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Credit Insights

Credit Spreads Rally Tighter, but Bond Prices Fall as Interest Rates Rise

Barring a re-emergence of the sovereign debt crisis or some other global calamity, interest rates will probably continue to head higher over the near to medium term.

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The credit market resumed its rally last week as corporate credit spreads tightened 6 basis points on average, with the Morningstar Corporate Bond Index dropping to 183 basis points over Treasuries. We think credit spreads will continue to constrict over the next few months and may tighten back to last April's levels (+134). However, prices on corporate bonds declined as the rise in interest rates more than offset the credit spread tightening. For example, the 10-year Treasury bond widened out 30 basis points to 2.30%. While we don't make explicit interest rate forecasts, it appears to us that barring a re-emergence of the sovereign debt crisis or some other global calamity that drives a flight to Treasuries, interest rates will probably continue to head higher over the near to medium term.

The preponderance of the increase in interest rates began soon after the Fed released its statement after the Federal Open Market Committee meeting. In the statement, the Fed highlighted that it is seeing further economic improvement (moving to "moderate" from "modest") and strains in the global financial markets have eased. In addition, the Fed acknowledged rising inflationary pressures as it noted the recent rise in crude oil and gasoline prices, although it continues to believe that longer-term inflation expectations are stable.

Based on the Fed's language, expectations for further quantitative easing or Treasury bond purchase programs diminished significantly. In addition, with the strains in the European sovereign debt and bond markets moderating, the demand for Treasuries as a safe-haven asset diminished as well. The Fed's current version of Operation Twist (selling short-dated Treasuries and buying long-dated Treasuries) will probably end this summer. Without demand from either the Fed or driven by the flight to a safe-haven asset, the remaining buyers of Treasury bonds will be more focused on economic returns as opposed to noneconomic factors.

Historically, longer-dated Treasury bonds provide a real rate of return over inflation. Bob Johnson, Morningstar's director of economic analysis, forecasts an average inflation rate of 2.5% for 2012, and the CPI is currently running at a 2.9% rate. While the range of the real return over inflation has varied over time, we can easily see the 10-year Treasury bond rising toward 3%. If the 10-year Treasury were to increase by 70 basis points, that would more than offset the 50 basis points of credit spread tightening we envision. As such, even in a rally in corporate credit spreads, investors could lose value as the price of corporate bonds decreases, although the decline in corporate bonds will be much less than Treasury bonds. So, investors may either look to invest in shorter- or medium-duration bonds whose price would not be as affected by rising rates, or invest in floating-rate securities.

New Issue Commentary
Philip Morris Issuing New Notes, but Lorillard Has More Upside (March 14)

Philip Morris (ticker: PM, rating: A) is reportedly issuing debt Wednesday morning consisting of 5- and 30-year notes in benchmark size. Considering Philip Morris' 2.50% senior notes due 2016 and 4.375% senior notes due 2041 are indicated around 60 and 110 basis points above Treasuries, respectively, we expect the new 5- and 30-year bonds will be priced around 65 and 125 basis points above Treasuries. We don't think there will be very much concession on the 5-year bond and only 10-15 basis points of concession on the 30-years. We think Philip Morris' existing bonds are fairly valued and will move in line with the market. If the new 30-year does come at a 15-basis-point concession, the bonds may initially pop toward where the 2041s are trading, but will probably level off in that context. As a comparison, Altria's (ticker: MO, rating: BBB) 4.125% senior notes due 2015 trade around 61 basis points above Treasuries and its 4.75% senior notes due 2021 look slightly cheap at 170 basis points above Treasuries.

In the tobacco sector, we think Lorillard (ticker: LO, rating: BBB) notes, which have long been on our best ideas list, have significantly more upside. Lorillard's 6.875% senior notes due 2020 currently trade around 237 basis points above Treasuries. The spread is significantly wider than the other tobacco names as Lorillard's revenue depends on the menthol category. The Food and Drug Administration has been examining the menthol category to determine if additional restrictions or an outright ban on menthol products should be instituted. While the headlines surrounding the release of the panel's conclusions may sound dire, we think an outright ban is highly unlikely. The scientific evidence is ambiguous, local governments would lose a substantial amount of tax revenue, a black market for menthol could emerge, thus limiting the FDA's ability to control the category, and 80% of menthol smokers are minorities. We expect the FDA will impose greater restrictions on the marketing and perhaps the availability of menthol cigarettes, which is incorporated in our forecast.

Nevertheless, any restrictions imposed on the menthol category are likely to hurt Lorillard more than its more diversified peers. Once the FDA releases its conclusions, and assuming our opinion is correct, we expect credit spreads for Lorillard's bonds to tighten significantly and should trade at about a 25-basis-point discount to Altria. Given where Altria is currently trading, that could provide investors with 3 points of upside potential.

Medtronic Likely to Offer Fairly Valued Benchmark Notes (March 14)
Medtronic (ticker: MDT) announced plans to issue benchmark-size 10-year and 30-year notes Wednesday. Because the proceeds of these notes are likely to be used to refinance existing indebtedness at historically low interest rates, we don't anticipate changing our AA- rating based on this event. Even after this issuance, we still believe Medtronic will represent a very low-risk issuer with its diverse set of wide-moat medical device businesses, including strongholds in heart disease, diabetes, spine implants, and structural cardiac products.

We'd expect the average firm rated AA- to issue 10-year debt around 85 basis above Treasuries, which is about where Medtronic's 2021 recently traded. Therefore, we'd expect Medtronic's new offering to be issued at a fair level, too. For investors looking for a more compelling investment opportunity in a high-quality medical device firm, we'd point them in the direction of Zimmer (ticker: ZMH). This top-tier orthopedic device firm is rated AA, one notch higher than Medtronic, but its notes typically offer a much higher yield than that rating would suggest, which we think is mainly due to the market anchoring on a size-based rating bias by the agencies. For example, Zimmer's 2021 notes currently offer a spread about 30 basis points wider than Medtronic's 2021 notes. When comparing these two investment opportunities, we think investors should seek the higher return offered at Zimmer rather than investing in Medtronic's notes because investors will face similarly very low credit risks at both entities.

Citi Remains an Investment-Grade Best Idea After Stress Test (March 14)
Late Tuesday, the Federal Reserve released the results of its stress test, and several banks failed to demonstrate that their Tier 1 common ratios would remain above 5.0% under the Fed's stress-case assumptions. Citigroup (ticker: C, rating: A-) was one of those banks that failed to meet the minimum, coming in at 4.9%. The Fed's stress-case assumptions not only apply a harsh economic scenario to the banks' portfolios, but also assume that the banks execute all planned capital actions, including dividend increases and share-buyback programs. While Citi fails to meet the minimum with its planned capital actions included, it would achieve an adequate stressed Tier 1 common ratio of 5.9% assuming no capital actions, supporting our relatively positive view of the company's current capital position.

This result does not surprise us, and we continue to leave Citi on our investment-grade Best Ideas list. Interestingly, while Citi's stock price fell about 3% on the news, its bonds rallied about 5 basis points, about the same for the other major money center banks.

New Vodafone Notes Look Unattractive (March 13)
As with most bonds across the telecom sector, we doubt Vodafone's (ticker: VOD, rating: BBB+) planned offering of 5-year notes will provide a compelling value for investors. The firm's existing 5.625% 2017 notes have recently traded at a spread of about 66 basis points above Treasuries despite carrying a high dollar price. Its 2.875% 2016 notes, issued last year, similarly trade at a spread of around 65 basis points above Treasuries. The Vodafone notes offer only marginally higher yields than AT&T (ticker: T, rating: A-) and Verizon (ticker: VZ, rating: A-) bonds of similar maturity. Given that our Vodafone rating is one notch lower, we'd prefer the bonds of its two U.S. counterparts. However, the bonds of all three firms trade far inside of the Morningstar Corporate Bond Index--the typical A- and BBB+ rated issues in the index, which carry a roughly 10-year maturity, trade at about 130 and 178 basis points above Treasuries, respectively. For comparison, Vodafone's 4.375% 2021 notes trade at about 100 basis points above Treasuries.

We believe Vodafone has the resources to improve its credit profile over the next couple of years, especially if Verizon Wireless continues to pay out a sizable dividend to its owners. We expect a large dividend will be necessary for Verizon to support both its dividend and debt-service obligations, but we'd still like to see a formal dividend policy put in place. Vodafone has prioritized shareholder returns over debt repayment in recent years, including its determination to increase its dividend 7% annually through 2013. As such, we believe that cash from Verizon Wireless is a necessity for Vodafone to support a stronger credit rating. Based on its consolidated results, which exclude Verizon Wireless, net debt stands at about 2.0 times EBITDA.

W.R. Berkley's Business Model Makes These New 10-Year Notes Attractive (March 13)
W.R. Berkley (ticker: WRB, rating: BBB+) announced that it is issuing $250 million of 10-year notes. Whisper on price guidance is in the area of 285 basis points over the Treasury curve. From a credit perspective, we like W.R. Berkley because of its strong business model. The company has developed a culture that allows underwriters to focus on the underlying profitability of the business they write, rather than chasing annual budget or premium targets. This allows Berkley to select risks that will compensate it over the long term while shunning less profitable business. This strategy has allowed it to maintain very high underwriting margins, evidenced by its low combined ratios over a cycle. While we like the business model, the company does score lower in some of our models because of the overall higher leverage it carries.

For the pricing, we think this deal is very attractive. For comparison, Allstate (ticker: ALL, rating: BBB) trades with a spread of 180 basis points over the Treasury curve at the 10-year point and Travelers (ticker: TRV, rating: A-) trades with a spread of +100. While we acknowledge that W.R. Berkley should trade wider because of its smaller size, we think the whisper talk is too wide, and we would recommend this deal all the way to +250 basis points.

We Don't Expect Much Value in Silgan's New Bonds; Aggressive Acquisition Strategy Remains a Concern (March 12)
Silgan (ticker: SLGN, rating: BB+) announced that it is issuing $300 million in senior unsecured notes to tender its existing 2016 note. The new notes mature in 2020, but are callable after 2016. The existing 2016 bond was trading at a yield to worst of 4.13% before the announcement (spread to worst: 380 basis points). If the new deal is priced in the similar neighborhood, that would be rather rich relative to the typical BB+ rated industrial name, but in line with packaging comparables. Peer Ball (ticker: BLL, rating: BB+) issued a 10-year unsecured note two weeks ago, which priced at a spread of 301 basis points and now yields 4.86% with a spread to worst of 286 basis points. Crown (ticker: CCK, rating: BB-) has a 2021 note that is trading at a spread to worst of 317 basis points and a yield to worst of 4.03% (the worst call is Feb. 1, 2016). All these bonds trade tight to the Merrill Lynch BB high-yield index, which carries an option-adjusted spread of 427 basis points.

Although Silgan has a very stable operating profile and sports low leverage compared with its ratings, we think management has shown a clear intent to use its balance sheet for financing acquisitions. For instance, Silgan launched a bid for Graham Packaging in 2011 for $4.1 billion, and a majority of the funding would have come from cash had the deal been consummated. We think the management team is content with higher leverage in the future. Further, we think Silgan aims to expand its packaging footprint in Europe, following a somewhat similar path adopted in consolidating the North American market. We'd expect such a strategy would entail a material increase in leverage. Ultimately, we think the pricing of the transaction may not fully reflect the potential for the company's growing leverage.

U.S. Steel's New Issuance May Price Attractively, Reflecting Short-Term Industry Headwinds (March 12)
U.S. Steel (ticker: X) is coming to market with a $400 million senior unsecured offering, which will be applied primarily to tendering an existing 2013 note. The new notes will mature in 2022, but are callable after 2017. Provided the new issue comes at levels commensurate with the company's outstanding bonds, we'd expect to see a coupon in the neighborhood of 7.25%, which we'd find fairly attractive relative to our BB- issuer rating.

U.S. Steel's existing 7.375% 2020 bond was trading at a yield of 6.56% before the announcement (494 basis points above the curve) and widened to 6.88% after the announcement (+527 basis points). The company's 7.00% 2018s trade at a yield of 6.28% (516 basis points above Treasuries). Assuming these levels are indicative of how the market will treat the new bonds, a coupon around 7.25% seems possible (525 basis points above Treasuries). With the average BB name in the Merrill Lynch High Yield Index yielding 5.5% (424 basis points above Treasuries, 7.4-year term) and the average B name at 7.2% (+607 basis points, 6.4-year term), we'd see fairly good absolute value at a 7.25% coupon.

Relative value is another matter, as nearly all steel names are trading wide of their ratings because of the obvious near-term headwinds for the industry. Indeed, we downgraded U.S. Steel's issuer rating in November 2011 based on such concerns, which may seriously hamper the firm's efforts to deleverage from high prevailing levels. For investors seeking exposure to this industry, we'd recommend ArcelorMittal's (ticker: MT, rating: BBB-) new 10-year bonds, which sport a speculative-grade yield in exchange for what we believe is an investment-grade risk profile. The steel giant's 6.25% notes due 2022 yield just shy of 6%, or nearly 400 basis points wide of the curve.

Norfolk Southern to Issue $500 Million 10-Year Bonds; We See Better Value Elsewhere in the Sector (March 12)
Norfolk Southern (ticker: NSC, rating: BBB+) intends to issue $500 million of 10-year notes with proceeds expected to be used for general corporate purposes. We recently saw the Norfolk Southern 3.25% due 2021 trade around 95 basis points over Treasuries and would expect a new 10-year to come slightly wider, in the area of 100 basis points over Treasuries, but would view fair value at closer to 110 basis points over Treasuries. In the rail industry, we still prefer CSX (ticker: CSX, rating: BBB+) to Norfolk Southern. The two have relatively similar leverage profiles, and both finished 2011 with operating ratios wrapped around 71%. However, with the CSX 4.25% due 2021 recently trading close to 125 basis points over Treasuries, we continue to see more value in CSX bonds. We also prefer Union Pacific (ticker: UNP, rating: A-) to Norfolk Southern. Our one-notch higher rating on Union Pacific is driven by its slightly better credit metrics and larger top line, and with the Union Pacific 4.0% due 2021 trading around 110 basis points over Treasuries, we also see more value in Union Pacific relative to Norfolk Southern.

Click here to see more new bond issuance for the week ended March 16, 2012.

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