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Credit Insights

New Issue Corporate Bond Market Reaches a Frenzied Pace

The draw of low interest rates combined with tight credit spreads keeps issuers coming back to the market for more.

The combination of tight credit spreads and the lowest interest rates since the beginning of the year drove a frenzy of activity in the new issue market last week. With borrowing costs so low, even  Google (GOOG), which had never issued public bonds before and has $37 billion of cash on its balance sheet, couldn't resist the temptation to issue debt.

The Morningstar Corporate Bond Index may have widened 2 basis points last week to +139, but the fact that it only widened 2 basis points in the face of a deluge of new issues, weak economic indicators, and a choppy stock market is actually a sign of strength to us. Credit spread widening was driven by portfolio managers selling lower-conviction positions to make room for new issues, not by increasing risk aversion. There were a few bid lists out on the Street, but those were easily absorbed by dealer desks that had been low on inventory.

The next week or two may set for the tone for the credit market this summer. Because of the sheer volume of new issuance over the past two weeks, a significant portion of the forward new issue calendar has been cleared out in the near term. The draw of low interest rates combined with tight credit spreads will keep issuers coming back to the market for more, albeit at a slower rate than the pace of the past two weeks. We suspect that the volume in the new issue market will slow to a more normalized pace, and credit spreads should hold these levels as the recently issued bonds settle into a permanent home. In this scenario, we expect that credit spreads will continue their trend tighter over the course of the summer and take us back to the lows we experienced in April 2010. However, if the pace of new issuance keeps up at this frantic velocity or credit spreads widen as the market digests new issues, that could set the tone for a correction and lead to a 10- to 20-basis-point widening in credit spreads.

New Issue Commentary
Google issued $3 billion in 3-year, 5-year, and 10-year notes, its first foray into the public debt markets. Looking at our model, we expect Google will garner a strong credit rating. The spreads at which Google issued debt are comparable to the peer group, but we don't see much upside from here. A quick sampling of the firm's peer group:  Microsoft's (ticker: MSFT, rating: AAA) 4% notes due 2021 currently trade at +64;  Cisco's (ticker: CSCO, rating: AA) 4.45% notes due 2020 offer +93;  Hewlett-Packard's (ticker: HPQ, rating: AA-) 3.75% notes due 2020 offer +82; and  Oracle's (ticker: ORCL, rating: AA) 5.75% notes due 2018 offer +89. Comparatively, Cisco's notes look particularly attractive to us.

Google plans to use the proceeds to eliminate commercial paper borrowings and for general corporate purposes. The firm doesn't have the same issue with overseas cash that many of its large-cap technology peers do. Of its $37 billion in cash, only about $17 billion is sitting outside the United States. Microsoft, by contrast, has no net cash remaining in the U.S., while nearly 90% of Cisco's cash is sitting outside the country. Google is certainly taking advantage of the current interest rate environment to gain additional flexibility, but it hasn't revealed its future plans. Unlike many other cash-rich tech firms, Google has returned very little cash to shareholders via buybacks. The firm mentioned to us that it isn't philosophically opposed to share repurchases and that the board regularly discusses the matter, but it currently has no plans to introduce a buyback. Google also hasn't been especially acquisitive, spending a cumulative $6 billion in cash on deals during the past decade.

Google is a very strong company financially. The firm continues to build cash at a rapid clip--it produced more than $7 billion during 2010--and to this point its only debt outstanding has been around $3 billion in commercial paper. While the firm is heavily reliant on the paid search market, which accounts for more than 80% of sales, we believe its position in this market is extremely strong (we've given it a wide economic moat rating).

 Johnson & Johnson (ticker: JNJ, rating: AAA) priced $3.75 billion in notes. While we wouldn't be surprised to see these issues tighten in the secondary market, we think these new issues were priced at yields that fairly reflect the firm's credit risk.

The company appears to be taking advantage of low available interest rates to boost its financial flexibility before acquiring Synthes, a deal expected to close in 2012. We don't plan on adjusting our credit rating on J&J because of this new issuance, which in part will be used to repay existing commercial paper borrowings. Given J&J's very light leverage and cash-rich balance sheet, this modest amount of extra debt doesn't move the needle on our view of its credit profile. We are maintaining our AAA rating for Johnson & Johnson.

 

 Disney (ticker: DIS, rating: A+) priced $500 million in new 10-year senior notes at +60 basis points--roughly where  McDonald's (ticker: MCD, rating: AA-) issued bonds earlier in the week. At one notch lower because of a more cyclical business, slightly weaker credit metrics, and a lower percentage of free cash flow generated from sales, Disney's bonds look very expensive to us at these levels. While Disney operates in the entertainment industry, we believe its stability and robust growth outlook make it a better comparison with consumer defensive firms we cover that are considered household names. At +60 basis points, the firm's bonds would be priced similarly to where  Coke (ticker: KO, rating: AA-) and  Pepsi (ticker: PEP, rating: AA-) trade, but look expensive relative to  Wal-Mart (ticker: WMT, rating: AA) and  Procter & Gamble (ticker: PG, rating: AA). Despite their higher ratings, the last two firms have 10-year bonds that trade roughly 20 basis points wider than these Disney bonds may price.

 Centene (ticker: CNC, rating: BB) priced $250 million in 5.75% senior notes due 2017 that look modestly wider than we'd expect for a BB rated firm. However, at a credit spread of +384, the margin of safety isn't wide enough for us. Centene appears to be taking advantage of relatively low interest rates by refinancing its outstanding 7.25% senior notes 2014, but this action isn't enough to move the needle on our credit rating. Although Centene holds $1.0 billion in cash and investments compared with $305 million in debt on its balance sheet, investment income hasn't covered interest expense in the past couple of years. Also, despite seeing positive growth trends in its Medicaid niche, we don't particularly like the Medicaid business in which Centene competes. We don't think Centene possesses any sustainable competitive advantages. The barriers to entry for Medicaid managed-care organizations are quite low, and large commercial insurers like  UnitedHealth (ticker: UNH, rating: A-) and  WellPoint (ticker: WLP, rating: A-) appear to be targeting the Medicaid markets as promising areas for growth. If Centene doesn't get acquired, we suspect these larger insurance companies may be able eat away at market share in the Medicaid niche and potentially squeeze Centene's profitability prospects. Also, we think cash-strapped state governments may use recent financial woes to negotiate lower rates when current contracts expire. Given those factors, we remain comfortable with our BB rating for Centene.

 Aetna (ticker: AET, rating: BBB+) issued $500 million in notes due in 2021 at +118. That spread anchors on the agencies' ratings of around A-, a notch higher than we rate Aetna. The spread is too thin to tempt us. We take a differentiated view of Aetna's credit quality primarily because we don't believe scale on a national level (Aetna ranks number three in the U.S. by medical members) is enough to dig a moat in the managed-care business. Local scale is also critical, and Aetna typically doesn't garner enough scale in a particular geographic region to exert much pressure on local care providers. In addition, Aetna's customer mix is skewed toward large employers, which can hurt its bargaining power on customer contracts as well. These factors lead to a differentiated view on competitive advantages among the top managed-care firms, leading to a lower credit rating at no-moat Aetna than we give to narrow-moat managed-care firms United Health and WellPoint. The agencies don't appear to make that differentiation, leading to relatively unattractive spreads for the risk at Aetna, in our opinion.

Taking advantage of historically low interest rates and strong demand from fixed-income investors,  Norfolk Southern (ticker: NSC, rating: BBB+) issued $400 million of 100-year notes. The deal was increased from initial talk of $250 million and was priced at a yield of 6.00%, representing a spread of +175 basis points over the 30-year Treasury. That's an enticing yield, in our view, for an investment-grade name in a defensive sector, and we think buy-and-hold investors looking for yield should consider these bonds. The yield pickup is roughly 60 basis points over the company's 7.05% notes due 2037, which seems fair to us. From a total return perspective, the bonds don't look quite as attractive to us. If interest rates begin to rise, as expected, returns will suffer given the longer duration (albeit only about three years longer than the 2037 bonds) and less liquid nature of century bonds. Within the sector, we still prefer the bonds of  CSX (ticker: CSX, rating: BBB+) to Norfolk Southern. The CSX 7.375% notes due 2019 recently traded at a spread of +132 basis points, representing a 30-basis-point premium over the Norfolk Southern 5.90% notes due 2019. Given that we view both credits as having similar risk profiles, we think the CSX bonds represent value for investors looking to add exposure to the sector.

Overall, we believe  US Bancorp (ticker: USB, rating: A+) is one of the strongest players among the regional banks. The company generates about 40% of its normalized revenue from its payment processing and wealth-management businesses, which earn large returns without much capital commitment. These businesses played a large role in the stability of revenue during the credit crisis and allowed the bank to never lose money in any quarter during the crisis. While capital levels are in line with peers, we believe the above-average underwriting quality rating of the loan portfolio provides the company with a superior balance sheet. Currently, the ratio of allowance for loan losses to uncovered nonperforming loans stands at more than 180%.

The new US. Bancorp bonds appear cheap to us. By comparison,  PNC's (ticker: PNC, rating: A-) 10-year trades at about +110 basis points and  BB&T's (ticker: BBT, rating: A-) 10-year trades in the high +120s. While we are fans of those two banks, we rate both lower at A-. The biggest difference among the three banks is U.S. Bancorp's diversified revenue stream and extremely conservative risk profile. For us, giving up about 20 basis points is well worth the two-notch rating improvement.

 Alpha Natural Resources (ticker: ANR, rating: BB) placed $1.5 billion of bonds, consisting of $800 million 6.00% senior notes 2019 priced at +308 and $700 million 6.25% senior notes 2021 priced at +325. We think the new deals are priced rich compared with the credit quality of the company. Proceeds will be used to partially fund the $8.5 billion acquisition of  Massey Energy (ticker: MEE, rating: BB).

We  downgraded Alpha Natural Resources to BB from BBB- after the Massey transaction announcement, mainly because of the increase in debt leverage and heightened corporate business risk Alpha has to undertake with the additional Appalachian mines. We think the price Alpha paid for Massey's asset and legacy issues is lofty, and we think the bond prices do not fully compensate lenders for the risks associated with the Massey integration, labor relations, and legal issues. Compared with  Cloud Peak (ticker: CLD, rating: BB+)--our favorite name in coal--Alpha Natural Resources' new bonds offer less attractive returns, in our view. We rate Cloud Peak one notch higher than Alpha Natural Resources, as we like its better credit metrics and stronger, long-term low-cost Power River Basin operations. Cloud Peak's 2017 issue trades at a yield to worst of 5.63%, resulting in a spread of +483, and the 2019 issue currently trades at a yield to worst of 5.88%, resulting in a +467 credit spread.

Alpha Natural Resources plans to retire Massey's senior bond that matures in 2013 (callable at par) and Massey's convertible issue that matures in August 2015. Alpha did not have much debt outstanding before this deal, except a small 2014 issue that's trading at a 107.5 price with a spread of +362, and a 2015 convertible that has an exercise price of 51.19. The yield to worst of the 2014 issue is 5.97%, which we think is fair for a BB coal miner.

Click here to see more new bond issuance for the week ended May 20, 2011.

David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.