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A 'Defensive' Bond Pick

Jeremy Glaser

Jeremy Glaser: For I'm Jeremy Glaser. I'm joined today with Rick Tauber, Senior Credit Analyst, to take a look at the defense aerospace industry  to see if there are any credit opportunities.

Rick, thanks for joining me today.

Rick Tauber: Thanks. I appreciate it.

Glaser: There's a lot of talk about budget cuts or potential budget cuts. That's an area that could obviously have a big impact on the defense industry. How have the aerospace and defense companies kind of held up, how the bonds held up in an environment where there is a potential for some cuts to that budget?

Tauber: Sure. I mean, the bonds have actually performed quite well I would say and held up very well in the face of that uncertainty. In the higher quality space, the investment grade area, for example, Raytheon which is rated weak A by the rating agencies, we haven't initiated coverage yet, but they came to mark with a 10-year bond 3.125% coupon, a spread of 60 basis points.

Now, Lockheed, which we do rate at A+ and also has the same rating agency ratings is a name that we follow. And if you compare that to the A+ Morningstar bucket, the spreads are at 94 basis points. So, the Raytheon issue relative to maybe where we would end up rating it is about 34 basis points tight to the market.

Now, on the high yield side, the bonds also trade reasonably well. They all trade above par amongst the names that we cover. But if you compare them to say the BB index, for example, which is probably the best benchmark, they trade slightly cheap to that benchmark. So, we actually see more relative value in the high yield part of the sector than the high grade part, but in both cases still trade quite well.

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Glaser: But it certainly doesn't sound like there's a lot of concern that there's going to be huge defense cuts so that they're going to see large portions of their revenue disappear.

Tauber: Yeah, I think that's the case. I mean, I think the base case is sort of flattish type revenues with margin contraction. But the risk that we focus on from a bondholder's point of view is, firms trying to grow their earnings and grow in general and not having that sort of fundamental growth. Now, they're going to have to look at acquisitions or share repurchases which typically is going to be detrimental to the bondholder. So, those are kind of risks on the defense side.

Glaser: You mentioned that the high yield companies might present slightly better opportunity. Of those names are they about pretty much the same or do you see differences between them?

Tauber: Well, amongst the five that we launched coverage on, the key thing is, there is the aerospace side of the business and now, there is the defense side. The aerospace side is on the front end of a nice up cycle here.

The airlines are all doing reasonably well now and potentially much better as consolidation kicks in, and if the economy recovers and that leads to improved orders. The backlog at Boeing and Airbus is pretty strong. Delivery schedules are going to rise. You have new planes coming out like the 787. So, the aerospace side has actually got a very good outlook from our perspective, while the defense side is a lot more cautious. So, we look at both of those pieces and where does each individual company fit on the spectrum.

Glaser: So, when your credit ratings came out, did they differ from the major agencies?

Tauber: They did. Yeah. I mean, we have a much broader range of what we view as credit risk.

Glaser: So, given our divergent view of credit risk, are there any opportunities then for bond investors?

Tauber: Sure. I mean, basically, what I did is kind of stack up where each of the companies rank in our credit spectrum. Spirit on top at BBB- followed by ATK and Moog get BB+, Oshkosh at BB and then Triumph at B+.

And then tooka look at the capital structures, all of them have secured bank debt ahead of the bonds and the capital structure. So, it's fairly easy to compare bonds which are all subordinated to some degree. And then basically lining up our capital structure again with Spirit being the highest rated, their bonds trade very similar to Moog and Oshkosh and also Triumph's senior bonds which are all about 50 basis points behind ATK. So, given our view of the credit quality, Spirit kind of stands out as giving you the best yield relative to what we view as the risk.

Glaser: So, what issue of Spirit do you think investors should look at in particular?

Tauber: Right. They have a bond due in 2017, a senior unsecured bond. It's about $300 million bond. It's actually their only bond outstanding. And it gives investors a yield of about 6.3%, which compares with under 6% for the BB index and similar type yields on ATK, although we view Spirit as being somewhat higher credit quality. So, the fundamentals are strong. We think the company has a good chance of delevering over the next several years as the ramp up of Boeing-based products continues which could allow for some good performance by these bonds.

Glaser: Great. Rick, thanks for talking with me.

Tauber: No. You bet.

Glaser: For, I'm Jeremy Glaser.