Credit Outlook: Spreads Still Have Room to Tighten

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• Although we expect near-term volatility, over the long term credit spreads will continue to tighten.
   
• With absolute rates near all-time lows, we recommend sticking with corporate bonds with medium-term durations issued by firms with a wide economic moat, strong free cash flows, and fortress balance sheets.
   
• Issuers have been increasingly accessing the debt markets to lock in low rates in order to finance new initiatives or fund share repurchases/dividends.

Credit spreads tightened significantly throughout the third quarter, but we think spreads have further room to tighten on a long-term basis compared with historical averages. While it currently appears that most companies should be able to meet third-quarter earnings guidance, we expect the pace of credit improvement and earnings growth will slow in the fourth quarter as the easy year-over-year comparisons become harder.

The bond market benefited from fading concerns regarding the solvency of several European sovereign issuers and related stress on the European banking system in the third quarter. Credit metrics for corporate issuers generally continued to improve due to a combination of easy year-over-year comparisons, which resulted in declining leverage metrics, and a moderate inventory-led economic rebound. The new issue market was especially active as issuers took advantage of relatively tight credit spreads and near all-time low interest rates.

Fixed-income managers welcomed the abundance of new supply as investors rebalanced their investment portfolios in favor of fixed-income products over equity. Year to date through the end of August, fixed-income mutual funds experienced almost $200 billion of inflows compared with more than $23 billion of outflows from equity funds.

Spreads Tighten
Credit spreads tightened through the third quarter, and at +160 are at the midpoint of the trading range for the year. The Morningstar Corporate Bond Index was as tight as +130 in April during the height of the inventory-led economic recovery and widened to +190 in June at the peak of European sovereign credit crisis.

The European crisis was in full swing as the quarter began, as investors finally grasped the full consequences of sovereign credit deterioration and the potential impact on European banks' balance sheets if a sovereign issuer were to default. These concerns eased as the ECB and IMF cobbled together a financing package to temporarily fund countries that were unable to access the public debt markets. Worries were further alleviated after European banks disclosed the results of their stress tests. For all of its faults, the stress test results revealed the banks' resilience to further significant credit deterioration in a downside scenario if the Eurozone economy were to weaken further.

Over a longer-term perspective, credit spreads still appear to be cheap compared with historical averages. For example, the Merrill Lynch Corporate Bond Master Index is currently +184. While this index gapped out to over +600 during the heart of the credit crisis when the credit markets were effectively shut down, over the past 10 years the peak had been approximately +250 during the 2002 recession. By October 2003, the index had tightened back to +100 where it stayed in a relatively narrow trading range until July 2007, when the first tremors of the credit crisis were beginning.

Since the release of the ISM Manufacturing Index at the beginning of September, which surprised everyone to the upside, credit spreads have experienced a pretty strong tightening trend. However, this momentum has begun to fade as the market awaits the beginning of earnings season. While it currently appears that most companies should be able to meet third-quarter earnings guidance, we are concerned that the pace of credit improvement and earnings growth will slow in the fourth quarter as the easy year-over-year comparisons become harder.

In the short term, we believe that credit spreads have a greater chance of widening as guidance for the fourth quarter may not be as robust as the market expects. We also don't believe that the sovereign and banking issues in Europe have been resolved, and new headlines may resurface the same credit fears. However, over the longer term, we continue to believe that credit spreads are still relatively wide compared to long-term averages and our expectations for further credit metric improvements.

 

Other Credit Trends
In the first half of the year, companies used newly issued debt primarily to refinance short-term debt or bank credit facilities. In the third quarter, we saw a big shift in how this new capital was deployed, as issuers have been taking advantage of strong demand for bonds and low interest rates to raise money to fund large capital expenditure programs, strategic mergers and acquisitions, share buybacks, and special shareholder dividends. For instance, Brazilian iron ore giant Vale (VALE Morningstar Credit Rating: BBB+) came to market in September with a $1.75 billion transaction whose proceeds will be used to fund the firm's massive capital expenditure activities in the coming years.

While the banks generally have been reluctant to rent out their balance sheets to provide commitment letters to support private equity LBO transactions, the bond market has been happy to provide financing for strategic mergers and acquisitions by investment-grade issuers. For example, Cliffs Natural Resources (CLF BBB) issued bonds to fund the acquisitions of INR Energy and Spider Resources.

In the consumer products sector, Wal-Mart (WMT AA) and McDonald's (MCD AA-) both issued debt to fund large share repurchase programs. The health-care sector has been especially active issuing debt to fund stock buyback programs. Large, highly rated issuers in this sector such as Gilead GILD and Baxter (BAX AA-) have been happy to add additional leverage at cheap rates to fund their share repurchase programs.

Companies in the technology sector, which have historically kept very low levels of leverage and significant cash balances, are being pressured by their shareholders to increase dividends. With the threat of increasing tax rates on dividends next year and equity valuations constrained by the burgeoning cash balances, we expect to see an increase in special dividends through the end of this year. However, a significant amount of cash is often domiciled in foreign subsidiaries. Rather than realizing the tax bite to repatriate this cash to pay dividends, CFOs are eyeing the low absolute interest rates available in the debt markets to fund dividends and effectively evade paying taxes. For example, Microsoft (MSFT AAA), is rumored to be contemplating a large bond issue to fund a one-time special dividend rather than pay the tax on repatriating cash from foreign subsidiaries.

Banks
We expect continued improvement in bank credit quality in the fourth quarter, though reported results are likely to remain weak by historic standards. The pace at which both credit losses and new delinquencies are occurring appears to have stabilized, if not peaked, for the time being.

With lending standards tight and loan demand weak, bank balance sheets are likely to continue shrinking as deleveraging continues. Furthermore, banks are shifting funds into less risky assets, such as government securities. Finally, some of the stronger banks have returned to profitability, and those that have are likely to remain profitable for the remainder of the year.

All of these factors have increased the capital levels of high-quality banks substantially over recent quarters, providing additional safety to debtholders. Though most banks we cover already meet the newly proposed Basel III capital standards, we expect banks to establish a comfortable cushion over minimum levels before aggressively pursuing dividend increases or share repurchases, further providing support for creditors.

On the other hand, we don't expect major improvement in credit quality or loan growth to occur for some time. Thus, banks that are currently experiencing losses could continue to see declines in capital levels as long as loan losses remain elevated. It's conceivable that further bifurcation of the bank credit universe could occur if the economic recovery continues at an anemic pace, with high-quality bank spreads tightening while the financials of low-quality banks deteriorate.

Basic Materials
Credit metrics continue to improve in most pockets of the basic materials sector, particularly for industries with direct exposure to emerging-markets growth rates, such as mining. Strong prices for commodities like copper and coal have afforded a significant lift to miners' cash flows, enabling firms that had taken on too much leverage heading into the downturn to reduce their debt load--e.g., Teck (TCK BBB-) and Xstrata (XTA BBB-)--and facilitating major growth spending, both organic and inorganic, at firms with balance sheets that had weathered the downturn rather well--e.g., BHP Billiton (BHP) and Vale.

Credit markets remain open for mining companies, many of which have been able to issue 30-year bonds at very little spread premium to their shorter-dated issues. As long as yields remain at present levels, we expect the mining industry will be avid issuers as they seek the funding required to embark on ambitious capacity expansions.

Concerns regarding the sustainability of Chinese growth rates and the associated appetite for raw materials will dominate the credit outlook for the mining industry in the fourth quarter. Recent declines in Chinese crude steel output in July (-1.9% year over year) and August (-1.1% YoY) could be a cause for concern. That said, considered in the context of still-strong industrial output (+16.6 YTD August) and fixed asset investment (+24.8% YTD August) data, we'd caution against viewing the negative numbers as a sign of mounting end-demand weakness in China.

In contrast to the improving credit metrics we've seen from companies tied to China and other emerging markets, firms heavily dependent on OECD construction spending haven't fared well. In particular, balance sheets of cement and aggregates firms lacking material emerging-markets exposure are still stressed and are likely to remain so as long as construction spending in the U.S. and Europe continues at a fraction of pre-slump levels.

 

Consumer
As the sluggish economic recovery decelerates and firms face tougher year-over-year comparisons, we do not expect much positive news to come from our consumer coverage as the calendar year comes to a close. In our view, consumer companies will face stagnant revenue growth and experience margin compression in the coming quarter.

Consumers are still skittish, and we expect retail and restaurant traffic to be flat to down. Consumer staples should hold up due to the segment's defensive nature, but we expect discretionary purchases to remain constrained.

Thus far in 2010, cost-cutting has borne fruit, and most companies have realized strong margin gains. However, for the remainder of the year, we expect to see some reversal in this trend as firms struggle to pass through higher commodity prices to the consumer and promotional activity remains elevated. We don't expect consumer products companies to ease promotional spending as they battle for market share. We also believe advertising spending will increase as companies endeavor to drive sales volume growth. After a muted back-to-school season, retailers will look to improve holiday traffic, and the value-menu party is still going for restaurants.

In light of these headwinds, we expect capital spending to remain conservative, which will allow for more free cash flow to go toward debt repayment. We believe improving the balance sheet--or maintaining a strong one--remains a top priority for management teams. For example, Macy's (M BB+), J.C. Penney (JCP BBB-) and Dollar General (DG BB+) have all focused on using excess cash flow to pay down debt in the first half of 2010, a welcome sign that we expect to continue. In addition, Macy's and J.C. Penney are still abstaining from share repurchases, which we believe is prudent given the persistent economic weakness. Even with improving credit metrics, however, we don't expect credit spreads in the consumer space to outperform the general credit market absent a positive near-term catalyst.

A final risk for some of our names would be private equity financed M&A activity that could impair existing bonds depending on change-of-control provisions. Fueled by the recent takeout of Burger King  by a private equity firm, rumors continue to swirl around Wendy's/Arby's (WEN BB) and Saks Fifth Avenue (SKS B).

The media sector generally continues to see a small top-line lift as the upward trend in ad spending improves. We expect margins to remain healthy as the sector has already been running lean, and any top-line growth should provide some operating leverage. As such, among the more stable credits in the sector, such as Viacom (VIA A-), we expect share repurchase activity to continue, which we do not take issue with given its stable credit metrics. At this point in the cycle, we believe the bonds in the media sector are generally trading appropriately, and therefore have a higher risk for underperforming than outperforming.

Energy
If it weren't for an influx of foreign capital supporting drilling to hold acreage leased during the boom (much of it expiring in 2011 if drilling commitments aren't met), energy budgets and the U.S. gas rig count would be much lower today, in our opinion.

At about 980, the U.S. gas rig count is well above the 700 that were active at this time last year. This rising gas rig count flies in the face of what we expect will be lower gas prices in the fourth quarter of 2010 compared to 2009. Very few of the E&P companies we cover have been able to fund their drilling budgets through internally generated cash flow during 2009-2010. More than $40 billion has come in from foreign JVs, and those that haven't participated in JVs have mostly sold assets and issued long-term debt. If we assume half of the $40 billion raised in JVs went to immediate balance sheet repair (as many companies that signed JVs were among the most financially distressed), then the remaining $20 billion could help explain how drilling held up so well despite very low gas prices.

If we assume the average horizontal gas well costs $5 million, and it takes 50 days to drill and complete these wells (which we think is a reasonable average of Haynesville, Eagle Ford, Fayetteville, and Marcellus Shale wells), then each rig running would drive $36.5 million in capital spending annually for an E&P company. So how much are the extra 280 rigs (980 minus 700) requiring E&P companies to spend each year on new wells? That's an extra $10.2 billion per year, or roughly our $20 billion estimate of excess cash raised from the JVs spread over two years. With the new JV money sunk largely in the ground now (or used in debt repayment), and lease expiration pressures set to subside as we push through 2011, we are likely to see a different set of U.S. supply fundamentals taking over. Those fundamentals will be driven largely by companies living within cash flow, which suggests a falling gas rig count. And, higher gas prices will be required to lift cash flows and fund greater drilling activity.

Companies have leaned more heavily on debt markets and asset sales relative to equity markets to improve liquidity, conduct deals, and fund budgets. This activity could support our view that energy sector equity appears a bit undervalued presently, though not by much. We'd need to see sustained oil- and gas-price strength or further equity multiples improvement to justify significant credit gains from here, in our opinion.

Health Care
With shares of both established and developing health-care companies often trading below what we think they are worth, we've seen more posturing around two activities that could hurt the credit profiles of covered firms--acquisitions and share repurchases.

For example, Genzyme (GENZ) and several Boston Scientific (BSX BB+) units appear to be on the auction block, as those management teams feel the market hasn't been valuing their firms appropriately for an extended period of time. We wouldn't be surprised to see those and other deals finalized in the next few months.

In the case of Genzyme, our analysis suggests potential acquirer Sanofi-Aventis (SNY AA) would deserve a credit rating downgrade if it completes the deal with Genzyme at recent prices or higher. On the other hand, the rumored suitor for Boston Scientific's neuromodulation unit, Stryker (SYK AA+), is so cash-rich that even a premium-priced deal for that unit probably wouldn't move the needle on its current credit rating.

Along a similar vein, share repurchases appear to be on the rise due to the recent slump in share prices in this sector. Established health-care companies typically have admirable cash-flow-generating abilities, which is one of the reasons why they often score so well in our credit rating methodology. However, with cash building on their balance sheets, manageable debt positions at low interest rates, and slumping stocks, health-care management teams may choose to reward shareholders rather than save that cash for future debt repayment. While we don't necessarily believe such behavior is friendly to debtholders, we haven't been concerned about repurchases materially damaging these firms' abilities to repay debtholders yet. If repurchase activity accelerates beyond our current expectations, we may consider some credit rating downgrades at covered firms. For example, Baxter and Gilead are companies we currently have on a short leash.

 

Industrials
Overall we expect credit quality to continue to improve in the industrials space. Most industries within this sector have continued to see steady recoveries from the cyclical bottoms of last year, generating meaningful free cash flow. We expect third-quarter earnings to be fairly robust overall, which could result in further credit spread tightening.

That said, the strength we saw earlier this year appears to be moderating based on our forward indicators, and we expect to see growth rates moderate starting in the fourth quarter. Also, auto sales appear to be stabilizing after a sharp improvement earlier in the year, as the industry laps tough Cash for Clunker comparisons. Even so, OEMs such as Ford (F BB) and suppliers such as TRW (TRW BB+) and Tenneco (TEN BB-) have continued to generate impressive free cash flow and pay down debt.

Sales declines have moderated in the homebuilding space, but the timing of a recovery is far from certain. More positively, railroads continue to show impressive recovery in volume, and the airline space continues to look strong compared with recent history. Airlines will benefit from the completion of the Continental-United merger, which could result in further capacity reduction and lower competition. The aerospace suppliers to this industry also should continue to benefit from a stronger airline sector. Their defense brethren, however, face gradual tightening in Department of Defense spending, and thus we are particularly cautious on this sector. We have seen several announcements of portfolio readjusting among defense firms, including division sales at Northrop (NOC A) and BAE Systems (BA. A-), as well as internal restructurings at Boeing (BA) and Lockheed (LMT A+).

We thus expect M&A activity to ramp up, along with increased share repurchases as companies focus on maintaining EPS growth. In general, we expect M&A among industrials firms to increase. However, we expect deals to largely be in line with our expectations and manageable from a free cash flow perspective, such as Emerson's (EMR A+) recent $1.5 billion purchase of Chloride, United Technologies' (UTX A+) recent $1.8 billion acquisition of GE's security business, and 3M's (MMM AA) recent spree of purchases exceeding $1 billion. Thus, we don't expect transactions will impair credit quality.

Overall, industrial companies continue to enjoy very strong balance sheets, impressive free cash flow, and improved margins after cost-cutting during the recession.

Technology
Cash is turning into the enemy across the technology sector. Record-low interest rates have pressured firms to either deploy cash, which the industry notoriously hoards, or borrow money to fund acquisitions, buybacks, and dividends. The blurring lines between several IT domains--software/hardware or networking/storage/computing, for example--have further fueled the technology acquisition binge. We expect the acquisition trend will continue as rivalry between tech giants escalates and these firms strive to offer customers end-to-end solutions.

Hewlett-Packard (HPQ AA-) and Intel (INTC AA) are clearly leading the acquisition charge. HP dropped nearly $4 billion on two deals in rapid succession, beating out Dell (DELL A+) in a bidding war for data storage vendor 3Par and quickly following with the purchase of security software firm ArcSight. Intel, a key HP supplier, kicked off the push among large tech firms into the security software market, dropping more than $7 billion on McAfee. The chip giant followed that move with a more traditional deal, spending $1.4 billion on Infineon's wireless chip business.

Both HP and Intel still have plenty of cash at their disposal, spending about a quarter and a third of available reserves, respectively. Of the two, HP seems likely to remain particularly active. Oracle's (ORCL AA) addition of dispatched HP CEO Mark Hurd to its executive ranks recently clearly signals the software giant's commitment to the hardware business and likely foreshadows additional acquisitions to come. We'd expect other tech conglomerates--such as Dell, Cisco (CSCO AA), and IBM (IBM AA-)--will also remain in the hunt for deals to keep pace.

Cisco made the biggest splash in terms of returning cash to shareholders with plans to institute a dividend at some point in the next year. The firm's targeted yield (1%-2%) implies a payout of up to $2.5 billion annually, a pittance relative to its $40 billion cash stake and $9 billion in free cash flow generated during fiscal 2010. Still, the move leaves only Apple (AAPL) among big tech's dividend holdouts.

Rumors have also swirled that Microsoft will issue as much debt as possible while still retaining its AAA credit rating, using cash to increase its dividend and share repurchases. Not to be left out, despite its rash of acquisition spending, HP further committed $10 billion to its share repurchase plan. Other notable firms that have announced major dividend increases or buybacks include KLA-Tencor (KLAC A+), a top bond pick that upped its dividend 67%, and Texas Instruments (TXN).

As long as rates remain low--and the cost of holding cash thus remains high--we'd expect tech firms to continue putting cash to work. We remain on the lookout for firms that are overreaching in this regard. Given the rock-solid balance sheets most firms in the industry enjoy and the nice rebound in cash flow many have posted over the past year, there's a lot of room for activity without meaningfully altering the industry's financial profile.

Utilities
In the near term, we expect credit quality to improve among utilities as third-quarter earnings will benefit from a demand surge as a result of record hot summer temperatures throughout most of the country coupled with an improvement in industrial demand. This anticipated strength in earnings could result in further credit spread tightening in the fourth quarter.

As a result of low rates and tight spreads along with robust demand for investment-grade paper, we note that issuance has been very strong in the third quarter, with approximately $15 billion of utility issuance in September alone. As an example, in early September Pacific Gas & Electric issued 10-year notes at a 3.50% coupon, representing just a 90-basis-point spread over the benchmark 10-year Treasury note.

Even sub-investment-grade independent power producer NRG Energy (NRG) was able to issue $1.1 billion of 10-year notes in late August at 8.25%. Market conditions permitting, we expect to see this trend continue in the fourth quarter as issuers take advantage of cheap financing to lower their cost of capital.

Looking further out, we expect several earnings headwinds during the next year or two from normalized weather and an increasingly unclear demand outlook. Increasing maintenance and capital expenditures to upgrade and replace infrastructure to meet tougher environmental regulations, energy efficiency standards, and renewable energy requirements also could be intermediate-term headwinds. Finally, the robust M&A activity in both strategic and sponsor driven deals (i.e. Mirant-RRI Energy and Blackstone-Dynegy) that we have seen year to date highlight further risk for credit investors in the utilities sector.

While there may be additional upside in the near term for investors in utility bonds, we believe the downside risks outweigh upside return potential in the sector.

 

Our Top Bond Picks
We pick bonds on a relative value basis. Typically, this means comparing a bond's spread against spreads on bonds that involve comparable credit risk and duration.

If the bond in question offers us a wider spread for a similar degree of risk, we'll conduct a closer examination.

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 a sustainable competitive advantage), and our year-by-year forecast of the firm's cash flows in comparison to the yield pick-up along the curve.

Top Bond Picks
	Ticker	Issuer Rating	Maturity	Coupon	Price	Yield (%)	Spread to U.S. Treas
Biogen Idec	BIIB	AA-	3/1/2018	6.875%	$115.245	4.445%	+223
KLA-Tencor	KLAC	A+	5/1/2018	6.90%	$111.500	5.059%	+279
Sealed Air	SEE	BBB	6/15/2017	7.875%	$108.500	5.791%	+380
Sprint Nextel	S	BB+	12/1/2016	6.00%	$97.750	6.444%	+451
KB Home	KBH	BB	2/1/2014	5.750%	$97.000	6.760%	+589
Source: FINRA. Data as of 09-17-10.

We think Biogen Idec (BIIB AA-) is a strong credit, given its current net cash and investment position and strong cash flow prospects. Share repurchases, potential acquisitions, and Tysabri problems could funnel some expected cash flows away from debt repayment. However, even with those risks to capital, we don't expect Biogen's ability to repay debtholders to come into question, and current spreads on its debt look much wider than merited to us. We believe investors looking for a high-quality health-care credit should consider Biogen's notes for their excess spreads relative to the risk.

While KLA-Tencor (KLAC A+) is modest in size and concentrated in the niche it serves, its entrenched position with customers and the feedback loop this creates reduce technology risk relative to other firms in the industry. KLA's 2018 notes yield more than 300 basis points above comparably dated Treasuries, a solid spread for a BBB-rated credit, let alone an A-rated issuer. We expect strong demand for semiconductor equipment will enable KLA to deliver strong results over the next couple of years. In the event of a change of control that causes a ratings downgrade, KLA is required to offer to repurchase the notes at 101% of par.

While the lingering asbestos liability associated with Sealed Air's (SEE BBB) acquisition of W.R. Grace's  Cyrovac assets undoubtedly weighs on its credit profile, we nonetheless regard the company as an investment-grade credit, due to the ample liquidity it has built up to fund the liability and the relatively steady nature of its business. The firm entered 2010 with $695 million in cash on the books, essentially earmarked for the fulfillment of the liability (ample revolver capacity is expected to cover the remainder). Once the asbestos liability flows off the books (tied to WR Grace's emergence from bankruptcy), we'd expect spreads to tighten, as adjusted coverage and leverage ratios should each improve by a turn.

Sprint Nextel (S BB+) has struggled over the past three years to stem customer losses, but the firm has managed to stay cash flow positive. Performance recently has been much improved, and we expect revenue and margins to stabilize over the next couple of quarters. Creditors have the added benefit of significant asset coverage and a management team that has clearly demonstrated a desire to reduce leverage as it comes due through 2012. The firm nearly has enough cash on hand to repay this debt already. Even with modest operational improvements, we expect Sprint will be on much firmer ground two years from now, allowing spreads on this bond to tighten considerably as the maturity shortens.

KB Home (KBH BB), like many of the builders, has a very well laddered debt maturity structure. All of the bonds are senior unsecured, and the spread curve is very flat. One of the issues that we would highlight and recommend is the 5.75% of 2014, which offers spreads around +100 bps wide of an average BB, as well as about +150 bps wide of D.R. Horton (DHI BB+) and +100 bps wide of Pulte (PHM BB-). This is the next meaningful maturity for the company, albeit only $250 million, and thus it is positioned well in the capital structure. KB's $1 billion of cash covers all debt maturities through this bond almost two times, so there is a healthy amount of room for a downturn before this maturity becomes a concern. We expect this spread to steadily decline as the maturity shortens and KB returns to profitability in line with our forecast.

Daniel Rohr, Joscelyn Mackay, Julie Stralow, Michael Hodel, Patrick Goff, Travis Miller, Rick Tauber, and James Sinegal also contributed to this report.

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