Mixed Performance Ahead for Credit Sector

Credit Sector Roundup
Banks
During the past quarter, large banks' credit spreads widened more than the index by approximately 10 to 20 basis points. This sell-off was driven by numerous factors including: potentially more restrictive capital requirements, the looming settlement from prior mortgage and foreclosure practices, the possibility of a weakening economy, and comments from the rating agencies about potential downgrades because of the loss of "too big to fail" status. One rating agency mentioned that some banks could even be lowered three to five notches when TBTF is removed. Compounding all these domestic issues was the looming possibility of a Greek sovereign debt default.

Overall, while many of these concerns are valid, we feel that they are accurately reflected in the relatively wide spreads of banks. More restrictive capital requirements on large banks would reduce overall profitability, but they would also serve to reduce the risks faced by bondholders. Although the economy has shown some signs of slowing, banks have not seen an increase in nonperforming loans and in fact have been able to reduce the amount of the nonperforming loans. Banks have also been steadily increasing their capital positions. Citigroup, for example, has raised its Tier 1 common ratio more than 200 basis points in the past year to 11.3%. We expect banks to continue building their capital ratios and should have little difficulty absorbing the effects of a slowing economy.

Analysis of a report from the Bank for International Settlements indicated that U.S. bank exposure to Greece totals $30 billion-$40 billion. That number, however, does not account for hedges or other security that the banks have in place to protect that exposure. We believe the actual exposure is a lot less. The real concern for U.S. banks would be if a Greek default led to a contagion panic across Europe leading to another credit crisis in the U.S. Although we think the probability of such an event is extremely low, we continue to monitor the situation closely.

Without TBTF status, it appears that rating agencies would rate big banks like  Citigroup (C) and  Bank of America (BAC) in the mid- to high BBB area, down from their low AA/high A current ratings. We, however, rate both banks at A-. Five-year credit default swaps on Citi and B of A are about 150 and 170 basis points, respectively. It is clear to us that the market already discounts the TBTF status, and though we expect some increase in CDS should the TBTF status be more explicitly removed, we doubt that it would have a meaningful long-term impact.

Basic Materials
After a couple years dedicated to repairing stressed balance sheets, we've begun to see firms in the basic materials sector undertake a more aggressive approach to capital structure management, highlighted by a return to large scale, debt-funded acquisitions ($2 billion-$5 billion range) in the past quarter. Given ample investor appetite for high-yield paper, acquirers have had little difficulty issuing intermediate and long-term debt to consummate deals.

In the near term, we expect acquirer credit metrics to materially deteriorate (see  Sealed Air (SEE),  Alpha Natural Resources , and  Arch Coal A (CI) for examples). Although we acknowledge that most acquirers trumpeted debt-reduction plans concurrent to their acquisition announcements, in many cases we doubt leverage can be reduced at the rate the companies foresee, and we have adjusted our credit ratings accordingly. Looking ahead, while investor appetite for high-yield issues seems to have waned somewhat (high-yield spreads have widened 35-40 basis points in the past few weeks), absolute rates nonetheless remain attractive to prospective acquirers looking to buy their way into growth. We expect the mergers and acquisitions trend to continue.

Consumer Cyclical
The muted economic recovery gives us pause when looking at the shareholder-friendly activities of many of the consumer cyclical names on our coverage list. We're concerned that some firms are banking on a stronger economic recovery than we foresee--particularly an issue for weaker credits. As we have previously stated, we believe management teams will continue to favor shareholders over bondholders throughout the year. That said, we expect firms to realize they may have gotten too far over their skis and reign in capital spending in the back half of the year.

 Best Buy (BBY) (rating: BBB-) recently announced a 7% dividend hike and a new $5 billion share-repurchase program. Given the firm's weak investment-grade credit rating and the strong potential for market-share loss as competition intensifies, we are concerned that this might not be a prudent move for the retailer. That said, we maintain our BBB- rating at this time. We downgraded  R.R. Donnelley & Sons   (rating: BB+), however, when it announced an accelerated $500 million share repurchase funded through its revolver. Management also stated that it is increasing its target debt leverage upward to 2.5 times-3.0 times from 2.0 times-2.5 times. From our perspective, not only is the firm clearly comfortable with holding more debt on its books, but it is willing to do so to benefit shareholders regardless of the effect upon the firm's credit risk and to the detriment of the existing bondholders.

More stable firms with higher credit qualities and wide economic moats are better-positioned in our view, and we do not have many issues with such firms' shareholder-friendly activities.  Home Depot  (HD) (rating A), is one such example, as it took on $2 billion in debt during the quarter to repay existing debt and for share repurchases. Home Depot remains one of our Best Ideas as its bonds trade roughly 30 basis points wide of  Lowe's (LOW). We find this differential to be much too large. Although we would expect Home Depot to trade slightly wider than Lowe's due to its marginally weaker credit metrics and lower credit rating (A versus Home Depot at A+), we think there is room for Home Depot's bonds to tighten.

We believe firms that need to pull back on spending later in the year could cause concern in the market, leading to wider credit spreads. Conversely, those firms that continue to perform well should be rewarded with tighter credit spreads. On the margin, however, we expect credit spreads in the consumer cyclical space to remain relatively flat as the market tries to determine the strength of the economic recovery.

 

Consumer Defensive
Issuers within the consumer defensive sector trade tight as compared with similarly rated issuers in other sectors. However, as opposed to earlier this year when we thought the sector would underperform as the credit markets strengthened, we believe this sector will perform admirably in a volatile credit market.

As we highlighted in the credit market overview, commodity prices have been increasing steadily for the past few quarters. Food and beverage manufacturing firms have thus far been able to withstand much of the increase in commodity costs as hedges and cost cuts have offset price increases. However, we expect that the benefit from hedges will fade during the next few quarters, and generating additional productivity gains will become increasingly harder. Fortunately, wholesale food prices appear to be decelerating and are now at a rate below retail prices for the first time since December 2009. This should allow the food manufacturers to hold their margins through the summer.

Food retailers have struggled to pass through price increases as cash-strapped consumers continue to live paycheck to paycheck. We expect that the supermarket sector will experience increased pressure on gross margins through August, when we expect the Food at Home Consumer Price Index to peak between 5% and 5.5%. Barring any natural disasters or further crop failures, we expect that food inflation moderates thereafter and stays in a manageable range through year-end. We expect credit spreads in the supermarket sector to be pressured throughout the summer and into the fall providing investors an attractive entry point. As the supermarkets' price increases catch up to producer price increases, we expect margins to normalize late this year and credit metrics to rebound.

The Finished Goods Food PPI is a three-month lead indicator for forecasting food inflation.

 Lorillard  (rating: BBB) bonds widened out 35 basis points to plus-283 last quarter after news articles highlighted the continuing overhang from the Food and Drug Administration's investigation on menthol products. The findings and recommendations from FDA's scientific panel concluded that menthol cigarettes have a negative impact on public health, but the panel fell short of recommending a ban on the use of menthol. In our opinion, we believe the FDA will implement additional marketing restrictions but will not ban menthol products. The bonds trade at a wide credit spread to compensate investors for the heightened credit risk as Lorillard derives substantially all of its cash flow from menthol products. Once the FDA releases its findings and assuming our opinion is correct, we expect credit spreads for Lorillard's bonds to tighten significantly.

Energy
As we head into the back half of 2011, we anticipate near-term weakness in gas prices to continue to pressure some E&P companies focused primarily on gas-directed drilling, but several firms have taken advantage of low rates and the market's hunger for yield to roll back near-term maturities, lessening the pressure of gas prices on cash flows. Looking beyond 2011, we think natural gas pricing fundamentals should improve, leading to a wave of long-awaited credit enhancement in 2012 and beyond, which makes 2011 an interesting year to consider gas-weighted E&P debt securities.

From a fundamental standpoint, we continue to believe that the combination of low gas prices, high service costs, less drill-to-hold acreage pressure, and weak internal cash-flow generation at E&P companies will sap the desire and ability to perpetuate the presently high active gas rig count. We've seen the shifting of capital expenditures and rigs from gas to liquids accelerate since the beginning of the year and expect to see this trend continue. Although this still argues for a weak gas price for the remainder of 2011, it should set up better fundamentals for gas-leveraged companies in 2012 and beyond.

Given all of the pain being experienced by gas-oriented E&P companies, it is somewhat unusual to note that U.S.-focused oil- and gas-services companies have continued to experience a period of very strong pricing power. Service-company consolidation and high oil and natural gas liquids prices, combined with a desire to drill-to-hold gas prospective acreage (even despite low gas prices), have contributed to strong services demand from U.S. E&P companies and pricing power for the services companies. Many E&P companies have thus felt the squeeze from both ends--lower gas selling prices and higher services costs--and earnings power has suffered. We think these dynamics are unsustainable longer term. Much like we expect higher gas prices in a few years, we question the ability for services companies to maintain present pricing power well beyond early 2012.

Alternatively, assuming a lack of leveraging M&A transactions, oil-weighted firms appear set for credit improvement in the remainder of 2011, as cash flows benefit from the higher oil prices we have been experiencing. Near-term oil price fundamentals continue to contrast sharply with gas fundamentals, and we think the market is largely factoring in better times ahead for those exposed to oil. Barring a collapse in demand due to economic weakness, marketplace fundamentals and uncertainty in the Middle East appear to support continued elevated crude oil prices.

 

Health Care
As we projected last quarter, higher commodity prices appear to be throwing a wrench in the economic recovery. Although most health-care firms display some level of recession-resistance, even health-care firms can experience slower-than-normal growth during times of economic uncertainty. For example, in the most recent recession, we saw potential patients who were either unemployed or worried about their jobs delay surgical procedures, including aesthetic, orthopedic, and even some cardiac surgeries. Going forward, if economic uncertainty weighs on health-care demand, we'd expect well-capitalized firms in affected niches to boost shareholder returns and growth opportunities through higher dividends, share repurchases, and acquisitions.

Those shareholder-focused activities could cause bond spreads to widen at health-care firms in the near term. For example, we've seen some spread widening in recent months at acquirers  Johnson & Johnson (JNJ) (rating: AAA), which plans to buy trauma device leader Synthes, and  Thermo Fisher Scientific T (MO) (rating: A+), which is leveraging up to make two relatively large acquisitions in the life-sciences sector. Although shareholder-focused activities might cause short-term headwinds for existing debtholders, investors with long time horizons might see wider spreads as opportunities to buy issues in economically sensitive health-care niches. For example,  Zimmer Holdings' (ZMH) (rating: AA) 2019 notes recently widened out after rumors of a potential acquisition emerged. Although  Dentsply (XRAY) won that bidding process, we think available spreads at Zimmer in recent weeks more than offset the downside risks associated with its potential acquisition of AstraTech, a dental implant subsidiary of  AstraZeneca (AZN) (rating: AA), which gave investors an opportunity to generate relatively high returns for the expected risk.

 Pfizer (PFE) (rating: AA) also appears to be considering divestitures of its consumer and animal-health businesses, and one use of proceeds could be share repurchases. Although our ultimate view of that potential deal would depend on transaction terms and subsequent capital allocation, we wouldn't expect Pfizer's long-term credit quality to fall dramatically as a result of those potential actions. However, we'd remind investors that Pfizer's dividend yield typically is higher than long-term bond yields, making the equity (which trades at a significant discount to our fair value estimate) more attractive than the debt at Pfizer in our opinion.

Industrials
The story last quarter was one of good news and bad news. In general, earnings trends remained positive across most of the industrial names we cover, driven largely by continued demand-side improvement. However, on the downside, concerns over the pace of the global economic recovery heightened as key economic indicators, including industrial production and the global purchasing managers' surveys, trended negative, and news from the labor and housing markets disappointed. Given this negative momentum, combined with significant new issuance, it's no surprise that we saw a widening of credit spreads during the quarter. Looking out over the next quarter, we think spreads will remain range-bound or drift wider until we gain more clarity regarding the pace and direction of the economic recovery.

Our outlook for most of the industrial space has not changed materially since the last quarter. However, it's probably fair to say our enthusiasm regarding the pace of the recovery, and therefore, near-term earnings outlooks, has been tempered somewhat by signs of a softening economy. We remain generally positive regarding the outlook for the diversified industrial sector. Although year-on-year comparisons are getting tougher to beat, we still think there's considerable room left in the capital-spending cycle. Our outlook for rails is also positive, buoyed by optimism regarding continued improvement in volume and pricing trends. Spreads in these two sectors, however, remain relatively tight, presenting few compelling opportunities, in our view.

We are also positive on the fundamental outlook for autos as we expect a rebound in new-vehicle demand from the supply-driven weakness in the second quarter. We like the bonds of both  Ford (F) (rating BBB-) and  TRW  (rating BBB-) as both companies continue to generate free cash flow and strengthen their balance sheets in an effort to achieve investment-grade ratings at the NRSROs. Also potentially on the way to investment-grade is Bombardier (rating BBB), which is benefiting from the upcycle in commercial aerospace and business jets. We expect near-term softness in the housing and building-materials sectors, though we continue to like the bonds of  Lennar L (EN) (rating BB) and  Owens-Corning (OC) (rating BBB) because of strong execution and good liquidity. Finally, we remain cautious on the high-grade defense sector given the tight trading levels combined with the ongoing uncertainty around defense spending and the appointment of a new Secretary of Defense. That said, BAE Systems (rating A-) jumps out as particularly cheap given its strong balance sheet and diverse customer base.

Technology
Acquisition activity remains high among well-positioned, financially strong tech companies, a trend we expect will remain in place for the foreseeable future. During the past quarter,  Applied Materials (AMAT) (rating: AA-), the strongest credit in our semiconductor equipment universe, agreed to purchase  Varian Semiconductor  (not rated) for $4.9 billion, while  Microsoft (MSFT) (rating: AAA) picked up Internet phone specialist Skype for $8.5 billion. We don't believe either deal will erode the credit quality of the acquiring firm, though we think Applied's purchase makes greater strategic sense. The firm will bolster its core chip equipment unit with a business that has ideal characteristics, including a strong market position and above-average growth characteristics. Applied has run with very little debt during the years, but it issued $1.8 billion of 5-, 10-, and 30-year notes in early June to finance the Varian deal. The spreads on these notes have tightened since issue, but we believe they remain attractive. For example, the 2021 notes, issued 138 basis points over Treasuries, now trade at plus-118, which is still wide given our rating on Applied (plus-85 would be more typical for the rating).

Despite the lure of low yields, tech and telecom debt issuance has remained relatively subdued; outside of acquisition funding, most firms simply don't need cash. Of the roughly 80 companies we've rated across the sectors, second-quarter issuance totaled $21 billion versus $23 billion the quarter before. One surprise new issuer did come to market, though:  Google (GOOG) (rated AA) issued $3 billion of notes at the end of May. In stark contrast to Applied, Google doesn't need the cash--it is sitting on $37 billion already, with $20 billion of that in the U.S.--and has no immediate plans for it. Instead, the firm appears to have merely taken the opportunity to raise cheap funds. The firm's 2021 notes priced at plus-58 and have since widened to plus-69, still too tight for our taste. The contrast between Applied and Google provides a nice reminder that debt issued for a solid business purpose is often a better deal for investors than that which is issued primarily to take advantage of market conditions. This holds particularly true in the cash-rich tech sector.

 

Utilities
After three quarters of fast-pace M&A activity in the utility sector, we expect the deal flow to slow in the second half of 2011.  Exelon's (EXC) (rating: BBB+) $7.9 billion bid for Constellation Energy in April topped the list of recent activity but should have minimal impact on either company's bondholders given the all-stock currency. All of the big deals in the sector thus far have been all-stock transactions, preserving or even enhancing credit quality.

For those utilities that have proposed deals in the works, the heavy-lifting to obtain state regulatory approval has just begun. As proposed deals work through numerous approvals, we will get a better sense for how receptive state regulators are to leveraged deals like  AES' (AES) (rating: BB-) bid for  DPL  (rating: BBB+) and to synergy-rich deals like  Duke Energy's (DUK) (rating: BBB+) bid for  Progress Energy  (rating: BBB+). Notable trends from these regulatory decisions could affect our outlook for M&A activity and credit quality across the sector.

We also anticipate seeing a continuation of healthy bond issuances given persistently low Treasury rates, tight investment-grade credit spreads, and some $90 billion of planned annual capital investment in the industry the next few years.

From an operating perspective, we expect to see several earnings headwinds during the second half of 2011 from a return to normalized weather and a subdued demand outlook. Residential and commercial demand, which account for about 70% of total demand, continue to lag the industrial recovery. 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 headwinds that utilities will face over the intermediate term.

Given these near-term challenges and the still-tight spreads on the high-quality issuers, we urge bond investors to approach domestic utilities with caution.

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.

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 advantages), and our year-by-year forecast of the firm's cash flows in comparison to the yield pickup along the curve.

Top Bond Picks
	Ticker	Issuer Rating	Maturity	Coupon	Price	Yield (%)	Spread to U.S. Treas
BAE Systems	LSE: BA.	A-	2027	7.50%	$120.46	5.55%	220
Celgene	CELG	A	2020	3.95%	$67.61	4.26%	143
Cisco	CSCO	AA	2020	4.45%	$105.08	3.75%	110
Citibank	C	A-	2020	5.375%	$105.15	4.67%	188
Posco	PKX	BBB+	2020	4.25%	$95.25	4.89%	192
Data as of 06-22-11.

BAE Systems (rating: A-)
We like BAE's solidly entrenched position in the defense industry which allows it to warrant a narrow economic moat. Given that, we are comfortable extending out to this long-dated maturity and capturing a healthy yield. We would buy all of BAE's bonds, as they trade at discounts of 40-80 basis points across the curve to other defense firms such as Northrop Grumman (NOC) (A) and Raytheon   (A). We believe this spread premium is excessive for the credit quality, even considering BAE is a yankee issuer in the 144a market. We also note that BAE's 2019 bond trades around plus-159, a significant discount to the Morningstar A- index. Although we do not see BAE as a deleveraging story, with flat earnings before interest, taxes, depreciation, and amortization projected over our forecast horizon due to softness in defense budgets, we also note that BAE sits in a nearly net-cash position and thus has excellent liquidity and financial flexibility.

Celgene C (ELG) (rating: A)
We think this Celgene issue offers higher potential returns than the risks implied in our A credit rating. We're using the 2020 maturity (T+129) as the firm's representative issue. However, its 2015 notes look relatively attractive to us, too; they recently traded at T+109. Given the firm's narrow moat (rather than wide moat), we'd remain cautious about the firm's 2040 issue (T+148), however, because of the many uncertainties associated with its prospects during the next three decades. Overall, we like Celgene's business prospects especially during the next 10 years and its light financial leverage. We think the firm's moat is primarily built around its expertise in hematological oncology therapies (Revlimid, Thalomid, and the recently acquired Vidaza). Revlimid represents about 68% of the firm's sales, and we expect significant growth from this drug in our bas- case scenario through its patent expiration in 2019, despite secondary primary malignancies that have emerged as a key safety risk. Given the drug's pending expanded approval in Europe and efficacy data that outweigh safety risks (patients still live longer than they otherwise could even with the additional malignancy risk), we think it would take worse data to cause declines in Revlimid's usage at this point. With a net cash position in excess of $1 billion and the potential to add at least $1 billion in free cash flows annually even in our pessimistic Revlimid scenario, we remain comfortable with our A credit rating for Celgene. Of note, Celgene also remains acquisitive. Althoughe we think tuck-in acquisitions remain the most likely use of excess financial resources, especially during the Abraxis integration, Celgene may consider certain acquisitions, such as Onyx Pharmaceuticals  , at the right price, too. Depending on terms of potential deals like that, we could still see current spreads at Celgene as relatively attractive.

Cisco Systems  (CSCO) (rating: AA)
Cisco might lack the flair of newer tech giants like Google, and the firm has hit a couple speed bumps recently. However, we believe it is one of the best-positioned players in the IT hardware sector. The firm also boasts a pristine financial position, with more than $43 billion in cash and investments set against $16.7 billion in debt. As the dominant provider of data-networking equipment, Cisco enjoys significant scale advantages, and its customers face meaningful switching costs. With a wide economic moat protecting the core switch and router business and management starting to exit noncore, highly competitive markets, we expect Cisco will have little trouble meeting its obligations for at least the next decade. The 2020 notes offer a spread more typical of a weak A rated issuer and significantly wide of the spread our rating--or the slightly lower rating from the agencies--would suggest is appropriate. The notes also offer a very strong yield relative to many other tech heavyweights, including Google. Rival Juniper Networks (JNPR) (rated A), which we believe is a substantially weaker credit, offers only modestly wider spreads on its notes.

Citibank  (C) (rating: A-)
In May 2011, we upgraded Citigroup from BBB+ to A-. The upgrade was driven primarily by a change in the economic moat rating to narrow from none as well as the increase in capital the company had been able to achieve during the past year. Citigroup has placed its troubled assets associated with housing bubble and financial market disruption into runoff mode and is concentrating on its core businesses where it has a competitive advantage. During the past year, Citigroup has raised its Tier 1 common ratio more than 200 basis points to 11.3%, and it stands in-line with, or better than, its peers. The company has also been able to reduce its nonperforming assets to less than 1% of total assets. As Citi continues to perform well during the next 12 months, we expect its capital ratios and balance sheet quality to meet or surpass other large well-performing banks. As such, we feel that there should be little difference in the credit spreads of large well-performing banks. For comparison, a newly issued 10-year note from U.S. Bancorp (USB) trades with a spread of 95 basis points.. Although U.S. Bancorp has performed extremely well throughout the credit crisis, and we rate it an A+, we expect that Citi's performance during the next 12 months will drive the firm's rating metrics closer to U.S. Bancorp's. As this happens, we expect the difference in credit spreads to lessen.

POSCO  (PKX) (rating: BBB+)
POSCO is the largest steel producer in South Korea and operates two highly efficient steel mills. We think the company's dominant position in its home market and strong regional presence (facilitated by very low-cost operations) serve to mitigate the potentially balance sheet-damaging effects of the inevitable swings in steel demand and prices. Although POSCO's bonds tightened somewhat recently in anticipation that the company will capitalize on the regional supply shortage caused by the Japanese earthquake, we still see attractive absolute value in the bonds. We've highlighted the 2020s which trade about 40 basis points wide of the average nonfinancial BBB+ credit in the Morningstar Corporate Bond Index, which traded at 150 basis points over Treasuries as of May 26, 2011. For reference, POSCO's U.S. peer Nucor's comparably dated 2022 issue trades at T+100. Although we rate Nucor a notch higher than POSCO, the prevailing spread between the two firms' bonds seems too wide.

Daniel Rohr, Joscelyn Mackay, Julie Stralow, Michael Hodel, Jim Leonard, Rick Tauber, Jeff Cannon, Min Tang-Varner, Travis Miller, and Jason Stevens also contributed to this report.