Credit Market Outlook: Tight Spreads Will Keep a Lid on Returns

• Lower interest rates and tightening credit spreads have led to strong corporate bond returns.
• Tight credit spreads will constrain returns for the remainder of 2014.
• Interest rates should normalize and rise as the Fed exits its asset purchase program.
• The spread between financial and industrial sectors holds steady.
• Investors view benign risk in the short term, but longer-term risks remain.
• ECB takes up the monetary-easing baton from the Fed.
• Idiosyncratic risk prompts downgrades during the second quarter.

Lower Interest Rates and Tightening Credit Spreads Have Led to Strong Corporate Bond Returns
Year-to-date through June 11, the Morningstar Corporate Bond Index has risen 5.12%, which more than erases the 1.51% loss that the index registered for the year in 2013. Roughly 45% of the return this year has been driven by declining interest rates, as poor weather and weak exports led to an economic contraction in the first quarter.

Since the end of last year, the yield on the benchmark 10-year Treasury bond has declined 39 basis points to 2.64%. Narrowing credit spreads drove approximately 25% of the return as the average spread in the Morningstar Corporate Bond Index tightened 17 basis points to +103, its tightest level since July 2007. Carry generated the remaining 30% of the return as the index yield at the beginning of the year was 3.20%. Among other fixed-income classes thus far in 2014, our U.S. Treasury Index has risen 2.42% year to date, the U.S. Agency Index has increased 1.60%, and our Mortgage Bond Index has gained 3.56%.

Tight Credit Spreads Will Constrain Returns for the Remainder of 2014
As credit spreads have tightened on a nearly continuous trend over the past year, they are becoming richly valued relative to their historical average. The current average credit spread of our index is +103 over Treasuries, which is 50 basis points tighter than the median level and 70 basis points tighter than the average spread level over the past 15 years. The tightest level the index has registered was 20 basis points tighter at +80 basis points in February 2007.

While this data point might suggest there is still more room for the index to run, the average rating of the index is lower now than it was back then. The average rating of the index is currently A-; whereas in February 2007, the average rating was A. Considering that the spread differential in the market between A and A- bonds is currently 16 basis points, on a rating-adjusted basis it appears there is much less room for credit spreads to tighten before they return to their historically tightest levels.

While volatility in credit spreads has not yet reached its historically lowest levels, similar to credit spreads, it has been steadily declining. In the following chart, we measure the differential between the average historical spread of the index and the daily spread of the Morningstar Corporate Bond Index. Using this differential, we then construct standard deviation bands based on 3-year trailing volatility. Based on the current spread differential and volatility calculation, the market has just recently surpassed being one standard deviation tighter than average.

Barring an unforeseen calamity this summer, the rolling volatility calculation should constrict as the volatility generated from the Greek debt and peripheral sovereign and bank crisis begins to roll off later this year. As that occurs, even without any further spread tightening, we expect credit spreads will likely enter a period similar to 2006 in which credit spreads were two or more standard deviations tighter than the historical average should dictate. By examining the 2006-07 time frame, it appears that in periods of low volatility, credit spreads can stay overvalued for several years and remain that way until there is a catalyst that causes investors to re-evaluate their risk tolerance.

With spreads grinding tighter and tighter, investors have been stretching further into lower-rated fixed-income securities to reach for yield. As such, the spread between corporate bonds with different ratings has been compressing. For example, the spread differential between the average single-A and BBB bond in our Corporate Bond Index has declined to +58 basis points from +82 basis points a year ago. Granted, the corporate bond market was still healing from the European debt and sovereign debt crisis a year ago, but even over a longer time period, the average spread differential between the ratings is +70 basis points.

Yields have also compressed among sovereign bonds with different ratings. For example, the yield on Spanish 10-year bonds is now trading at almost the same level as the U.S. 10-year Treasury bond, and Italian 10-year bonds are only 20 basis points higher. While the real, after-inflation returns on Spanish and Italian bonds are still higher than U.S. Treasuries because of the differential in underlying inflation, this is indicative of the compression that has occurred among different rating classes as credit spreads have continued to tighten in across the market.

Based on a long-term fundamental perspective, we continue to believe corporate credit spreads are fairly valued--albeit at the tight end of the range that we view as fairly valued. Across our coverage universe, our credit analysts generally have a balanced view that corporate credit risk will either remain stable or improve slightly, but that the tightening in credit spreads on those names will likely be offset by an increase in idiosyncratic risk (debt-funded M&A, increased shareholder activism, and so on). However, considering spreads are already at the tight end of where we think fair value lies and liquidity in the market is low, we think there is risk in the near term, given a negative catalyst that credit spreads could quickly gap wider.

For the remainder of the year, we think the best-case scenario will be for the corporate bond market to earn its current 2.94% yield. While credit spreads may tighten slightly from here, we think corporate credit spreads are already fully valued. In addition, as the economy rebounds from the first-quarter contraction, interest rates have begun to rise off of their recent lows and will provide a headwind for further gains in the second half of the year.

Interest Rates Should Normalize and Rise as the Fed Exits Its Asset Purchase Program
Interest rates have begun to rise as the economy expanded in the second quarter. Although the flight to safety pushed interest rates down during the first quarter, we continue to think that interest rates will rise toward historical norms as compared with inflation, inflation expectations, and the steepness of the Treasury curve. We expect the Fed will continue to taper its asset purchase program, winding it down and exiting it fully by the end of this year, at which point it will no longer affect the Treasury and MBS market. At a normalized level, we think the 10-year Treasury could increase to between 3.25% and 3.75% from 2.60% currently.

Three of the metrics we watch include the spread between current inflation and interest rates, inflation expectations, and the steepness of the Treasury curve. Historically, the yield on 10-year Treasury bond has averaged 200-250 basis points over a rolling three-month inflation rate. Currently, the three-month average of the annual increase in the Consumer Price Index is 1.5%, and the rate has risen sequentially in each of the past three months.

While we expect interest rates will normalize at higher levels as asset purchases decline, we are not overly concerned that the rise in long-term interest rates will overshoot too much above our estimates. It has declined slightly recently, at 220 basis points, but the spread between the 2-year and 10-year Treasury bond is still not that far from its historically widest levels (290 basis points). Since the 2-year bond is highly correlated to short-term interest rates and the Federal Reserve is planning on keeping the Federal Funds rate near zero until sometime late in 2015, the yield of the 2-year Treasury bond should be well-anchored. Considering this, we think the 2/10s curve can return to its widest levels. Based on where this spread has historically peaked, the 10-year yield could increase another 70 basis points over the 2-year before beginning to breach its prior ceiling.

After peaking in November 2012 (a few months after the most recent quantitative easing program had been launched), market-implied inflation expectations have been normalizing based on the five-year/five-year forward break-even measure. With inflation expectations back to a normalized level, these expectations will moderate the rise in Treasury rates and hold the 10-year note back from rising too much above normalized levels.

Spread Between Financial and Industrial Sectors Holds Steady
The spread between the financial and industrial sectors within the Morningstar Corporate Bond Index held steady during the second quarter. Historically, apart from the 2008-09 credit crisis, the credit spread for the Financial Sector Index traded tighter than the Industrial Sector Index, and currently the Financial index is trading 9 basis points tighter than the Industrials Index.

Before the credit crisis, the Financial Index traded 40 basis points tighter on average. However, a significant portion of the historical skew was due to the fact that the average rating in the Financial Sector Index was about two notches higher than the Industrials Index prior to the 2008-09 credit crisis. Since then, the average rating in the financial sector has dropped and is now only slightly higher than the A- rating in the Industrials Index.

While we don't expect the spread differential to return to the historical average, we do think that the financial sector will outperform slightly in a low-volatility world where idiosyncratic risk is of greater concern than systemic risk. Regulatory constraints mean the financial sector has less of a predisposition to incur higher debt leverage to make acquisitions or reward shareholders at the expense of bondholders.

The caveats to this outlook are if U.S. economic growth slowed unexpectedly, raising the rate of nonperforming loans; or a major global macroeconomic disruption such as a replay of the peripheral sovereign debt crisis in Europe; or if the incipient corporate credit defaults in China begin to snowball into a full-blown Chinese credit crisis. Any of these events would probably spread to and pressure other global banks that have significant counterparty exposure.

After suffering the ignominy of being the worst-performing sector in 2013, the media sector has rebounded strongly in the first half of 2014, outperforming the general market by 28 basis points. The outperformance thus far this year was predominately due to Time Warner Cable (rating: BBB-, wide moat), which agreed to be acquired by highly rated Comcast (rating: A-, wide moat). For example, after the announcement, TWC's 4% notes due 2021 tightened to +129 basis points from +305 basis points. Last year we had stated our belief that TWC bonds presented a compelling risk/reward proposition, trading as if an acquisition by highly leveraged Charter Communications (not rated) and a resulting move to high-yield was a foregone conclusion. We now believe TWC bonds are fairly valued.

Investors View Benign Risk in Short Term, but Longer-Term Risks Remain
It may be purely anecdotal evidence, but across our client base, the preponderance of investors we have spoken with think that credit spreads are fully valued to slightly overvalued. Yet, with new fund flows continuing to come in the door and feeling the pressure to keep up with index returns, these same investors are putting those funds to work as quickly as possible and keeping cash levels as low as possible. Even though a common refrain is that they expect the credit markets to correct to more historically normalized levels, they don't foresee any high-probability events occurring over the three to six months that would cause them to sit on the sidelines and risk underperforming the broader market in the near term.

When asked about which events would cause these investors to move to the sidelines, geopolitical events, inflation, and recession are the most commonly cited. From a geopolitical standpoint, the current turmoil in Ukraine by itself is unlikely to have an impact on the corporate bond market. However, if the situation were to change and other nations significantly ratcheted up sanctions on Russia, the economic impact on Europe could hamper its economic rebound and possibly reignite the worries about the Spanish and Italian banking systems. The other most cited geopolitical risk is the worry that oil prices could spike up if the political situation in the Middle East, Nigeria, or Venezuela were to deteriorate enough to disrupt oil supplies.

The Federal Reserve has succeeded in fending off deflationary fears in the United States, and with CPI now growing at an annual rate of about 2%, inflation could become a concern. In addition to rising CPI, the Personal Consumption Expenditures Deflator, the Fed's favored measure of inflation, has also been trending higher:

With the drought on the West Coast and Midwest still covering significant portions of the agricultural growing areas, food prices could escalate later this year if there isn't enough rain to support the crops. If inflation does rise in the latter half of this year, interest rates could rise in sympathy and lead to another sell-off in the corporate bond market such as we experienced last year when the yield on the 10-year Treasury began to rise in May.

Morningstar director of economic analysis Bob Johnson expects strong GDP growth in the second quarter and is forecasting GDP growth for 2014 between 2.0% and 2.5%, so we don't foresee a material increase in cash flow compression or defaults resulting from a recession, which could push spreads wider. As such, we continue to expect idiosyncratic credit risk to once again be the greatest determinant of differentiated portfolio returns.

Over the near term, idiosyncratic risk leading to downgrades and issuer-specific credit spread widening will continue to be the greatest threat to corporate bond investors. Over the longer term, as interest rates rise, a few elements of this idiosyncratic risk diminish. For example, higher all-in yields on corporate bonds as compared with dividend yields will make debt-funded share buybacks become less attractive. With equity prices reaching new highs, the combination of highly valued share prices and increasing interest rates may also dampen the amount of debt that a firm may utilize in pursuing strategic acquisitions and limit the attractiveness of spin-offs.

ECB Takes Up the Monetary-Easing Baton From the Fed
As the Federal Reserve continues to wind down its quantitative easing measures, the European central bank is stepping up its monetary easing, as the EU's annual inflation rate slowed to 0.5% in May, down from 0.7% in April. At its June meeting, the ECB announced it was cutting its main lending rate to 0.15% from 0.25% and implementing a negative interest rate on overnight bank deposits. Essentially, this means that a bank would have to pay a fee to leave its deposits with the ECB. The ECB also will provide up to EUR 400 million in additional loans to banks for the purpose of bolstering private lending.

The ECB hasn't implemented its own quantitative easing program yet, but it is preparing a program to purchase asset-backed securities and portfolios of bank loans. If the current monetary easing is not enough to bolster the EU economy and raise inflation rates toward the ECB's targeted levels (2.0%), then this program could be instituted within another three to six months.

The ECB's actions were well-received by both the equity and fixed-income markets as stock indexes rose to all-time highs, corporate credit spreads tightened, and sovereign interest rates in Europe fell. The average spread in both the Morningstar Eurobond Corporate Index and Morningstar Corporate Bond Index tightened 2 basis points after the announcement. The additional liquidity provided by the ECB's latest monetary easing may help to push credit spreads on European corporate bonds slightly tighter in the near term; however, we think that the degree of additional tightening is limited. While credit spreads of the index have been tighter during its history and may lead investors to think there is additional room to run, the average rating of the eurobond index was several notches higher at those times.

The average spread within the Morningstar Eurobond Corporate Index has declined to +87, some 17 basis points tighter since the end of last year and its tightest level since January 2010. This spread level is slightly tighter than the median level the index has traded at since the beginning of 2000, and is 15 basis points tighter than the average over the past 14 years. While these spread levels appear reasonable on the surface, accounting for differences in ratings, investors are receiving much less compensation on a risk-adjusted basis. Since the beginning of 2000, the average rating of the Eurobond Corporate Index has steadily declined. In 2000, the average rating of the index was AA-; it declined to an A+ by 2002, and fell precipitously in 2011-12 to an A- as the European debt crisis raged on.

Over the past few months, as the ECB has telegraphed its intentions to ease monetary policy and provide greater amounts of liquidity into the European markets, investors have been stretching further and further into lower-rated fixed-income securities to reach for yield. As such, the spread between corporate bonds with different ratings has been compressing. For example, the spread differential between the average single-A and BBB bond in our eurobond index has declined to +31 basis points from +140 basis points a year ago. The current spread level is also low as compared with a longer time period, as the average spread differential between the ratings is +60 basis points.

For the remainder of the year, we think the best-case scenario will be for the European corporate bond market to earn its current 1.39% yield. While the EU economies are slowly recuperating from the effects of the sovereign debt and banking crisis, we think the corporate bond market has already priced in the preponderance of the recovery, and we don't foresee much more tightening in corporate credit spreads. In addition, after the recent decline in sovereign interest rates to their lowest level over the past year, we don't expect interest rates to decline much further.

Idiosyncratic Risk Prompts Downgrades During the Second Quarter
Even though economic growth contracted in the first quarter, it was idiosyncratic events specific to individual issuers that drove the preponderance of downgrades during the quarter. In fact, half of the downgrades were registered in the health-care sector, where debt-fueled strategic acquisitions have run rampant.

The most severe downgrade was made to Zimmer's credit rating, which we cut to BBB+ from AA on its plan to purchase Biomet for $13.35 billion, including the assumption of Biomet's $5.5 billion in net debt. Excluding synergies, Zimmer's debt/EBITDA will rise to about 4.0 times after the planned merger, which is expected to close in early 2015, up from 1.0 times at the end of March. While we recognize management's goal to actively deleverage after the merger, we estimate debt/EBITDA will stay above 2.0 times until about 2018, which informs our rating. If Zimmer can deleverage more quickly than that, we would consider upgrading our rating. We may also upgrade Zimmer if it operates with debt leverage below 2.0 times on a sustainable basis. However, at this point, we believe that may take three to five years to achieve.

Similarly, Actavis plans to raise its debt leverage to about 4.0 times pro forma EBITDA from an estimated 3.6 times at the end of 2013 in order to fund its purchase of Forest Laboratories . As such, we downgraded our credit rating for Actavis to BBB from BBB+. Mallinckrodt will double its debt leverage to nearly 5 times in order to acquire Cadence Pharmaceuticals. While the deal gives Mallinckrodt a new platform to build out a hospital-focused pharmaceutical business, we believe the acquisition is challenging to justify financially. Cadence's only material asset is Ofirmev, an acetaminophen injection delivered in the hospital setting to treat pain. Mallinckrodt is paying a hefty 7 times estimated 2014 sales ($175 million), and although the product is still in launch mode, it is already in its fourth year on the market, making it unlikely to reach a peak sales number that is multiples higher than estimates for 2014. As such, we downgraded our issuer credit rating to BB- from BBB-.

Not all of the downgrades were as severe as these examples, though. For example, we only downgraded Bayer's issuer credit rating one notch to A- from A after the firm agreed to buy Merck's consumer unit for $14.2 billion. Strategically, we think this acquisition makes sense because it will significantly expand Bayer's already well-positioned consumer business. Further, the redeployment of capital from less competitively positioned units of crop and material science toward Bayer's health-care operations supports the unit that we believe holds the strongest competitive advantages within Bayer. However, we estimate Bayer's debt/EBITDA on a pro forma basis will stand around 2.0 times at the deal's closing, or about a half-turn higher than its debt/EBITDA of 1.5 times at the end of March and about a turn higher than its debt/EBITDA of 1.2 times at the end of 2013.

Similarly, we only downgraded our credit rating for Novartis by one notch to AA from AA+. The downgrade was prompted by the firm's portfolio reshuffling through planned deals with GlaxoSmithKline and Eli Lilly . As expected, Novartis is divesting several assets that lack leading positions in their respective markets. However, on top of those divestitures, Novartis also plans to purchase GlaxoSmithKline's oncology products. On a net basis, Novartis will experience a cash outflow of about $7.6 billion due to those planned deals. That expected outflow combined with shrinking scope of Novartis' business cut into our credit rating by one notch.

Not all of the news out of the health-care sector was negative. We upgraded Merck to AA from AA- on its rising net cash position and improving moat trend. Aftertax proceeds from its consumer unit sale to Bayer are estimated between $8 billion and $9 billion, which the firm will probably use to develop its pipeline, make acquisitions, and return cash to shareholders. Overall since last June, Merck's financial position has improved despite $5 billion in shareholder returns during that nine-month period. Adding another $4 billion-$5 billion in net cash to its coffers through these transactions should improve Merck's financial health even further.

Besides the strategic transactions in health care, within the telecommunications sector we lowered our credit rating on BCE to BBB+ from A- as a result of the rise in leverage following the 2013 Astral Media acquisition, and the high prices paid recently for wireless spectrum at government auction. BCE has traditionally maintained a fairly conservative financial position, but the Astral acquisition and spectrum purchase put net leverage at about 2.6 times EBITDA versus 2.2 times at the end of 2012. We also lowered our credit rating on Rogers Communications to BBB+ from A- after the firm's decision to spend CAD 3.3 billion for additional wireless spectrum at auction. The purchase enhances Rogers' competitive position, providing a large block of consistent spectrum covering 90% of the Canadian population; however, Rogers' net leverage will move up to about 3.1 times EBITDA from 2.4 times at the end 2013.

Rounding out our actions in the Canadian telecommunications sector, we are raised our credit rating on Telus to BBB+ from BBB despite the firm's recent purchase of wireless spectrum at government auction. The rating change brings Telus in line with rivals BCE and Rogers, which we believe is appropriate given the firm's relatively modest debt load. Following Telus' payment of CAD 1.1 billion for spectrum, net leverage will increase to about 2.1 times, still lower than Rogers (3.1 times after funding its spectrum purchase) and BCE (2.6 times). Unlike its peers, Telus hasn't pursued debt-financed acquisitions in the media sector, and it hasn't repurchased shares historically.

In the energy sector, we upgraded our issuer credit rating of SandRidge Energy to B+ from B- upon reviewing its announcement of the sale of all of its Gulf of Mexico and Gulf Coast properties for $750 million in cash and the assumption of $370 million of abandonment liabilities. After the sale, SandRidge will be solely focused on increasing production through multizone oil and gas development in its Mid-Continent acreage, where the company believes it has 10 years of high-return drilling opportunities.

We also upgraded our issuer credit rating of Anadarko Petroleum to BBB- from BB+ following our review of the company after it reached a settlement in the Tronox litigation. In April, Anadarko announced a settlement regarding the ongoing fraudulent conveyance litigation related to Kerr-McGee's 2005 spin-off of its titanium dioxide business, Tronox. (Anadarko purchased the oil and gas assets of Kerr-McGee in 2006.) Under the settlement, Anadarko will pay $5.15 billion to the plaintiffs in exchange for a release of all claims asserted against Kerr-McGee. In addition, Anadarko will receive from the U.S. government "contribution protection" from third-party claims seeking reimbursement from Kerr-McGee at more than 4,000 sites covered under the settlement. Anadarko had faced a potential liability of over $14 billion, which would have materially weakened the company's credit metrics because of increased total debt to fund the payment.

With the U.S. economy expected to recover in the second quarter, continued economic expansion in the EU, and cash burning a hole in the pockets of many management teams, we expect company-specific actions will drive credit risk in the third quarter once again. With organic growth opportunities sluggish and cash balances building, management teams are increasingly feeling the pressure to deploy capital, and we expect companies will continue to pursue strategic mergers and acquisitions. For example, we recently placed our credit rating for Tyson Foods under review for downgrade after it announced a proposal to acquire Hillshire Brands . The greatest near-term sector-specific credit risk lies in basic materials as many infrastructure-related commodity prices (such as iron ore, coal, and copper) have been falling because of decreased demand out of China.

Sector Updates and Top Bond Picks

Basic Materials
In early June, the U.S. Environmental Protection Agency announced proposed rules to reduce carbon dioxide emissions from existing power plants 30% by 2030. While the proposed rule is one of the most far-reaching environmental regulations in history, the amount of the reduction was in line with our expectations. Clearly, there is significant risk to coal given its highest carbon emission per megawatt hour among power generation alternatives. However, we think the proposed rules are not as detrimental to coal miners as feared, and that the true impact will remain uncertain until more is known about how individual states tailor their plans to meet the new requirements.

We see two silver linings for coal in the proposal. First, the EPA proposal allows states to reduce carbon dioxide emissions from four different approaches: 1) plant heat rate improvement; 2) substituting with less carbon-intensive generation, including natural gas; 3) substituting with low- or zero-carbon generation; and 4) reducing total demand through energy efficiency. Furthermore, carbon emissions reductions are evaluated on a state-average level rather on an individual-plant basis. We think the flexibility of this proposal means that states can continue to employ coal in energy generation. For example, reduction can be achieved by investing in alternative energy or improving coal plant efficiency rather than shutting down a single coal plant that exceeds the target. Second, the EPA chose 2005 as the base year for the proposed reduction levels. Current carbon emissions are already roughly 15% below that year's levels, limiting the potential risk to coal had the EPA chosen a more recent year as its base year.

U.S. price trends for thermal coal have been positive through the beginning of 2014. Since the end of 2013, Western Rail Powder River Basin (PRB) coal swaps have gained 5% to over $13 per ton. We believe PRB coal will continue to carry positive momentum, with prices expected to further strengthen amid higher natural gas prices and increased coal burn. Among thermal coal producers, we favor PRB pure-play and Best Idea Cloud Peak Energy (rating: BB+, narrow moat) which maintains a favorable cost structure and the strongest balance sheet among its peers.

Domestic steel prices rose in the first few months of 2014 as weather-related issues caused supply chain disruptions. We view these price increases as temporary and unsustainable. The price increases were not influenced by organic improvements and have resulted in U.S. prices diverging from global prices, which have declined steadily year to date. We believe this increases the risk that low-priced imports will take market share and weigh on domestic average selling prices. Also, our forecast for lower steelmaking raw material prices will prevent steel prices from holding steady and, instead, augurs that they will remain depressed over the medium term.

Contributed by Dale Burrow, CFA

Consumer Cyclical
With soft growth impacted by severe weather in most parts of the country, many retailers increased promotional activity and discounting to the detriment of profitability. We do not expect this trend to improve with the weather, as discounters Wal-Mart (rating: AA, wide moat), Target (rating: A, no moat), Dollar General (rating: BBB-, no moat) and Family Dollar (rating: BBB-, no moat) continue to invest in price amid increasing competition. All but Family Dollar reiterated their commitments to the credit ratings. We were concerned about Family Dollar's noncommittal comments regarding the balance sheet and leverage targets. If the firm is unable to improve earnings and/or decides to add more leverage, we may contemplate a rating downgrade.

Promotional activity from retailers such as Gap (rating: BBB-, no moat), Nordstrom (rating: A-, narrow moat) and L Brands (rating: BB+, narrow moat) also had an impact on gross margins. However, we are less concerned with firms that have economic moats, as we believe they will rely on less on price competition in the long run. However, we continue to expect Gap's gross margins will be under pressure, indicative of the firm's little pricing power.

More management teams announced a ramp-up in shareholder returns, issuing debt to do so, and we expect this to continue. Most notable was McDonald's (rating: AA-, wide moat), which issued $500 million in debt to help fund increased shareholder returns. We believe the firm has roughly $2.5 billion of debt capacity within Morningstar's AA- credit rating, which is 2 notches above the agencies. Management noted that it remains committed to its balance sheet, calling out the A credit rating by the agencies. McDonald's wide economic moat and low uncertainty rating have been driving forces behind our higher credit rating. While these haven't changed, leverage is also a factor. It has been maintained around 2.25 times, but an increase toward 2.5 times may have a negative impact on our rating.

The disappointing operating performance has created more bond opportunities, in our view, and we have upgraded our opinions on a number of firms. We believe the home improvement retailers, Home Depot (rating: A, wide moat) and Lowe's (rating: A, wide moat) trade slightly cheap. We are positive on these wide moat firms' abilities to drive solid operating performance in the long term, but believe the poor weather conditions will create a sales boost due to the need for repair work in the short term.

Contributed by Joscelyn MacKay

Consumer Defensive
For the sector, we expect sales growth will only marginally exceed nominal GDP growth rates and operating income growth will range in the mid- to high-single digits. With organic growth opportunities sluggish and cash balances building, management teams are increasingly feeling the pressure to deploy capital and we expect companies will continue to pursue strategic mergers and acquisitions. Firms will likely continue putting excess cash to use by building out their distribution platforms at home and abroad, and pursuing smaller, bolt-on transactions.

We have long recommended that investors Avoid Hillshire Brands' (rating: BBB/UR-, narrow moat) and Underweight Tyson Foods’ (rating: BBB-/UR-, no moat) bonds. We founded our Avoid recommendation on Hillshire on our expectation that after finishing spinning off and divesting itself of other business lines, that the company would either conduct a debt-funded acquisition to beef up its product portfolio or would be subject to takeover bids. Both of these events took place last quarter. First, Hillshire announced that it would purchase Pinnacle Foods in a debt-fueled transaction. However, Hillshire itself was then subject to a bidding war between Pilgrim's Pride and Tyson, of which Tyson eventually succeeded. Tyson is paying a hefty 17 times projected fiscal 2014 EBITDA enterprise multiple for the business. However, if management is able to realize the $300 million of synergies it expects within three years, mostly attributable to operational efficiencies and supply chain rationalization, the pro forma forward enterprise value/EBITDA multiple drops to a more reasonable 10.7 times. Our Underweight recommendation on Tyson was based on our opinion that investors were not receiving enough compensation for both the credit risk inherent in Tyson's business, as well as capital allocation risks.

Within the consumer Defensive Sector, we continue to recommend an Avoid on ConAgra's (rating: BBB-, narrow moat) bonds. In early 2013, ConAgra leveraged up its balance sheet to acquire Ralcorp and we downgraded our issuer credit rating to BBB-; however, the firm's 3.20% senior notes due 2023 are trading at a meager +118 basis points over Treasuries. Considering this spread level is much closer to where BBB+ bonds are trading, we don't believe investors are being paid nearly enough for the credit risk. With household spending on food constrained and brutal competition among supermarkets and nontraditional food retailers, conditions are especially tough for those brands that aren't top in their segment. Citing lingering issues in restoring private-brand segment profitability, weaker-than-anticipated consumer food volume, and commercial food margin headwinds, ConAgra cut its financial targets for 2014 and 2015. The reduction factors in a lower contribution from acquired Ralcorp assets, a 3%-4% decline in consumer food segment volume, and anticipates that 2015 growth will fall short of previous targets of double-digit growth. In our view, this update confirms our concerns that management's previous guidance hadn't fully incorporated competitive and consumer spending pressures. These pressures have had a meaningful impact on ConAgra's branded portfolio, and the integration of Ralcorp's private-label business was the primary reason behind our already below-market expectations for 2014.

Contributed by Dave Sekera, CFA

Energy
Our second-quarter outlook focused on natural gas price volatility and concerns about a cyclical downturn in the offshore drilling market. These two themes continue to be of key interest in the energy sector.

Although the spot price of natural gas retreated after peaking above $6 per thousand cubic feet in the first quarter, replenishment of depleted storage volumes has been slower than hoped as a cool spring kept demand levels elevated. Natural gas storage level of 1,606 billion cubic feet, as of June 6, is 31% below the 2013 level at this time, and 35% lower than the 5-year average level. While this is an improvement from March, when storage levels were 50% below 2013 levels, if the impending summer cooling season proves to be a period of high demand, natural gas prices at the front end of the futures curve could move sharply higher. Offsetting this positive data point for prices, natural gas production volumes have remained stubbornly high and are on an upward trajectory. While we have a positive view of industrial and power generation demand in the long term, these sources of incremental demand will not grow fast enough to offset production gains in the near term, particularly when new pipelines in the Marcellus shale begin operation in 2015. Still, natural gas futures strip prices across the curve are higher today than six months ago with the average price for delivery in 2017 about 12% higher than it was on Dec. 31. In general, E&P spreads performed with the market in the second quarter, and with spreads tight relative to their ratings basket, we anticipate more of the same in the third quarter. We continue to favor Cimarex (rating: BBB–, narrow moat), whose continued risk-adjusted outperformance relies primarily upon the company's consistent execution of its drilling program.

Spreads of offshore drillers outperformed the market in the second quarter despite cautious statements regarding the 2014 outlook. Coming into the second quarter, we recommended investors exercise caution as the long-term outlook for day rates was less certain and companies were commenting about the difficult contracting environment. Since that time, Rowan announced a contract for a rig that is still under construction. While some market participants pointed to the strong day rate the rig earned, we remain cautious as the term of the contract was a relatively short two years. The short term suggests that exploration companies are unwilling to commit to longer terms because they sense that day rates could move lower in 2016-17 when a sizable portion of the newest rigs in the fleet come off contract. Currently, we expect a difficult 15-18 months as the market adjusts to the surge of new deep-water rigs that are entering service. As the second quarter spread performance leaves little room for continued compression, we believe that investors will be well served to look to other sectors that offer better spread compensation for the fundamental risk.

Contributed by David Schivell

Financials
In the wake of the financial crisis, a consistent theme among global, as well as certain U.S. regional banks, has been fines and large legal settlements with bank regulators. The first wave centered on U.S. universal and investment banks concerning their underwriting, disclosure, and distribution of complex securitizations--those believed to have fueled the financial crisis. The next phase concerned questionable loans originated by the large U.S. banks and later sold into mortgage-backed securities--those issued either by the U.S. GSEs or by private issuers. Excluding JPMorgan's record $13 billion settlement in third quarter 2013, Bloomberg, based upon regulatory filings, estimated that the six largest U.S. banks paid $47 billion to mortgage investors since 2008 (Bloomberg, Aug. 28, 2013, "U.S. Bank Legal Bills Exceed $100 Billion"). The fines continue to this day with Bank of America (rating: BBB, narrow moat) in talks with the U.S. Justice Department and several states for a reported $12 billion settlement. Another wave, still cresting today, includes fines by U.S. regulators involving non-U.S. banks for violating U.S. laws concerning tax evasion, money laundering, payments to countries under U.S. sanctions, and market manipulation.

These matters have been highly publicized recently with high-profile companies like Credit Suisse AG (rating: A, narrow moat) and BNP Paribas (rating: A, narrow moat). In May, Credit Suisse AG entered a guilty plea to one count of conspiracy to assist U.S. customers in presenting false income tax returns and agreed to pay fines totaling $2,815 million (CHF 2,510 million) which was almost 3 times the amount the bank had reserved for the fine and represented about 70% of the trailing year's pretax income from continuing operations. BNP Paribas is currently negotiating a settlement with a variety of U.S. regulators regarding payments made through its New York branch to countries under U.S. sanctions. The highly publicized settlement has been widely reported to be as high as $10 billion, dwarfing the $1.1 billion the bank has reserved for the settlement and the roughly $6.4 billion (EUR 4.83 billion) of 2013 net income. These examples illustrate the unpredictable nature of the final settlement as well as the severity. And while we can't attest to the assumptions used, a recent article by Reuters ("Litigation Risk is Increasing For European Banks," June 4, 2014) estimates total litigation cost for European banks increasing to $103 billion from $58 billion. Both the range and size of the costs pose challenges for the involved banks. An investor is challenged by often limited disclosure pertaining to the amount reserved, further obscuring the true impact of a settlement. We believe that the difficulty predicting fines revolves around regulators' desire to find a figure that will inflict substantial economic pain without destabilizing the bank involved, thereby causing a panic.

Of the global European banks under investigation, it's not clear which bank could become the next target of a fine, which metric will be utilized to calculate the penalty, and what amount is reserved to pay the fine. Given these uncertainties, we think it is important to focus on capital and profit potential when considering which is most capable of handling a fine. Accordingly, we see the following banks as more capable of handling potential fines and continue to recommend Overweight allocations: HSBC (rating: A+, narrow moat) with 10.8% CET1 and 9% trailing 12-month ROE; UBS AG (rating: A, narrow moat) 13.2% CET1 and 6.7% ROE. We believe that Deutsche Bank's (rating A-, narrow moat) EUR 8 billion capital raise in May, which brought its CET1 to 11.8%, improves that bank's ability to handle potential litigation. However, the bank's low recent profits leave us with some concerns. We think Credit Suisse's (rating: A, narrow moat) recent settlement with U.S. authorities for tax evasion for $2.8 billion, which reduced CET1 to 9.3%, will keep the bank out of regulatory scrutiny for the foreseeable future and maintain a Market weight recommendation. We would place BNP Paribas in the middle of the pack given its 10.6% CET1 and 5.6% ROE. Although the final amount of a settlement is uncertain, we estimate the $10 billion being reported would reduce their core capital to 9.3%. We see this number as acceptable and believe that BNP could organically increase it to 10% within 18 months. Conversely, given their lower capital levels and restrained profits, we see the following banks as less capable of handling fines: Royal Bank of Scotland (rating: BBB+, no moat) 9.3% CET1 and negative 10% ROE; Barclays PLC (rating: A-, no moat) 9.6% CET1 and 1.3% ROE and recommend Underweight allocations.

Contributed by Chris Baker, CFA

Health Care
With low interest rates, tax-advantaged domiciles, and valuable equity currencies available to them, health care players have been extremely active in merger, acquisition, and divestiture activities during the first half of 2014. Those activities can play key roles in credit rating changes for health care issuers, and during the first half of 2014, we downgraded Actavis , Bayer , Mallinckrodt , McKesson , Novartis , and Zimmer because of these events. Also, in early 2014, Baxter announced a plan to split into two entities next year, which will likely cause us to downgrade our credit rating after more details about eventual capital structures are released.

If similar conditions persist in the marketplace, more events that hurt credit profiles within the industry are possible going forward. In the pharmaceutical sector, for example, our fundamental analysis identifies many firms that have incentive, due to weak growth outlooks and other factors, to pursue capital allocation activities that negatively affect bondholders. Even prior to Pfizer's efforts to merge with AstraZeneca announced this spring, we identified those two firms and Eli Lilly as having significantly weak fundamental prospects relative to their large pharmaceutical peers, which gives them incentive to make negative capital allocation decisions from a bondholders' perspective. While a potential Pfizer and AstraZeneca merger may be on hold for at least the next six months because of U.K. takeover rules, we wouldn't be surprised to see these firms weaken their credit profiles through other activities, going forward, because of ongoing fundamental weakness. For example, Pfizer still appears set on splitting into three entities around 2017, which will result in smaller, less diverse entities that may operate with weaker credit profiles than the current entity. Additionally, in the specialty pharmaceutical sector, Valeant is pursuing a hostile bid for Allergan . If it is completed, Allergan's credit rating and bonds may fall substantially. We also identify Teva, Endo, and Mylan as having the most incentive in the specialty pharmaceutical sector to pursue acquisitions that boost their currently lackluster growth prospects. While Teva and Endo's notes appear to compensate investors for that event risk, Mylan's notes do not, which keeps it on our Bonds to Avoid list.

Contributed by Julie Stralow, CFA

Industrials
Severe weather that blanketed most of the Midwest and East Coast had an impact on first-quarter industrial earnings. Weather issues, along with a negative headwind from a volatile inventory series, helped cause first-quarter GDP to contract by 1%, but a continued positive trend of above-50 readings through May in the Institute for Supply Management's Purchasing Managers' Index augurs well for industrial firms during the next few quarters.

We experienced a number of industrial new issues during the second quarter, with an estimated total of $24 billion in unsecured, dollar-denominated, fixed-rate deals. The weighted-average maturity of these issues was slightly above 10.5 years, but Caterpillar (CAT) and Johnson Controls (JCI), which were on our Potential New Supply List, each capitalized on the subdued interest rate environment by issuing 30- and 50-year notes-- 3M (MMM) also offered a 30-year issue. If the low inflation-and-interest-rate environment persists, we expect additional companies will look to extend maturities and satiate investors' demand for additional yield.

A brewing issue that we expect to become more prominent is the potential taxation implications associated with corporations' overseas cash balance. We find in our subset of multinational industrial firms that 70% of the total cash balance resides overseas. We will continue to monitor on upcoming earnings calls any updates to uses of foreign cash holdings. We also note that GE (GE) is attempting to deploy some of its overseas cash by bidding for Alstom assets, and we expect M&A to potentially ramp up in the coming quarters.

Two firms with large overseas cash balances that also carry our underweight recommendations are 3M and Caterpillar. 3M has renewed its commitment to increase shareholder value, including planned repurchases of between $3 billion and $5 billion in 2014, as well as a willingness to add $2 billion-$4 billion of debt to do so. 3M has roughly $4.2 billion in cash and marketable securities, but we estimate that 90% of this balance resides overseas. We believe that the potential increase in leverage and overseas cash position the firm weakly in its rating category. Caterpillar ended the March quarter with $4 billion of cash, of which $3.5 billion is held abroad. We think the firm's leverage of 1.2 times, its near-term risks associated with mining, and its foreign-held cash justify our underweight rating.

Elsewhere, U.S. automakers reported a strong seasonally adjusted annualized selling rate of 16.8 million for May, the best May SAAR since 2005 and the highest SAAR since 17.2 million in July 2006. While the month benefited from certain nuances, the consumer appears to have taken recent recalls in stride. Our expectation for 2014 sales remains at 15.9 million-16.2 million units. We think the dealer sector is the most competitively advantaged business in the automotive supply chain. Parts and service operations gives the dealer an intangible advantage over an independent garage. Many customers bring their vehicles to the dealer for servicing because the vehicle is either under warranty or because the dealer has the factory parts and expertise to service the vehicle. The recent recall activity should provide a near-term surge for dealers. This supports Investment Grade Best Idea AutoNation (AN) (rating: BBB-, narrow moat), whose 2020 maturity notes offer spreads wide of the BBB- Industrials Index.

Contributed by Rick Tauber, CFA, CPA and Basili Alukos, CFA, CPA

Technology and Telecommunications
Total technology and telecom global U.S. dollar issuance was $26.7 billion during the second quarter, including $5.6 billion from non-U.S. issuers. Key deals included AT&T's (T) (rating: A-, narrow moat) issuance of $4.8 billion of 30-year notes, Verizon's (VZ) (rating: BBB, narrow moat) placement of $3.3 billion of 3-year notes and Apple's (AAPL) (rating: AA-, narrow moat) massive seven-tranche offering of both fixed and floating debt totaling $12 billion.

For the quarter, the top-performing telecom name was AT&T: its 2024 notes tightened 16 basis points relative to the Morningstar A- rated index. Meanwhile, rival Verizon underperformed; its 2024 notes widened 7 basis points relative to the Morningstar BBB rated index. We think AT&T's performance since its announcement of the Directv (rating: BBB, narrow moat) acquisition reflects investor relief that the firm didn't use its balance sheet to undertake a larger deal.

The market will be watching these merger approval processes carefully, which we expect will contribute to periodic volatility in the credit spreads of the issuers involved as well as for the sector as a whole. We also expect to see more deal announcements. Recently, it has been reported in the press that Sprint (rating: BB-, no moat) and T-Mobile US (TMUS) (rating: BB-, no moat) are progressing toward a merger agreement. We suspect Sprint is primarily motivated to keep T-Mobile out of the hands of another strategic buyer. Given the material uncertainty around the deal, we think Sprint could underperform if it agrees to a large breakup fee ($2 billion has been most recently reported in the press).

During the second quarter, technology spreads continued to grind tighter, but modestly underperformed the Morningstar index (+2 basis points). The top-performing tech name for the second quarter was Texas Instruments (TXN) (rating: A+, narrow moat). Its 2.25% 2023 notes tightened 15 basis points relative to the A+ rated index. Meanwhile, Google (GOOG) (rating: AA, wide moat), IBM (IBM) (rating: AA-, wide moat), Cisco (CSCO) (rating: AA, narrow moat) and Intel (INTC) (rating: AA, wide moat) each underperformed, with Google the weakest. Its 3.375% notes due in 2024 widened 7 basis points relative to the AA rated index.

We expect capital allocation policy to remain a key theme through the balance of 2014 as cash balances continue to build. Management teams have been adhering to allocation targets, but keep in mind that these targets have been supported by rising cash flow levels.

Contributed by Michael Dimler, CFA

Utilities
Utilities have outperformed the corporate bond market thus far in 2014, having benefited from a rebound in power and natural gas prices. The utilities sector in Morningstar's Corporate Bond Index has returned 7.1% through June 13, compared with 5.0% for the overall index. Most utilities are in strong financial positions, with robust growth investments allowing them to continue raising dividends. The utilities sector average dividend yield remains near 4%, nearly double the market's average yield. In our view, gas utilities should be able to increase their dividends 3%-5% annually with investment that will strengthen the existing infrastructure and serve new demand seeking to capitalize on historically low gas prices. We expect utilities companies to be able to do so without having a material impact on credit qualities, given robust earnings growth.

The key risk in the sector right now is environmental regulation. The U.S. Environmental Protection Agency won two key court cases during the second quarter, supporting its regulations limiting certain noncarbon coal plant emissions. The caps on mercury emissions, in particular, are leading utilities to shut down old, inefficient coal plants. In addition, the EPA released its proposed carbon emission limits on June 2. The proposal is a complex set of regulations for each state that will go into effect in 2030. Although the proposal represents all upside for nuclear and renewable energy, the distant and flexible compliance guidelines limit any near-term benefits.

Power and gas markets in the United States awoke with a start from their three-year slumber following the January-February polar vortex. Between January and May, forward power prices and natural gas prices in the Mid-Atlantic region climbed 18%. This represents a significant earnings boost for all utilities with wholesale generation fleets in the Eastern United States, especially nuclear plant owners. In the Northeast, some power plants couldn't get the gas they needed to run their plants because there wasn't enough pipeline capacity to ship the amount of gas they needed. Ongoing concerns about pipeline capacity are driving billions of dollars of investment in the Eastern U.S. gas pipeline network.

Contributed by Travis Miller

Our Top Bond Picks
We pick bonds on a relative-value basis. Typically, this means comparing a bond's spread with spreads on bonds that involve comparable credit risk and duration. Following is a sample of a few issues from our monthly Best Ideas publication for institutions.

When selecting from bonds of different maturities from a single issuer, we weigh a variety of factors, including liquidity, our moat rating (we're willing to buy longer-dated bonds from a firm with sustainable competitive advantages), and our year-by-year forecast of the firm's cash flows in comparison with the yield pickup along the curve.

Top Bond Picks
	Ticker	Issuer Rating	Maturity	Coupon	Price	Yield	Spread to Treas
eBay	EBAY	A+	2022	2.60%	$95.70	3.21%	79
Maxim Integrated	MXIM	A+	2023	3.38%	$96.49	3.85%	135
BorgWarner	BWA	A-	2020	4.625%	$108.65	3.10%	116
AutoNation	AN	BBB-	2020	5.50%	$108.88	3.73%	188
Hospira	HSP	BBB-	2023	5.80%	$111.56	4.26%	175
Data as of June 12, 2014. Price, yield, and spread are provided by Advantage Data.

eBay (EBAY) (rating: A+, wide moat)
Marketplace innovations and an expanded portfolio of payment technologies have reshaped wide-moat eBay into a major commerce hub. Amazon (AMZN) may hold the title of top destination for U.S. online shoppers, but we believe eBay will remain relevant in the years to come because of a desire to partner, not compete, with other merchants, and enable them to compete in the converging world of online, offline, and mobile commerce. Our positive long-term outlook is supported by recent PayPal and Marketplaces active user growth, and resilient margins despite customer experience and engagement, cross-border, and PayPal investments. We're also intrigued by eBay's exposure to mobile commerce, and estimate that around 40% of new Marketplaces and PayPal users in 2013 came from mobile devices. Many of these mobile users are younger customers with lower disposable incomes, often from emerging markets, but with a lifetime of potential transactions ahead.

Maxim (rating: A+, wide moat)
We believe Maxim is a stronger company than it may appear at first glance. The firm has a strong position in the high-performance analog semiconductor business. Analog chip design expertise is not easy to come by, so firms that have spent years developing proprietary designs and retaining experienced engineers have an advantage over new entrants. These designs do not rapidly evolve or require cutting-edge production techniques, which enables strong profitability. Maxim has entered more competitive markets in recent years, including the consumer electronics market. The firm has built a strong relationship with Samsung, which has introduced customer concentration risk and more volatile results. However, we believe the underlying high-performance analog business provides a stable base of business that the consumer market sometimes masks.

BorgWarner (BWA) (rating: A-, narrow moat)
BorgWarner reported strong first-quarter 2014 results and management increased its expectations of year-over-year revenue growth to 12%–15%, including the impact of the Wahler acquisition, from 7%-11%. Operating margin remained at 12.5%. These updates are in line with our current forecast. The company disclosed a total consideration paid for this of $143 million. The company also ramped up capital spending during the quarter to $126 million from $87 million, leading to free cash burn of $80 million. Despite all that, total debt increased only about $100 million to $1.4 billion while cash remains substantial at $808 million. Sales grew 12.6%—with only limited impact from Wahler—while EBITDA increased 14.2% on modest margin expansion. As such, actual debt/EBITDA remains at 1.1 times with net leverage at 0.5 times. We expect gross leverage to remain in the 1 times area with cash and free cash flow available for additional acquisitions.

AutoNation (AN) (rating: BBB-, narrow moat)
AutoNation maintains a disciplined capital-allocation strategy with a priority of investing in the business and then returning cash to shareholders, while keeping credit metrics solid. A recent increase in share-repurchase authorization and first-quarter share repurchases is in line with this strategy. The company has maintained rent-adjusted leverage in the low 3 times area, where we expect it to stay. We expect AutoNation's scale as the largest public dealer as well as its focus on the domestic market to continue to result in industry-leading financial performance. We believe investors remain well compensated for the credit risks and see potentially 50 basis points of additional tightening.

Hospira (rating: BBB-, narrow moat)
Hospira's bonds could outperform its peers, as it deleverages primarily on expected profit growth. On a trailing 12-month basis, we estimate debt/EBITDA has declined to about 3.5 times on rising profitability, and we believe more deleveraging is possible. Specifically, we expect improving manufacturing levels, diminishing remediation costs, a shifting product mix to higher-margin biosimilars, and lower-cost manufacturing from its India-based manufacturing facility to start boosting Hospira's profits within the next year. This potential for rising profitability not only informs our BBB- rating, but it also makes us believe an upgrade is possible in Hospira's near future.

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