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Values in Railroad Bonds?

Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Are there values in railroad bonds? I am here today with Keith Schoonmaker and Jeff Cannon to take a look at the industry and see where fixed income investors should set their gaze. Gentlemen, thanks for joining me.

Jeff Cannon: Thank you.

Keith Schoonmaker: Thank you, Jeremy.

Glaser: So Keith, can you give us a general overview of how the railroad industry is doing. Has the recovery really caught up to them? Are they doing well?

Schoonmaker: Sure, I will be glad to Jeremy. Let me comment briefly on volume recovery, and on profitability performance of the railroad.

First on volume, we saw volumes fall off precipitously in 2009, when both carloads and intermodal volume both sunk about 15%. In 2010, we saw carloads recover about 9% and intermodal back up about 15%. But coal gained just 2% that year, after losing more than 10% in 2009. Now this year-to-date we've seen carloads up an additional 3.3% and intermodal up 7.9%, coal up by just a little bit 2.4%, year-to-date. Looking forward, we expect volume to continue to recover long run at low single-digit pace.

Now, as far as profitability, that's a different story. The rails have performance just exquisitely throughout 2009, 2010, and to-date, setting new records and many rails for example Union Pacific, CSX, Kansas City Southern, all achieved record profitability in 2010 and also first quarter profitability in 2011, and as a whole we've seen the industry go from operating ratio, that is operating expense over revenue, so lower number is more desirable, and indicates better performance. We've seen the industry as a whole go from about mid-80s performance to low 70s performance in the past 10 years or so. So, it's really been a remarkable margin improvement story for rails since rail renaissance began.

Glaser: So, in light of this recovery Jeff, I know that you've taken a look at some of the credit metrics and credit worthiness of the railroads. Can you give us an overview of where your ratings shook out?

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Cannon: Sure. We currently have credit ratings on seven names across the sector right now including five investment-grade names and two below-investment-grade names. Starting at the higher end of the spectrum, we rate Canadian National and Union Pacific at A-. Those companies have rent-adjusted leverage of around two times and are the most efficient operators in the industry.

Next there is Norfolk Southern and CSX, which we rate one notch lower at BBB+, and their rent-adjusted leverage is around the mid-2s at this point for 2010. The last investment grade rail is Canadian Pacific, which we rate BBB, and that company is levered on a rent-adjusted basis around three times.

Moving into below-investment-grade space, we have Kansas City Southern, which we rate at BB+. Now we recently upgraded their rating from BB to BB+, due largely to the fact that we changed the moat from a no-moat to a narrow moat status, and then also the company took some action in 2010 to delever the balance sheet--namely, they applied proceeds from a share offering to pay down debt. So, that is what drove that upgrade there.

Lastly, we just initiated a rating on RailAmerica. We initiated at BB-. The company is one of the largest short-line rails in the North America, but they are significantly smaller than the class ones, and the leverage is fairly high at about four times rent-adjusted leverage. So again their rating is BB-.

Glaser: So, when looking at relative values of the bonds across the industry, where should investors be looking and what areas do you think they might want to avoid.

Cannon: Well, first of all the rails historically have traded tight for their ratings, especially at the higher end of the credit spectrum, and that's really driven by the defensive nature of the sector. So, in general, our view is, given the positive outlook that Keith talked about, we would tend to underweight the higher rated names and move down in credit quality a little bit towards some of the lower-rated names and pick up some yield.

So, with that in mind, we would recommend an underweight on Canadian National, Union Pacific and Norfolk Southern. We have no concerns over the fundamentals of the companies, but right now their bonds are trading very tight. The 2019 maturities for each of the names trade at spreads of 80 to 85 for Canadian National and Union Pacific. Norfolk Southern is about 10 basis points behind that given the fact that they're one notch lower in rating. So, we don't see a lot of value in that, especially considering the fact that those spreads are about 30 to 40 basis points inside the respective rating bucket of the Morningstar Index.

Moving to CSX, which again we rate at BBB plus, the same as Norfolk Southern, we have an overweight on that name given the fact that CSX trades about 20 basis points wide of Norfolk Southern. Part of that could be due to the fact that our rating is one to two notches higher than the rating agencies', but we see value there because we view the risk reward tradeoff between those two names as being similar.

The last investment-grade name that we follow is Canadian Pacific, and we also have an overweight on that name. Canadian Pacific bonds trade at about 20 basis points wide to CSX. Given that we have an overweight on CSX, we view that relationship as fair and would overweight Canadian Pacific as well. Now that name is not quite as liquid as CSX, so it might be a little tougher to source some bonds there, but again we see value there if you can find the bonds.

Glaser: What about some of the below-investment-grade names?

Cannon: Well, starting with Kansas City Southern which again we rate BB+, we have an overweight on that name. The company has bonds issued from both their U.S. and their Mexican subsidiaries. Now, there are no cross guarantees or cross defaults in the bonds, but there is a high degree of implicit support, and we are comfortable owning the bonds of either issuer, and given that we prefer the bonds of Kansas City to Mexico, and they have an 8% bond due 2018 that we saw trading at around a yield to worst of 5.4%, and we find that attractive given our BB+ rating and our outlook for continued improvement in credit metrics.

Also, our rating on Kansas City Southern is two notches higher than both Moody's and S&P. Moody's has a positive outlook, so any potential upward migration of ratings there could potentially drive prices higher.

The last name is RailAmerica. We have a market weight on RailAmerica. They actually have one bond outstanding, a decent size, there is about $600 million outstanding, and it trades at about 5.80 yield to worst, which sounds relatively attractive, but one thing to point out, there is a claw-back provision in this bond. The management has the ability to call 10% of the original principal at a price of 1.03 each year, and they've exercised that the last two years, and given the liquidity on the balance sheet, we think there is a good chance they will do that again this year. So, with the bond trading around $1.11, claw back at 1.03, once you factor that in, the yield goes from about 5.80 down to the low fives, which we think puts it at fair value and therefore drives our market weight.

Glaser: Well, that sounds great. Jeff, Keith. Thanks so much for talking to me today.

Schoonmaker: Thank you, Jeremy.

Cannon: You're welcome.

Glaser: For Morningstar, I'm Jeremy Glaser.