Credit Outlook: Sector Updates and Top Bond Picks

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Credit Sector Roundup
Banks
For nearly four months, the credit markets have been hit with wider spreads and increased volatility. No sector has been hit harder than the banks. While some of the concerns are due do a possible slowing economy and continued mortgage-related problems, the recent volatility appears also to have been driven by sovereign debt concerns out of Europe. It is hard to predict what will happen in Europe as there numerous outcomes for how the European sovereign debt situation will be resolved--from a disastrous contagious default and dissolution of the euro to a more benign support scenario where the European Central Bank can allow the governments to "muddle through" their problems. One thing is clear, however: The situation won't be resolved quickly, and credit spread volatility, especially for banks, will be with us for a while.

We expect that the credit metrics and balance sheets for U.S. banks will continue to improve, especially for the regional banks. Banks like PNC (PNC, rating: A-), BB&T (BBT, rating: A-), and Fifth Third Bancorp (FITB, rating: BBB+) have all decreased their percentage of nonperforming assets to total assets and have increased their LTM (last 12 months) return on assets--or in the case of BB&T, never had their LTM return on assets run negative. The regional banks in the U.S. have very little, if any, exposure to Europe. The current improved capital positions of these banks allow them to withstand any reasonable downturn in the U.S. economy. We continue to stress that while regional bank credit spreads may be volatile, investors should continue to focus on the banks' sound long-term fundamentals.

Like the regionals, we expect credit metrics for the larger banks in the U.S., such as J.P. Morgan (JPM, rating: A+) and Citigroup (C, rating A-), to continue to improve. While some of these banks have larger exposures to Europe, whether directly or indirectly, we believe that they are manageable. We also expect these names to be affected by continuing mortgage underwriting lawsuits from both the investors and homeowners, but that the potential losses from these cases are also manageable. The key exception, however, is Bank of America (BAC, rating: BBB). We have recently lowered our rating on Bank of America to BBB from A- on our belief that total mortgage underwriting-related losses could reach almost $60 billion and that BofA will need to increase its reserves accordingly for such losses. While we acknowledge that BofA could force its Countrywide Financial entity into bankruptcy, thereby insulating itself from lawsuits associated with Countrywide's underwriting, we doubt that this maneuver would alleviate BofA's obligations. We expect BofA's credit spreads to be even more volatile than those of its counterparts. While our expectation is that the bank will be able to meet all of its financial obligations, the possibility of a stressed scenario has increased.

Basic Materials
Bonds in the highly cyclical basic materials sector endured significant spread widening in the past quarter, markedly slowing the pace of new issue activity among the firms we cover. Given the significant strides many more leveraged firms in the space have made in extending their maturity profiles, we'd expect new issue activity to remain rather muted in the fourth quarter.

Some of the larger issues placed on the market in the third quarter came from companies that had agreed to acquisitions in a starkly different yield environment. Consider the case of Sealed Air's (SEE; rating: BB) largely debt-funded acquisition of Diversey. At the time the acquisition was announced in early June, the average BB name in the BofA Merrill Lynch Index sported an OAS of 384 bps. But by the time Sealed Air came to market on Sept. 16, with $1.5 billion in 2019 and 2021 notes, average BB spreads had blown out to 562 bps. The company ultimately priced the new bonds at coupons of 8.125% and 8.375%, respectively, far more than it probably hoped to achieve at the time of the deal's announcement.

While we've seen decent-sized, debt-funded M&A activity in many pockets of the basic materials sector this year--International Paper's (IP; rating: BBB) takeout of corrugated packaging peer Temple-Inland, agreed in September, being the latest--one corner of the sector that has been relatively quiet is arguably the one best-placed to undertake big deals: mining. Thanks largely to a post-crisis surge in Chinese metals demand, big miners are positively swimming in cash and, in our view, possess ample spare debt capacity. But the biggest of the big--the Vales (VALE; rating: BBB+), Anglos (AAL; rating: BBB), and Xstratas (XTA; rating: BBB-) of the world--have largely remained on the sidelines, perhaps balking at the high share prices assigned to potential targets.

To be sure, there's been some activity in the space--BHP's (BHP) acquisition of Petrohawk and the various U.S. coal deals being the most prominent examples--but it's a far cry from the flurry of large deals struck in the quarters leading up to the financial crisis. Given the recent negative trajectory of mining stocks, acquisitions could very well be looking increasingly attractive to many miners. As such, we could very well see a pickup in M&A activity in the fourth quarter and an accompanying uptick in new issue volume.

 

Consumer Cyclical
The global economic uncertainty has made bond investors skittish about cyclical firms, with credit spreads in the space--along with other industries--widening up to 100 basis points over the past quarter. That said, a flight to quality has prevented spreads on strong investment-grade issuers from expanding too much.

Accordingly, we continue to recommend certain solid credits that have economic moats, but we caution that spreads could continue to widen amid continued dislocation in the global markets. Darden (DRI; rating: BBB+) earns a narrow economic moat, and its brands have consistently outperformed the Knapp-Track industry same-restaurant sales benchmark. Given the firm's continued success, coupled with moderate lease-adjusted leverage in the mid-2 range, we believe the bonds trade much too wide and could tighten over time.

We continue to have strong conviction in wide-moat issuer Home Depot's (HD; rating: A) bonds, given the firm's positive credit trajectory and continued healthy free cash flow. Moody's recently upgraded the firm to A3 from Baa1 (moving closer to our rating), which should prove a positive catalyst to the bonds.

With stock prices tumbling and management teams' reluctance to increase capital spending, many firms are electing to return cash to shareholders. However, most have abundant free cash flow and are able to repay their debt and debt-like obligations even after these shareholder-friendly activities. Both Darden and Staples (SPLS; rating: BBB+) have Cash Flow Cushions above 1 times, indicating they should have little difficulty meeting their commitments. Darden has less than $600 million in debt due in the next five years, and while Staples has a significant amount of debt due in the next five years from the 2008 Corporate Express acquisition, the firm generates roughly $2 billion in annual free cash flow, and we expect it to largely pay down this debt, reducing leverage. As such, we do not view Darden's dividend hike and increased share repurchase target and Staples' new $1.5 billion share repurchase authorization as concerns from a credit perspective.

However, we are not so favorable on Sears (SHLD; rating: B+). We downgraded our credit rating again this quarter on softer long-term revenue growth assumptions and continued share repurchases amid rising leverage. With a Cash Flow Cushion just below 1 times our five-year base-case expense and obligation forecast, we expect the firm will barely be able to cover its debt and debt-like commitments and remain concerned that further share repurchases will reduce cash flow available to debtholders.

Consumer Defensive
Investors flocked to the consumer defensive sector during the third quarter as credit spreads widened out. Last quarter, we opined that this sector would outperform in an increasingly volatile credit market, and true to form, spreads within this sector have widened less than cyclical sectors.

Proving the sector's resilience, even in the face of widening credit spreads, the new issue market was very receptive to food, beverage, and tobacco issuers. Within our sector coverage, seven issuers raised $8 billion of new debt this past quarter. Over the course of the fourth quarter, we expect significant new issuance as corporations lock in remarkably low coupon levels, and we expect consumer defensive names will find the greatest receptivity until credit spread volatility abates.

As we highlighted last quarter, commodity prices have been increasing steadily. 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 over the next few quarters, and generating additional productivity gains will become increasingly harder. Fortunately, commodity prices appear to be decelerating and are now at a rate below retail prices. This should allow the food manufacturers to hold their margins through the rest of the year. Cautious consumer spending may pressure sales volumes, especially in markets plagued by high unemployment and elevated gas prices. However, we've generally factored in a modest deceleration in sales and earnings growth across much of the coverage universe against difficult back-half comparisons. Any material changes in consumer spending patterns or reignited inflationary pressures would prompt us to reassess our credit rating assumptions.

Campbell Soup (CPB; rating: A+) is representative of the type of issuer whose bonds we expect to outperform in a volatile market. We believe that the firm has a wide economic moat, a reinvigorated management team, and strong balance sheet. Based on Campbell's unrivaled economies of scale, market leadership in the U.S., and expansive global distribution network, the firm will be able to survive even in a protracted global economic recession. Our A+ rating is one notch higher than the rating agencies, and the firm's bonds are priced attractively compared with it peers.

Energy
Energy stocks as a group came under pressure during the August market sell-off amid renewed fears of recession and a credit crunch. Given the market's anxiety over the prospects for economic growth, we're unsurprised by the impact on the oil patch, as a recession would likely result in a drop in oil demand, particularly from Europe and the U.S. For the most part, we think these fears are overblown, as challenging oil supply dynamics and the continued pressure of emerging-market demand growth trump developed markets' demand response over the medium and long term, in our view.

Recession jitters translate to lower revenues for oil and gas producers, given lower near-term average selling prices. However, even WTI oil prices remain above levels where most projects are highly economic, and we do not see short-term oil price dips as a material threat to E&P credits. A sustained oil price collapse to below $60 per barrel would be a different story, as companies with less solid balance sheets and limited hedging could be forced to dial back drilling programs to preserve cash. Similarly, should events in Europe metastasize into a full-blown credit crunch, we could see a repeat of 2008-2009, when E&Ps concentrated on shoring up balance sheets through a combination of asset sales, joint ventures, and reduced drilling.

Gas-focused E&Ps continue to see low selling prices and little reduction thus far in gas production. For the near term, gas supply and demand fundamentals continue to weigh on prices, but we expect tighter environmental regulations for coal-fired generation to provide a needed catalyst for increased gas demand, suggesting improving fundamentals beyond 2011. On the supply side, gas-directed rig counts have fallen roughly 10% year over year, less than we had hoped to see by this time. Instead of a full gas drilling pullback, we've seen E&Ps shifting rigs from noncore dry gas acreage toward liquids-rich gas plays, where the associated natural gas liquids stream can materially boost netbacks.

We continue to see cash flow strength from integrateds, midstream firms, and services companies. Integrated oil and gas producers with significant international production continue to enjoy higher selling prices thanks to the significant Brent/WTI pricing differentials. Midstream firms, particularly MLPs, benefit from largely fee-based cash flow structures and new projects coming online to support shale development in the U.S. Services firms continue to enjoy significant pricing power in the U.S. and Canada, though a material slowdown in the oil patch would likely pressure currently attractive margins.

 

Health Care
This quarter, health-care firms will be coming to a crossroads of economic, regulatory, and reimbursement uncertainty. Specifically, while most display some level of recession-resistance, health-care firms can experience slower-than-normal growth during times of economic uncertainty, which appear to be upon us again. Also, device firms may gain more clarity on approval process changes in the U.S., which may alleviate uncertainty clouding the outlook on these firms while also ushering in a new era of regulatory hurdles.

On the reimbursement front, austerity measures in the developed world could cut reimbursement levels for care. For example, Medicare officials have proposed an overall reimbursement rate cut on in-hospital procedures in the low single digits for 2012, and if successful, we think this proposal provides a glimpse of how developed countries may react to large fiscal budget deficits and rising demand for health care due to a growing elderly population going forward.

With these ongoing uncertainties constraining stock prices, we may see well-capitalized health-care firms boost shareholder returns through higher dividends, share repurchases, and acquisitions in emerging geographic and technology markets. Those shareholder-friendly activities could keep bond spreads relatively wide at health-care firms--even those with strong balance sheets. For example, despite already possessing a cash-rich balance sheet, Stryker (SYK; rating AA) recently issued debt to finance corporate initiatives including acquisitions, repurchases, and dividends, which kept spreads modestly wider than expected for its credit profile, in our opinion. Also, we've seen some spread widening in recent months at potential acquirers, such as Thermo Fisher Scientific (TMO; rating: A+), which recently levered up to make two relatively large acquisitions in the life sciences sector, and at Express Scripts (ESRX, rating: A-) which is planning a colossal PBM merger with Medco (MHS, rating A-).

While shareholder-focused activities may cause short-term headwinds for existing debtholders, investors with long time horizons may see these wider spreads as buying opportunities. Specifically, in the proposed PBM merger, we think investors are being fully compensated for the risks associated with that combination, offering a compelling margin of safety to Express Scripts and Medco bond investors.

Industrials
Industrial credit spreads continued to widen with the broader market last quarter as investors fled risky assets in favor of safe haven investments such as Treasuries and gold. Mixed results during the second-quarter earnings season coupled with concerns surrounding the potential for a double-dip recession, the European debt crisis, and the Standard & Poor's downgrade of the U.S. combined to push spreads meaningfully wider. However, the rally in Treasury rates more than offset the spread widening we saw, resulting in meaningful new issuance as companies looked to lock in historically low yields.

Our outlook for most of the industrial space has not changed materially since last quarter, although there is heightened uncertainty regarding the pace and direction of the global economic recovery. We remain generally positive regarding the outlook for the diversified industrial sector. Although second-quarter earnings were mixed, most companies we follow continued to show improvement in key credit metrics, including leverage and margins. Our outlook for rails is also positive, buoyed by optimism regarding continued improvement in volume and pricing trends. Although spreads widened in these two sectors, they remain relatively tight, presenting few compelling opportunities, in our view.

We remain positive on the fundamental outlook for autos as we expect a rebound in new vehicle demand from the supply-driven weakness in the last few quarters. We like the bonds of both Ford (F; rating BBB-) and TRW (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 (BBD; rating BBB), which is benefiting from the upcycle in commercial aerospace and business jets.

Near-term softness in the housing and building materials sectors continues. However, we still like the bonds of Lennar (LEN; rating BB) and Owens-Corning (OC; rating BBB) due to 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.

Technology & Telecom
Turbulence hit the technology and telecom sectors during the third quarter, positioning them for an eventful, and potentially rocky, end to 2011.

The U.S. telecom industry has been placed in a holding pattern thanks to the Department of Justice's decision to challenge AT&T's (T; rating: A-) T-Mobile USA acquisition. We continue to believe that smaller players in the industry, including Sprint (S; rating: BB+), Leap Wireless (LEAP; rating: B-), and MetroPCS (PCS; rating: BB-), need to join forces, but these firms are certainly waiting to see what comes of T-Mobile USA and its assets. However, the three aforementioned firms posted weak second-quarter earnings, prompting both the equity and credit markets to shun each of them. A deal sooner rather than later is in the interest of the group, in our view, to maximize the odds of gaining financing needed to roll debt maturities and ensure financial flexibility.

On the tech side, we are seeing early indications of a slowdown in demand across the sector, with wireless handsets providing a possible exception. Several semiconductor firms have taken down revenue estimates recently, including Texas Instruments (TXN; rating: A+), Xilinx (XLNX; rating: A) and Altera (ALTR; rating: NR); these firms often provide a leading indicator of technology demand generally. Industry giant Intel (INTC; rating: AA) has yet to feel the effects of a slowdown, though, as enterprise and emerging-markets demand has offset weakness in the consumer PC market thus far. Intel took advantage of its position and pristine balance sheet to issue $5 billion of low-cost debt late in the quarter, adding straight debt to its capital structure for the first time in many years. Though Intel plans to use the proceeds to buy back stock and a downturn could crimp sales in the near term, we believe the firm's new notes are attractive.

We've long held that most semiconductor firms have built in the financial wherewithal to handle the cyclicality of the industry, making firms with strong competitive positions attractive investments if short-term pessimism pushes asset prices down. The analog semiconductor segment fits this bill currently. We recently added Analog Devices (ADI; rating: A+) to our equity best ideas list, and the firm's 2016 bonds are starting to look attractive. The spreads on these notes have widened about 25 basis points since July and now trade about 20 basis points wider than the typical A+ rated credit in the Morningstar Corporate Bond Index.

 

Utilities
American Electric Power's (AEP, rating: BBB+) announcement in September that it plans to split off its Ohio generation unit and assign existing utility debt to the commodity-sensitive unit caught bondholders by surprise. The plan, part of a settlement with opposing parties, would resolve the long-simmering debate around Ohio regulation that has weighed on our credit assessment. We remain concerned. If regulators were to approve this plan, it could be a bad omen for bondholders of other Ohio utilities such as Duke Energy (DUK; rating: BBB+), DPL (DPL; rating: BBB+) and FirstEnergy (FE; rating: BBB-).

The sector's four large pending M&A deals continue to creep toward closing. We see little impact on bondholders from the all-stock deals involving NSTAR (NST; rating: A) and Northeast Utilities (NU; rating: BBB); Exelon (EXC; rating: BBB+) and Constellation Energy; and Progress Energy (PGN; rating: BBB+) and Duke Energy. The fourth deal, involving AES (AES; rating: BB-) and DPL, is two-thirds financed after AES issued $2.05 billion of parent debt during the second quarter. AES has pledged to maintain the utility DP&L's capital structure, but extra leverage at the DPL and AES parents, management's stock buyback program, and proposed plans to initiate a dividend in 2012 raise concerns.

We expect new issue activity to stay active as utilities take advantage of low rates and low spreads to refinance and pre-finance some $90 billion of projected capital investment in the sector during the next few years. Given still-tight spreads on the high-quality issuers and lackluster earnings outlooks with a slow economic recovery, we urge bond investors to approach domestic utilities with caution.

If regulators continue to support M&A and rates stay low, we could see more leveraged deals like AES'. Highly levered deals for renewable energy projects remain hot for companies like AES, NRG Energy (NRG; rating: BB-), and others. Government loan guarantees have sped up the development pipeline this year, but the recent Solyndra bankruptcy in September could lead to higher rates and more skepticism from lenders and the Department of Energy.

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 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
Covidien	COV	AA-	2020	4.20%	$109.45	2.96%	126
Symantec	SYMC	A+	2020	4.20%	$101.17	4.04%	230
Citigroup	C	A-	2020	5.375%	$104.62	4.73%	301
Lorillard	LO	BBB	2020	6.875%	$109.66	5.45%	377
Ford Motor Company	F	BBB-	2031	7.45%	$111.87	6.38%	394
Data as of 09-26-11.

Covidien COV (rating: AA-)
We rate the firm AA-, reflecting its top-tier position in a variety of surgical instrument niches, including minimally invasive tools, which enjoy high barriers to success and low cyclicality. Also, we think its $2.4 billion net debt position as of the end of June is highly manageable. We expect the firm to generate $2.2 billion in free cash flow annually on average during the next five years, which should ensure repayment of debtholders. We think current yields being offered at Covidien remain attractive compared with other AA- firms. Also, we believe Covidien and other medical device firms often provide better opportunities for bondholders than similarly rated credits in the large pharmaceutical industry. Even compared with other similar medical device credits--such as Becton Dickinson, Medtronic, Stryker, and Zimmer--Covidien's issues often offer relatively attractive spreads.

Symantec SYMC (rating: A+)
Symantec has a solid balance sheet and record of consistent cash flow generation. The firm currently carries $2.3 billion in cash against a $2.6 billion debt load. Despite heavy share repurchases and acquisition activity over the years, Symantec has typically carried more cash than debt, though a recent acquisition has pushed leverage up a bit. Free cash flow has been positive every year for more than a decade, typically running at about 20% of sales. The firm's 2020 notes offer an attractive spread relative to our A+ rating (+95 is more typical) and trade more in line with the BBB rating the major agencies have placed on it. The bond is also attractive relative to other wide-moat software firms with similar ratings. Adobe's 2020 notes, for example, offer a spread of around +190. Finally, Symantec is required to repurchase these notes at 101% of par on a change of control that causes a rating downgrade. While we don't believe the firm is a strong takeover candidate in its current form, Intel recently acquired McAfee, its closest peer.

Citigroup C (rating: A-)
In May, we upgraded Citigroup from BBB+ to A-, 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 over the past year. Citigroup has placed its troubled assets associated with the housing bubble and financial market disruption into runoff mode and is concentrating on its core businesses where it has a competitive advantage. Over the past year, Citigroup has raised its Tier 1 common ratio more than 200 basis points to 11.3%, and it now stands in line with or better than peers. The company has also been able to reduce its nonperforming assets to less than 1% of total assets. As Citigroup continues to perform well over the next 12 months, we expect its capital ratios and balance sheet quality to meet or surpass other large well-performing banks.

Lorillard LO (rating: BBB)
The Food and Drug Administration's 90-day update on the status of its investigation into the use of menthol in tobacco turned out to be a nonevent and has no impact on our thesis. In a statement on June 27, the FDA said the Center for Tobacco Products was conducting an independent review of the scientific evidence relating to menthol's impact on public health. A draft of the conclusions of this review will be submitted for peer review and, we expect, will be released in the fourth quarter. This announcement does nothing to change our belief that ultimately, menthol will not be banned. First, the scientific evidence is ambiguous, making a ban of the $25 billion category and around one third of the total U.S. cigarette industry difficult to justify. Second, it is likely that an underground market for menthol cigarettes would emerge in the event of a ban. This would slash the tax revenue generated by federal, state, and local governments from tobacco (we estimate that taxes from menthol products contributed around $13.5 billion in total tax receipts in 2010). It would also take regulatory control of the menthol category out of the hands of the FDA, potentially leading to higher youth smoking rates, an outcome that would conflict directly with the FDA's aims. Third, the preferred brand of around 80% of African-American smokers is a menthol product. We think it is unlikely that a government agency would ban a product that is so popular in a key voting bloc just one year before a presidential election. We continue to believe that less draconian measures, such as tighter selling and marketing regulations, are a higher-probability outcome.

Ford Motor Company F (rating: BBB-)
Ford reported solid second-quarter results that were in line with its guidance at its recent analyst day. Net automotive cash improved to $8 billion, and the company continues to generate impressive cash flow performance. After significant second-quarter debt reduction, the firm still has $1.8 billion of secured bank debt in its capital structure, which we believe will be paid back within a few quarters. We have a very constructive intermediate-term view of Ford, the upcoming negotiations with the United Auto Workers notwithstanding. We believe the firm will eventually achieve investment-grade ratings at the agencies, representing a multinotch upgrade and driving spread tightening as investment-grade buyers move into the name.

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.