Credit Outlook: Sector Updates and Top Bond Picks

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Credit Sector Roundup
Banks
Last quarter we predicted that U.S. bank credit spreads would continue to be volatile, and the market certainly met our expectations. For example, the five-year credit spread for Citigroup (C, rating: A-) had a high of over 350 basis points and a low of 220 basis points for the quarter. Morgan Stanley (MS, rating: BBB) was even more volatile with its five-year credit spreads hitting a high of over 600 basis points and low of 300 basis points for the quarter.

The main source for all of this bank volatility is the possibility of a European financial crisis due to European sovereign debt problems. The market remains concerned that a European financial crisis could have serious direct and indirect effects on U.S. banks. European governments and the European Central Bank continue to attempt to address the primary issues, but to date they have not successfully achieved a comprehensive solution, which would include real enforcement measures and enable the European Union to require countries to follow a long-term plan. Even if they propose a comprehensive solution, we question whether or not European governments would have the populace support to implement such changes. We, therefore, continue to expect that bank credit spreads will remain volatile over the near term, and, for now, we believe this situation could remain for several quarters.

Even though U.S. bank credit spreads are volatile, the credit metrics for the banks continue to improve. Banks, and especially regional banks, are decreasing their percentage of nonperforming assets and increasing their core Tier 1 capital. We expect this trend to continue. Due to the flattening of the yield curve, however, we expect that bank net interest margins will continue to decline, damping overall returns and hurting the return on assets. As for European exposure, we continue to maintain that regional banks in the U.S. have very little, if any, exposure to Europe and that the large U.S. banks have manageable exposure. The overall situation in Europe, however, will still be the main catalyst for credit spread movement in the banking sector.

Basic Materials
Basic materials bonds endured a wild ride in the fourth quarter, with day-to-day movements in spreads particularly exaggerated for industries levered to global industrial production and companies tied to European macroeconomic conditions. Despite what seem like weekly announcements by European politicians of critical "breakthroughs" in efforts to resolve the sovereign debt crisis, it's highly unlikely that the New Year will bring an end to the kind of whipsaw volatility in bond spreads that defined the fourth quarter.

From our perspective, the big swings have afforded opportunities to snap up solid investment-grade paper at spreads more indicative of high-yield land. One such name that periodically pops up on our radar has been ArcelorMittal (MT, Rating: BBB-), which we've been happy to add to our Best Ideas list when spreads have blown out to levels far exceeding our assessment of underlying credit risk.

Although we expect headlines out of Europe will continue to play a big role in basic materials bonds in the first quarter of 2012, we think macroeconomic conditions in the benighted continent are likely to share some of the unwanted spotlight with what has hitherto been the global economy's model student: China. Here, we've begun to see worrying signs, particularly as it pertains to the real estate market, where prices have begun to turn over and transaction volumes have dropped. Most commentators seem to expect Beijing to ride to the rescue, pulling multiple policy levers to relax the flow of credit (see, for example, the early December 50-basis-point cut to the reserve requirement ratio) and keep the situation from spiraling out of control.

Yet while policymakers in Beijing probably have more room to operate than their counterparts in Brussels or Washington, this isn't what we'd term an "easily managed" situation. After all, Beijing can increase the supply of credit all it wants, but it can do little in the near term to stimulate demand for credit. At the end of the day, the latter is really a story of sentiment. If homebuyers (many of whom are investors with no intention to occupy a purchased property) perceive that the real estate market is no longer the massively profitable one-way bet it has been for the past decade, things could spiral out of control pretty quickly, with potentially serious ramifications for the balance sheets of Chinese banks and local governments, both of which are significantly levered to the fortunes of the real estate market.

As far as basic materials bonds are concerned, significant deterioration in Chinese real estate construction activity--a primary pillar of the country's unprecedented fixed asset investment boom of the past decade--would hit miners especially hard, particularly those focused on the building blocks of China's boom: iron ore, metallurgical coal, and copper. With this risk in mind, we'd suggest current and prospective investors pay particularly close attention to the cost positioning of firms in this space, favoring low-cost producers, such as Southern Copper (SCCO, rating: BBB+) and Vale (VALE, rating: BBB+), that would be able to weather a sharp and sustained drop in price realizations better than more marginally positioned peers.

Consumer Cyclical
The dislocation in Europe and concerns about the domestic economy have driven most consumer cyclical credit spreads to the widest we've seen in the past year. Although this indicates that many bonds may look attractive, we still caution investors to be selective as shareholder-friendly actions or M&A activity could drive spreads even wider.

This was seen clearly with Lowe's (LOW, rating: A), which widened its lease-adjusted leverage target to 2.25 times from 1.8 times and took on $1 billion in debt for share repurchases. As a result, bonds widened 20-40 basis points. Prior to these announcements, we downgraded the firm on higher leverage due to share-repurchase activity. Still, we believe the market's reaction is overblown. With moderate leverage and strong free cash flow generation, we believe the bonds of this wide-moat issuer should trade on top of the Morningstar A index--yet they trade roughly 20 basis points wider.

We expect commodity costs to abate as we enter 2012, taking some pressure off many of our consumer cyclical names--particularly the restaurants. Darden (DRI, rating: BBB+) is still our top pick in the space despite its recently lowered fiscal 2012 outlook. We suspect food costs hit the firm harder than expected and Darden was unable to mitigate the higher input costs with reductions in labor and restaurant expenses as it has in the past. Bonds widened 10-15 basis points on the news, but we believe spreads will tighten as we expect Darden will reverse its margin losses. Additionally, Darden is less leveraged than restaurant chain Yum Brands (YUM, rating: BBB+), and we believe there is an attractive relative-value play, with Darden's 2021s trading over 70 basis points wider than Yum's bonds of similar maturity.

A final trend we expect to see in the consumer cyclical space in 2012 is an increasingly competitive environment in office products and consumer electronics, thanks to increasing market share from Amazon (AMZN) and mass merchants. In office products, these newer entrants--all known for being low-price competitors--could pressure prices within the category, leading to margin erosion for Staples (SPLS rating: BBB+), Office Depot (ODP, rating: B-), and OfficeMax (OMX, rating: B-). That said, we don't see the competition as a catalyst to push spreads of these firms wider. On the other hand, our pessimistic expectations for the consumer electronics industry govern our opinion on the bonds. While the levels on both Best Buy's (BBY, rating: BBB-) and RadioShack's (RSH, rating: B+) bonds may look attractive, the competitive challenges weigh on our opinions of their bonds, and we see more downside than upside.

Consumer Defensive
For the past few quarters we have opined--and we continue to believe--that the consumer defensive sector would provide a safe port in the storm for bond investors as market volatility has impacted all asset classes. Commodity cost increases have been generally slowing, and inflation expectations remain under control. Margin pressures should ease over the next few quarters as many firms in the sector have increased prices to offset the higher input costs; however, we don't expect margins to return to pre-2011 levels and think they will remain constrained. Further price increases will be tough to pass through as private-label competition and consumer pushback will constrict volume growth.

The main risks to credit quality in the sector will likely stem from management teams looking to enhance shareholder value through financial engineering, often to the detriment of bondholders. A number of firms, such as Kraft (KFT, rating: BBB-), Ralcorp (RAH, rating: BBB+), and Sara Lee (SLE, rating: BBB) have pursued spin-offs and break-ups in order to unlock shareholder value. We see this trend continuing in 2012 as management will have a tough time enhancing shareholder value through top-line growth or additional cost-cutting programs. Debt-funded share buybacks could also pressure credit quality, but in this volatile environment we expect management teams would limit the size of share buyback programs to fit within their existing credit rating profiles.

Safeway (SWY, rating: BBB) issued new five- and 10-year bonds this past quarter at a significant concession to where its existing bonds were quoted. We think that the bonds are attractively valued both compared with its peer Kroger (KR rating:BBB) and compared with the Morningstar BBB Index. Depending on an investor's time horizon, both the five-year and 10-year bonds provide good value compared with the underlying credit risk. Based on our expectation for modest inflation and payroll gains, we believe Safeway is well positioned to return to positive identical-store sales and improved results.

Energy
Despite looming financial storm clouds on nearly every horizon, oil prices have remained persistently high and relatively stable during 2011. We're less sanguine that this will be the case in 2012. Currently strong emerging-markets demand has OPEC producing flat out, and there's very little spare capacity in the system, supporting high prices. Geopolitical tensions have also helped support prices since the Arab Spring, most recently with renewed fears over possible Iranian retaliation over trade embargoes. But with Europe apparently entering a major recession and China bracing for a potential "hard landing," we fear that 2012 could be a rough ride for energy investors.

Recession jitters translate to lower revenues for oil and gas producers, given lower near-term average selling prices. However, even West Texas Intermediate (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
The fourth quarter of 2011 was marked by massive debt issuance in the health-care industry. Through Dec. 12, 10 rated firms in the industry had cumulatively tapped the market for about $27 billion in new debt. Although we take a differentiated view of many health-care issuers versus the rating agencies--often leading to attractive spreads for the risk, in our opinion--we suspect that many investors experienced indigestion swallowing this much new debt in the quarter, widening spreads more than normal in the industry.

As such, we added three new issuers to our Best Ideas list in December. We see attractive value in Amgen's (AMGN, rating: AA-) new issues, which are trading at about double the spread of the average company with its very low risk profile. We also believe investors would be well-served by considering managed care organization Amerigroup's (AGP, rating: BBB-) debt rather than Cigna's (CI, rating: BBB-) debt, as it offers a spread that is nearly 250 basis points wider on its 2019 issue than similar credit Cigna's 2022 issue. We see a similar relative valuation play with Zimmer's (ZMH, rating: AA) new notes compared with Stryker's (SYK, rating: AA) notes.

While some health-care debt was placed to fund previously announced acquisitions--such as the Express Scripts (ESRX, rating: A-) merger with Medco (MHS, rating: A-) and Gilead's (GILD, rating: A) Pharmasset acquisition--much of the new debt was issued to either refinance existing issues at relatively low rates or to boost shareholder returns in these uncertain times through share repurchase and dividend activities. Although spreads remain wider than normal, prevailing interest rates remain low, so we wouldn't be surprised to see health-care organizations continue taking on more debt in order to lower borrowing costs or boost shareholder returns in early 2012.

This past quarter, Gilead was the only downgrade we made due to capital-allocation practices, but we could see further downgrades next quarter if shareholder-friendly (rather than debtholder-friendly) activities escalate in the industry. For example, we could see large health-care firms take Abbott Laboratories' (ABT, rating: UR-) lead by splitting up unrelated segments. Pfizer (PFE, rating: AA) has already outlined plans to eventually split off its animal health and nutrition businesses. Depending on how that or other deals in the industry are structured, we could see divestitures eat into credit ratings at health-care firms that are looking to boost returns for shareholders.

Industrials
Across the industrial landscape, we would expect the opening quarter of 2012 to look somewhat similar to the past couple of quarters. Although fundamentals likely argue for tighter spreads than we're currently experiencing, the ongoing crisis in Europe will undoubtedly continue to play a significant role in the pace and direction of where spreads go from here.

Across the key subsectors, we remain generally positive regarding the outlook for the diversified industrials sector. Although third-quarter earnings were mixed, most companies we follow continued to show improvement in key credit metrics, including leverage and margins. Our outlook for rails also remains positive. Third-quarter earnings were generally strong, buoyed by optimism for continued improvement in volume and pricing trends, and we expect these trends to persist over the near term. However, on a relative basis, spreads in these two sectors remain tight, presenting few compelling opportunities, in our view. In the agricultural and construction equipment space, fundamentals continue to improve out of the downturn, although leverage has ticked higher for several names due to debt-financed acquisition activity, and we generally view the sector as fairly valued at this time.

We remain positive on the fundamental outlook for autos as we expect a rebound in new vehicle demand from the supply-driven weakness of the past few quarters (e.g., Thai floods and the Japan earthquake). This could cause spreads to grind tighter, and in the industry, we still like the bonds of TRW (TRW, rating: BBB-) as the company continues to generate free cash flow and strengthen its balance sheet 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.

We expect to see continued trough conditions in the housing and building materials sectors. 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 uncertainty surrounding defense spending, exacerbated by the failure of the supercommittee to reach an agreement on further deficit-reduction plans.

Technology & Telecom
The early signs of a slowdown in semiconductor demand that we highlighted a quarter ago have continued to grow. Notably, giants Intel (INTC, rating: AA) and Texas Instruments (TXN, rating: A+) sharply lowered their sales outlooks for the fourth quarter in early December. However, many of the issues facing the semiconductor sector remain shorter term in nature, in our view. Intel blamed the entire slowdown in its business on PC supply-chain issues stemming from the flooding in Thailand.

TI also noted the flooding issue and stated that customers across most end markets are reducing inventory. Communications infrastructure appears to be the most important headwind facing the company, as management believes that the now-failed merger between AT&T (T, rating: A-) and T-Mobile caused both firms to cut equipment spending. At some point, customers will need to replenish chip inventory levels, especially if they see an uptick in demand and as wireless carriers around the globe continue to expand their wireless networks. Importantly, balance sheets across the sector remain generally strong, with many firms building cash during the upturn.

Although AT&T's pursuit of T-Mobile has ended, the deal continues to haunt the telecom sector. Smaller players in the industry, in need of consolidation to better compete with AT&T and Verizon Wireless, remained largely stuck as they awaited T-Mobile's fate. The impact of this position was most clearly felt at Sprint (S, rating: B+), which was forced to raise capital in November on very unattractive terms. We lowered our credit rating on Sprint during the fourth quarter as a result of the competitive challenges it faces, though we believe the credit market has overly punished the firm.

M&A activity has ramped back up in the tech sector, with software taking center stage recently. On-premises software vendors have started picking up software-as-a-service firms to retool their product portfolios. Oracle's (ORCL, rating: AA) purchase of RightNow, SAP's (SAP, rating: A+) acquisition of SuccessFactors, and IBM's (IBM, rating: AA-) addition of DemandTec all fit this trend. With several SaaS targets remaining and loads of cash on the books at several mature software firms, we believe that these recent acquisitions could be the start of another acquisition wave.

Utilities
Two environmental regulations that the U.S. EPA finalized this year continue to cloud the utilities sector's near-term landscape. Coal plant retirements and increased capital investment are two likely outcomes from the EPA's Cross-State Air Pollution Rule (CSAPR) and the Air Toxics Rule. Additional environmental rules could follow in 2012-13 addressing water cooling and coal ash disposal. All of these likely will raise costs for consumers and put more rate pressure on utilities.

Despite the environmental compliance risks, we view domestic utilities as a defensive safe haven for investors who are skittish about near-term European-induced market volatility. As European sovereign uncertainties begin to fade, we expect spread contraction, particularly down the credit quality spectrum. However, given already tight spreads on higher-quality issuers that face lackluster earnings growth outlooks, we urge bond investors to approach investment-grade utilities with caution.

We expect high-quality utility issuers to remain active in the debt markets as they continue to take advantage of low rates to refinance and pre-finance up to $80 billion of projected 2012 capital investments, albeit dependent on the severity of regulatory rulings and energy efficiency initiatives. Utilities are eager to secure financing ahead of potential allowed return cuts we expect as regulators adjust to lower interest rates. This year, regulators in several states have approved or proposed allowed ROEs below 10%, limiting creditors' margins of safety.

M&A activity has been robust in 2011, particularly in the first half. AES gained Ohio regulators' approval in November for its levered acquisition of DPL and became the first of the five mergers proposed during the last 18 months to close. The deal suggests regulators might not be averse to extra leverage at the parent, possibly spurring similar deals. We also expect further industry consolidation to capture cost efficiencies, geographic diversification, and growth opportunities in new retail markets such as in Ohio. American Electric Power (AEP, rating: BBB+) announced in September its intention to separate its Ohio transmission and distribution business (T&D) from its generation business by 2013 to complete its transition to competitive markets. Either one of those units could be an attractive post-transition acquisition target.

Entergy (ETR, rating: BBB) announced in December its intention to double its transmission network and become one of the largest transmission owners in the U.S. by divesting and then subsequently merging its transmission lines with ITC Holdings. In connection with the merger, ITC will issue $2.48 billion of additional debt to fund a $700 million pre-merger recapitalization followed by a $1.775 billion payment to Entergy. In return, Entergy will transfer to ITC its 15,700-mile transmission business and then acquire a majority stake in ITC.

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 Treas
Amgen	AMGN	AA-	2021	3.875%	$100.17	3.85%	200
Applied Materials	AMAT	AA-	2021	4.30%	$105.73	3.58%	176
Lowe's	LOW	A	2021	3.75%	$103.72	3.27%	152
Safeway	SWY	BBB	2021	4.75%	$101.96	4.50%	260
ArcelorMittal	MT	BBB-	2021	5.50%	$90.50	6.91%	511
Data as of 12-14-11.

Amgen (AMGN, rating: AA-)
We believe investors are getting a higher spread than warranted for this high-quality biotech issuer. The market and rating agencies don't appear to be giving Amgen credit for the cash it plans to hold on its books, which we estimate will largely offset its recently inflated debt position despite its plans to make large share repurchases. Even if we strip out all the cash from Amgen's balance sheet, we'd still only cut our rating by about two notches to A. However, Amgen's notes appear to be trading closer to spreads of the average BBB+ rated firm. We believe that assessment is too harsh, which provides an opportunity for long-term investors. Also, in general, we like Amgen's position in the biologic business, which will help it ensure repayment of its obligations through free cash flow generation of around $4.6 billion on average during the next five years. While we recognize biosimilar competition is coming for some of its top products, it probably won't be as severe as generic competition for pharmaceutical products for a variety of reasons. In fact, Amgen is already facing biosimilar competition in Europe for Aranesp and Neupogen, which is causing those products to tread water rather than decline substantially.

Applied Materials (AMAT, rating: AA-)
Applied Materials is the largest player in the semiconductor equipment industry, with the broadest product portfolio in the business. The firm recently issued $1.75 billion of debt, spread across five-, 10-, and 30-year maturities, to partially fund the acquisition of Varian Semiconductor, the leader in the ion implant tool segment. We believe Applied's scale gives it an advantage competing with smaller rivals in areas like research and development, sales, and customer support. The business is cyclical, but Applied has weathered the industry's ups and downs well, generally maintaining a conservative financial profile. Though it paid a high price for Varian, we expect Applied will carry more cash than debt for the foreseeable future. The firm's debt offers spreads more typical of a weaker A- rated issuer, presenting an opportunity to pick up a nice yield on a solid, competitively advantaged firm.

Lowe's (LOW, rating: A)
During its third-quarter earnings call in November, Lowe's announced that it was increasing its lease-adjusted leverage target to 2.25 times from 1.8 times to fund share-repurchase activity. Before the earnings release, we had already downgraded our credit rating to A from A+ based on our expectations for increased share buybacks. Lowe's lease-adjusted leverage has edged higher during the past two years from the mid-1 times range to above 2 times due to incremental debt taken on to fund share repurchases. We expect share-repurchase activity and dividends to total nearly 2 times free cash flow in 2011. Yet, we believe the bonds of this wide-moat retailer took too much of a beating, as they trade roughly 20 basis points wide of the Morningstar A index. As such, we expect these bonds to tighten as the market reverses its overreaction.

Safeway (SWY, rating: BBB)
While Kroger (KR, rating: BBB) is a better-run company and has slightly better credit metrics, we view the long-term credits risks of Safeway and Kroger to be substantially similar. Kroger's 6.15% senior notes 2020 were indicated around +157 over the curve before Safeway's new bond deal. Historically, similar-dated Safeway bonds traded 25-30 basis points behind Kroger, and we expect the new Safeway bonds will tighten toward Kroger's credit spread over time. Safeway's bonds are also cheap compared with the BBB component of the Morningstar Corporate Bond Index as well as other consumer defensive names. We recommend overweighting the Safeway bonds and underweighting the Kroger bonds, as we expect the spread to compress over time to a more normalized range.

ArcelorMittal (MT, rating: BBB-)
Steel industry bonds have endured a wild ride over the past several months, and ArcelorMittal, the world's largest steel producer, has been no exception. Prevailing spreads on this investment-grade name are more indicative of those we expect to see from a high-yield issuer and offer an attractive entry point to grab 10-year investment-grade paper at a yield of over 7%--an uncommon find at present. Although investors could be in for a bumpy ride in the coming quarters as the sovereign debt situation in Europe comes to a head and worries of a double-dip in the U.S. persist (roughly 60% of steel EBITDA is generated from production assets in these two economies), we think ArcelorMittal has the financial and operational wherewithal to weather another bout of weak GDP numbers in the OECD economies. Leverage is fairly high by the firm's historical norms, with net debt-to-EBITDA at 2.4 times on a trailing-12-month basis, but it's far from worrying. Critically, the company has a very manageable maturity profile and ample liquidity ($11.3 billion as of Sept. 30), two important qualities if indeed we're looking at an extended period of weakness for Europe.

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