paying back TARP preferred stock with newly raised common equity in the wake of the CCAR. KeyCorp also raised its dividend, though it is only paying out approximately 15% of our projected earnings for the year, leaving plenty of room to build capital as the bank works through a large portfolio of problem loans.
While we don't see blinding bargains in the bonds of these banks, a few issues stand out. As of this writing, Wells Fargo's five-year bonds are trading 142 basis points above comparable government issues, and roughly 50 basis points over the average A+ rated bond in our coverage universe--an attractive price for this high-quality name. Additionally, SunTrust's 10-year bonds are trading 200 basis points over similar government bonds and 40 basis points over the average BBB rated issuer we cover. In the unlikely event SunTrust's credit quality were to take another serious turn for the worse, we think the bank's operations are appealing enough to attract quality bidders at the right stock price, providing further support for the company's bonds.
The global economic recovery has been very kind to those portions of the basic materials sector with direct exposure to emerging-markets economic growth. No corner of the basic materials sector has benefited more than mining, where surging commodity prices have dramatically improved credit metrics. As we've previously discussed, spreads have tightened dramatically over the past several quarters, making it increasingly difficult to find value.
In contrast to high-flying mining, steel has been a clear laggard throughout the upturn. Indeed, for most U.S. steel companies, profitability and financial health remain weak compared with pre-crisis levels. In the second quarter, we expect to see signs of improvement driven by stronger steel prices and improved utilization rates, which could lead to some spread tightening in steel industry bonds. Heading into the back half of the year, however, there's risk of slippage, as some of the order book improvement we expect for the second quarter seems to be a function of customer restocking activity and pre-buying behavior.
Despite continued uncertainty, we see good value among steel bonds, at least in contrast to mining bonds. Here, our favorite pick remains Steel Dynamics (STLD, rating: BB), one of the few domestic steelmakers that remained profitable each quarter in 2010. In the investment-grade space, we think ArcelorMittal (MT, rating: BBB-), Gerdau (GGB, rating: BBB-), and Posco (PKX, rating: BBB+) offer decent value.
From where we stand, the consumer cyclical names on our coverage list have shaken off the dust of the credit crisis. While shareholder-friendly activities began to emerge well over a year ago, the late-cycle recovery firms are now jumping on the bandwagon. Because office products distributors are tied to unemployment, they tend to lag an economic recovery. As such, it was no surprise that Staples (SPLS, BBB+) shied away from share repurchases and dividend hikes in 2010 as it waited out the end of the credit crisis. But the firm's recent dividend increase signals to us that it is comfortable with its trajectory in the slowly improving economy. We believe we will continue to see management teams favoring shareholders over bondholders throughout the year.