Wed, 27 Feb 2013
Updates to Morningstar's Bonds to Avoid list include a handful of companies with significant downside risk for bondholders as well as removal of a name with an improved risk/reward profile.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Rick Tauber. He's our director of corporate bond research. We're going to look at Morningstar's Bonds to Avoid list, which we recently updated.
Rick, thanks for joining me today.
Rick Tauber: Good to be here, Jeremy.
Glaser: So let's talk about this list. Is this a list of companies that we think are in imminent default risk, or is it just the risk/reward profile doesn't make sense? How do you think about compiling these names?
Tauber: The genesis of this list is really primarily from investment-grade buyers who wanted to know about which names to stay away from that have particularly downside-skew risk, or really what we think of a sort of gap-down risk and not necessarily default risk per se. But names that have, like you highlighted, sort of a risk/reward skew that kind of goes against you.
Glaser: So what are some of the names that we have recently added to the list and what are some of those risks to those bonds?
Tauber: Sure. [There are a] couple of names in the energy sector that we added most recently, for example, which also highlights a couple of the things that we look for. One is Hess, which we rate BBB and has an activist investor who is trying to gain some seats on the board and potentially carve out some assets, which could be at the detriment of bondholders. That's a risk that is hard to quantify, but we think there is risk of that credit going to junk in the worst-case scenario, which could be another 50 to 100 basis points of spread-widening.
Similarly in that sector is a company called Rowan Companies, a company that traditionally makes and operates jack-up rigs and is now moving into ultra-deep-water drill ships. So it's a new business line that they are moving into, where they need to generate contracts to support the operations. We think there's a lot of competition there and a risk that they don't succeed in that business expansion, which similar to Hess, could result in ratings pushed below investment-grade and up to 100 basis points of spread widening.
Glaser: How about anything in the consumer sector?
Tauber: Yes, we added a couple names recently among the retailers, one of which was Kohl's. Kohl's is another name that we've identified that potentially is having some conversations about leveraging up and potentially even going as far as a leveraged buyout. So we've identified a bond in their capital structure actually that has no change-of-control provisions, and should they go down that path, again we see significant downside for bondholders.
Glaser: That could be a case in which what might be best for the equityholders could be slightly different than what's best for those bondholders?
Tauber: Right, and often these are the situations we're seeing with event risk or shareholder-friendly activities, increased dividends, share repurchases, and what not.
Glaser: On the other side, are there any companies that have dropped off this list recently?
Tauber: Yes, we had ADT actually on the list, which also has an activist shareholder that we felt provided unwarranted risks should they decide to, again, leverage up. However, after various discussions, management's come out with a much more consistent policy that we believe will maintain investment-grade credit quality. So we removed that name from the list because we think a lot of the downside risk has been removed.
Glaser: Rick, thanks so much for your thoughts on this today.
Glaser: For Morningstar, I'm Jeremy Glaser.