Rally on Rumors Rings Hollow
The markets were quick to give back rumor-fueled gains last week, but at currently heightened spreads, credit risk looks attractive from a fundamental viewpoint.
Never before have we seen the markets place so much faith in the hands of European politicians. At the start of last week, credit spreads began to tighten and the equity markets took off higher. The improvement in the markets was attributed to unsubstantiated rumors that European policymakers were close to formulating a comprehensive liquidity and recapitalization plan.
But the rumors appear to be for naught, as no formal news was released over the course of the week. By the end of the week, the credit market gave up the early-week gains and closed relatively unchanged. The Morningstar Corporate Bond Index ended the week at 250 basis points over Treasuries, 1 basis point wider than last week.
We were amazed at how much the markets had rallied on these rumors. While we fully expect that the European policymakers are working on such a plan, we were skeptical that politicians would be able to get each of the eurozone members to agree on a plan of action in such short order.
Trading volume in the credit markets was weak, perhaps suggesting that investors were not buying the hype. In fact, we heard from several sources that high-quality, short-dated corporate bonds were in demand, which suggests to us that many investors were shortening duration. We're not sure if investors are concerned that interest rates could rise or credit spreads could widen further, but either way, it had the feel that investors were looking to reduce risk.
As we have pointed out before, over the next few weeks (maybe months?) credit spreads will continue to be whipsawed by the headlines out of Europe. At these heightened levels, from a fundamental viewpoint, we think credit risk is attractive. In fact, we are beginning to find significant value in some of the more beaten-down issuers, such as those in deeply cyclical sectors.
New Issue Commentary
Bemis' New Bonds Look Relatively Cheap
On Tuesday, Bemis (ticker: BMS, rating: BBB+) announced it was offering $400 million in senior notes due 2021, with proceeds aimed at retiring its $300 million 4.875% notes due April 2012. The new unsecured bonds, priced at 258 basis points above benchmark Treasuries, will carry a coupon of 4.50%. The bonds came in about 25 basis points wide of Bemis' existing 2019s (thinly traded, but a decent-size trade was executed Monday at roughly 235 basis points above the curve), a reasonable difference thanks to a slightly longer duration and new issue concession.
Relative to our published BBB+ issuer rating, the new bonds look fairly cheap, offering a spread more typical of what we're seeing on BBB issues. At present, the average nonfinancial BBB in the Morningstar Corporate Bond Index carries a spread of 265 basis points above Treasuries, with the average BBB+ at 229 basis points above Treasuries, in our view suggesting decent spread-tightening potential or at least superior yield for the assumed risk. We expect the pace and magnitude of post-Alcan deleveraging will drive a good deal of the idiosyncratic movement in Bemis' spreads in the coming quarters. In our view, the company has the cash flow-generating capacity to take leverage back to pre-Alcan levels in relatively short order, but the pace of debt reductions may be slowed by increased distributions to shareholders ($123 million in share repurchases year to date).
Caterpillar Financial Adds on to Existing Bond Issue
Caterpillar Financial Services tapped the market this week, adding $250 million to its outstanding 2.05% due 2016, taking the total issue size up to $1 billion. Our A- rating on Cat Finance is directly linked to the rating of Caterpillar (ticker: CAT, rating: A-) based on the strong interrelationships between the two entities. Caterpillar enjoys a wide-moat position as the world's largest manufacturer of heavy equipment and has a very substantial dealer network, which allows it to dominate the U.S. market and provide competitive advantages. However, the cyclicality inherent in the company's business combined with the largely debt-financed acquisition of Bucyrus constrains our rating.
The new notes were issued at a spread of 100 basis points over Treasuries, about 5 basis points wide of where the existing 2016 bond was trading at the time, representing fair value to us. John Deere Capital (ticker: DE, rating: A), the best comparable, issued five-year notes in June at a spread of 65 basis points over Treasuries, and we recently saw them trading around +100 basis points. Given our one notch higher rating on Deere Capital and the similar spread, we maintain a slight preference for Deere Capital over Cat Finance.
Investors Receive Attractive New Issue Concession for High-Quality Issuer, but Bonds Still Expensive
Frequent debt issuer McDonald's (ticker: MCD, rating: AA-) came to market Tuesday with a $500 million (upsized from $350 million), 10-year issuance. At the time of the announcement, the firm's $400 million 10-year notes issued in May were trading around +45. Given McDonald's solid credit quality and investors' usual demand for the name, we were surprised to see the deal price well wide of where existing bonds were trading, at +78. Existing bonds widened accordingly, now trading around +60, and the new issue has tightened slightly, to around +70.
While we have a more positive credit opinion on McDonald's relative to the agencies (we rate the firm two notches higher) and acknowledge the bonds could compress to recent levels, we still do not find the bonds attractive. The average 10-year AA- credit in Morningstar's index trades just over +100. Additionally, similarly rated credits that also receive strong investor demand-- Coca-Cola (ticker: KO, rating: AA-), Pepsi (ticker: PEP, rating: AA-), and Wal-Mart (ticker: WMT, rating: AA)--all trade wide of McDonald's, with 10-year notes in the +90-100 area.
In the restaurant industry, we continue to favor Darden Restaurants (ticker: DRI, rating: BBB+). The firm's 6.20% notes due 2017 trade around +200, which we view as exceptional value for the narrow-moat issuer. Darden's brands have consistently outperformed the Knapp-Track industry same-restaurant sales benchmark, which we attribute to strong brand loyalty and an increasing emphasis on everyday value offerings. 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.
Benchmark Deal for 3M
Taking advantage of historically low interest rates, 3M (ticker: MMM, rating: AA) last week issued $1 billion of five-year notes. Its innovative culture, bottom-line focus, and low-cost manufacturing have carved a wide moat around its business that we believe will enable the firm to reap outsize rewards over the long run. Although 3M has several outstanding bond issues, they tend to not trade very frequently as investors typically buy the bonds and tuck them away for the long term. We expected the new bonds to be well received, and we weren't disappointed.
The new bonds priced at a spread of 65 basis points over Treasuries, which represented fair value to us. Looking at other highly rated comps, Coca-Cola and PepsiCo each have 2016 bonds that were quoted around 72 and 82 basis points above Treasuries, respectively. Procter & Gamble (ticker: PG, rating: AA), similarly rated to 3M, has a 2016 bond that was quoted much tighter, around 50 basis points over Treasuries. Looking at industrials, Illinois Tool Works (ticker: ITW, rating: AA-) has a 2021 bond that was quoted at a spread of 105 basis points over Treasuries. Assuming 20 basis points of spread to go from a 5-year to a 10-year would put a hypothetical ITW 5-year around 80 basis points over Treasuries. Since issuance, the new 3M bonds have tightened significantly, recently trading hands at a spread of close to 50 basis points over Treasuries. Although we are very comfortable with the credit, at these levels we think there is little opportunity for further spread contraction.
Sanofi Takes Advantage of Low Interest Rates to Issue New Notes
Last week, Sanofi (ticker: SNY, rating: AA-) issued $1 billion in senior unsecured notes due in 2014, which will be used for general corporate purposes, including the repayment of existing debt. We don't anticipate changing our credit rating as a result of this issuance. We think Sanofi is merely taking advantage of historically low interest rates and a calmer window around the European debt crisis. Given the volatility in the marketplace in recent weeks, pinpointing a fair spread was fraught with error. However, the firm issued debt in the middle of our projected range at 1.20%, or 83 basis points above Treasuries, which we deemed as fair. Last spring, the firm issued $750 million in three-year notes with a coupon of 1.625%, or a spread of 55 basis points above Treasuries.
As with most of the pharmaceutical firms we cover, we tend to take a more positive view of Sanofi's credit profile than the rating agencies do. However, the market often agrees with our assessment that these credits are high quality, and we rarely find attractive spreads at these issuers, especially when comparing them with the dividends offered on their equities. Sanofi's dividend yield currently sits above 4% and its stock is trading around 72% of what we believe it is really worth, which gives investors a significant margin of safety around their capital. For investors looking for income and not limited in security type, Sanofi's equity may be more attractive than its debt.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.