Credit Outlook: Sector Updates and Top Bond Picks
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Quarter-End Insights
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Credit Sector Roundup
Banks
For large U.S. banks, the possibility of a European financial crisis due to European sovereign debt problems has been an overriding theme, as the market has been concerned about U.S banks' direct and indirect exposure to European banks. The European Central Bank's LTRO (Long-Term Refinancing Operation) program has helped alleviate many market fears of European bank failures by providing low-cost, three-year funding to European banks as needed. As a result, we have seen the credit spreads for large U.S banks tighten approximately 50 basis points over the last quarter. Although we see this action by the ECB as a short-term solution, which does not address the long-term solvency concerns of certain troubled European governments, it has dramatically lowered the probability of a near-term European financial crisis.
With the large U.S. banks trading at spread levels still more than 50 basis points above index levels for equivalent ratings, we expect to see further spread tightening on a relative basis in the coming quarter. We note, however, that any unexpected news events on government solvency issues out of Europe will quickly move spreads back out for the large banks. We continue to believe that while situations in Greece, Ireland, Portugal, and Spain are of serious concern, Italy's overall size causes it to dominate the future prospects for Europe.
The credit metrics for large and regional banks have continued to improve over the past several quarters, and we don't foresee that trend stopping anytime soon. According to the FDIC, for institutions with greater than $10 billion in assets, noncurrent loans to total loans averaged 4.35% at the end of 2011 after hitting a high of 6.09% in late 2009. In the near future, we don't foresee this number getting below 1.00%, which was observed in the unusually benign credit environment in the mid-2000s, but the slow and steady improvement will continue. While banks have released reserves due to the improving credit metrics, many of them have experienced increasing percentages of reserves to nonperforming loans as the amount of releases has been less than the improvement in the percentage of nonperforming loans. As a result, we expect that banks will continue to bolster earnings with continued reserve releases over the coming quarters.
Basic Materials
The bond market has clearly distinguished between companies that have higher macro-related risks versus companies that are decidedly steady-eddie in the past quarter, and we expect the pattern to persist as long as the global economic recovery remains somewhat muted.
Two steel companies in our coverage universe tapped the U.S. bond market, and both had to pay a high coupon.ArcelorMittal(MT, rating: BBB-) raised $3 billion in February, pricing its 10-year note at a 6.25% coupon. US Steel (X, rating: BB-) raised $400 million of 10-year debt in March, paying 7.5% in coupon. Both of these companies had to pay materially wider spreads compared with other industrial names in their respective rating categories, reflecting the market's broad unease about their operational improvements in the near term.
At the same time, two high-yield packaging companies, Ball (BLL, rating: BB+) and Silgan (SLGN, rating: BB+), issued new 10-year debt, both priced at just 5%. We concede that the latter two companies have more stable operations, as they are the leading metal food and beverage can providers, and sport better near-term credit metrics than the steel companies. However, the spread differentials between these two groups hardly justify the underlying credit qualities of these companies. From our perspective, despite some near-term headwind from Europe, the level ArcelorMittal is trading at offers good opportunities to snap up solid investment-grade paper at spreads more indicative of high-yield land. Conversely, the low yield Silgan's bond is trading for hardly compensates bond holders of its inherent risk of credit deterioration over the long term.
Looking ahead, our biggest concern about credit metric deterioration comes from the coal sector. In general, coal companies have BB-type credit metrics and limited breathing room for withstanding prolonged operational weakness. As thermal coal prices in the U.S. remain weak due to both a mild winter and low natural gas prices, and as metallurgical coal prices weaken due to Chinese economic uncertainty, we think the environment is particularly painful for companies that pursued acquisitions in 2011. Both Arch Coal (ACI, rating: BB-) and Alpha Natural Resources (ANR, rating: BB) took on significant debt to finance their consolidation of Appalachian miners, which left their balance sheets considerably stretched heading into the current industry weakness. If gas prices stay low and metallurgical coal prices remain soft when annual coal contracts are resetting, 2013 may witness further production and margin contraction. We suspect many Appalachian miners will have to cut production and scrimp on capital improvements to hoard cash or service debt.
Despite the bond market's discrimination against steel companies, we think the concern may be overblown. In the second quarter, we expect some incremental earnings improvements from steel firms, particularly if raw material costs begin to ease. The second quarter is seasonally the strongest for the steel sector in the U.S., which should provide some small upside for spread tightening. In addition, the majority of steel companies under our coverage have no direct exposure to Chinese steel demand, even if they may face some competitive pressure on the import front if the Chinese economy slows down and pushes excess capacity overseas. Still we maintain that this should be to some extent offset by positive impacts on the raw material front. The slowdown in China has caused some easing in iron ore and coal costs, with iron ore prices down some 20% from year-ago levels and coking coal even lower due to the lack of last year's supply constraints out of Australia.
Consumer Cyclical
We expect the preponderance of our consumer cyclical names to perform well in the second quarter of the year. With retail sales up, consumer confidence improving, and commodity pressures beginning to abate, first-quarter earnings should look solid. Still, we don't necessarily expect a fundamental improvement in credit quality, as many firms will look to return cash to shareholders, likely tapping the credit markets to maintain leverage levels as earnings improve. However, while we believe credit spreads can--and likely will--continue to tighten as the dislocation in Europe eases, we argue that the majority of consumer cyclical firms already trade much too tight for their credit ratings.
Yum Brands (YUM, rating: BBB+) is a solid example of these trends. The firm reported a strong finish to 2011, and we remain confident that the company can sustain midteen operating income growth, yet management has expressed that it intends to keep leverage levels constant. We believe this implies that it may issue debt to fund capital spending and increased share repurchase activity. While we're favorable on the credit, we don't think the bonds are attractive, trading well inside our BBB+ index.
We believe value will be found in credits that either the market is mispricing from our perspective, or in those where credit quality is improving. Relative to Yum, we prefer similarly-rated Darden Restaurant's (DRI, rating: BBB+) bonds. Darden's 4.5% notes due 2021 trade wide of both the index and Yum's bonds. We believe there is room for them to tighten to, or even inside, Yum's bonds. Despite competitive headwinds that will likely pressure earnings, Hanesbrands (HBI, rating: BB) is on the upswing from a credit perspective. The firm has consistently paid down debt through free cash flow generation, bringing leverage down to 3.2 times from over 5 times in 2006. Management has consistently stated that it would like to bring leverage to below 3 times. Even with a slight softening in EBITDA, we believe Hanesbrands can accomplish this by the end of 2012 as it plans to pay off $300 million in debt in this year through an expected $400-$500 million in free cash flow. Although the firm's bonds are currently fairly priced for a BB credit (we rate the firm higher than the agencies), if spreads widen given softer expected earnings, it could present a buying opportunity, as we have a favorable long-term credit opinion on Hanesbrands.
Consumer Defensive
As compared to last year, we expect credit metrics will remain steady within the sector. Our forecast is based on our expectations for stagnant top-line growth within the developed markets and minimal margin expansion as price increases have been generally limited. Food retailers have continued to invest heavily in pricing to draw consumer traffic and will pressure food manufacturers for further price concessions. In the second quarter, those issuers with greater-than-average exposure to emerging markets will fare better on the top line, but may not necessarily be able to expand margins as inflationary pressures in those markets have not yet begun to subside as we have seen in the developed markets.
During the first quarter, credit spread tightening within the consumer defensive sector has trailed the rally within the corporate bond market. Considering most consumer defensive names trade tighter than the equivalently rated component of the Morningstar Corporate Bond Index, we expect the sector will continue to lag further credit spread tightening. 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. We see the potential for this trend to increase throughout 2012 as management teams 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 we expect management teams would limit the size of share buyback programs to fit within their existing credit rating profiles.
SABMiller (SBMRY, rating: A) recently issued several benchmark size bonds to finance the acquisition of Fosters Group. While SABMiller's leverage did increase appreciably in the transaction, we believe the firm will quickly repay debt and return to pre-acquisition leverage by 2015. We have previously opined that the existing trading levels for SAB were cheap for the rating and relative to its competitors in the beverage sector such as Anheuser-Busch InBev (BUD, rating: BBB+). We think technical market issues have kept the credit spread on SABMiller's bonds artificially wide. The credit market was well aware that SAB would access the capital markets to term out the bank financing used to complete the acquisition, and this overhang held the bonds back. Now that this overhang has been lifted, we think the notes will continue to tighten toward Anheuser-Busch InBev levels.
Health Care
Two major factors could affect health-care firms next quarter. First, industry shares are trading close to their fair value estimates on average compared with about a 15% discount at the November lows. Given that change in health-care firm valuations, we suspect management teams will be less willing to use excess cash flows to repurchase shares next quarter, which would be a good thing for debtholders. Instead, we believe health-care firms may increasingly look to use excess cash flow to make acquisitions. While acquisitions can be viewed as a better use of excess cash flow than repurchases from a debtholders' perspective, they typically involve the issuance of new debt, which can add risk to acquiring firms. We believe most of the likely acquirers in health care remain very well capitalized, though, and we suspect most acquiring firms can maintain high-quality credit profiles even if potential acquisitions require a small cut to ratings.
Also, the Supreme Court plans to review the constitutionality of the health-care reform law March 26 through 28, and the final ruling on that law could come in June. From a credit perspective, this decision likely won't affect our ratings significantly. However, it could affect how investors view the sector due to ongoing uncertainty, especially if the Court punts on a number of issues.
The Court has several questions to answer in reviewing the Patient Protection and Affordable Care Act. Does Congress have the constitutional authority to require individuals to purchase health insurance, or else pay a penalty? If it does not, what parts of the reform law, if any, can stand without the individual mandate? Can the Court even rule on this matter before the individual mandate is enforced starting in 2014? The Court will also consider whether the Medicaid expansion will infringe on state sovereignty, although an appeals court dismissed this argument as the federal government is expected to pick up a big chunk of the total cost. The Court will not consider issues such as employer mandate or the validity of a health benefit exchange requirement.
We see four possible directions the Court could take. It could strike down the entire law; it could strike down just the individual mandate and related insurance market regulations while upholding the rest of the law; it could uphold the entire law; or it could postpone judgment until after 2014. Going forward, we'll keep investors abreast of the latest developments.
Industrials
Across the industrial landscape, spreads continued to grind tighter during the first quarter, and we think there's a good chance this trend will continue over the near term, driven by a combination of improving economic data and relatively robust corporate earnings.
Our outlook remains generally positive across the key sub-sectors that we follow. Fourth-quarter earnings were generally positive and most companies continued to show improvement in key credit metrics, including leverage and margins. Our outlook for rails also remains positive. Fourth-quarter earnings were generally strong, buoyed by optimism regarding continued improvement in volume and pricing trends, and we expect these trends to continue over the near term. Although spreads across the sector remain relatively tight, we still like the bonds of Kansas City Southern (KSU, rating: BB+), given its improving credit profile and potential to achieve investment-grade status.
In the agricultural and construction equipment space, fundamentals have improved out of the downturn, although slower growth is anticipated in the emerging markets, and leverage has ticked higher for several names due to debt-financed acquisition activity. We generally view the sector as fairly valued at this time, although we like the bonds of AGCO (AGCO, rating: BBB-), given its relatively wide spreads for what we view as investment-grade risk.
We remain positive on the fundamental outlook for autos and expect a continuation in the rebound in new vehicle demand from the supply-driven weakness of the past few quarters (e.g., the Thai floods and Japan earthquake). This could cause spreads to grind tighter, and in the space we still like the bonds of supplier 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.
We're becoming more constructive on the near-term outlook for the housing and building materials sectors and continue to like the bonds of Owens-Corning (OC, rating: BBB), which should benefit from an upswing in housing starts.
Finally, we continue to see divergence in the aerospace/defense sector, as commercial aerospace orders have generally been robust while the defense sector remains under a significant cloud of uncertainty following the Budget Control Act of 2011 and sequestration. In the former group we continue to like the bonds of Bombardier (BBD, rating: BBB) given its strong liquidity and substantial backlog, which should convert to free cash flow and deleveraging over the next few years. Among credits in the defense sector, we would steer investors to the bonds of L-3 Communications (LLL, rating: BBB-), which we believe will retain its investment-grade ratings due to healthy cash flows and despite macro challenges.
Technology & Telecom
The tech M&A theme that we've highlighted consistently over the past several quarters shows no signs of receding. Specifically, deals designed to augment software capabilities are especially en vogue across all tech sectors, including amongst hardware firms looking to add proprietary technologies.
With large amounts of cash still swashing around the sector, most tech acquisitions have little direct bearing on our ratings in and of themselves. However, we do consider the impact of each deal on competitive positioning and the potential course that future M&A activity may take. Dell (DELL, rating: A+), for example, recently announced that it will spend around $1.5 billion to acquire SonicWALL, a firm that develops security and firewall products. The SonicWALL purchase will consume only a small portion of cash on hand and the move makes strategic sense, but it is borne of necessity for Dell. SonicWALL represents only one additional step in the long process of shifting Dell's business away from the commodity PC market. We expect Dell will continue to make acquisitions, especially as the firm builds out its new software group. A strategy built on M&A is fraught with execution risk, as Hewlett-Packard (HPQ, rating: A) can attest.
The semiconductor industry was faced with slowing demand as 2011 drew to a close, but we opined at the time that the downturn would be brief. That view has already played out, as economic fears have largely lifted, shorter-term supply constraints are working through the system, and smartphone adoption continues at a rapid clip. We expect conditions will continue to improve for chipmakers in the coming months. Spreads on KLA-Tencor's (KLAC, rating: A+) 6.9% 2018 notes have tightened recently to around 185 basis points over Treasuries but still remain well wide of what we'd expect given our rating. The bonds remain one of our favorites, especially relative to the exceptionally tight spreads seen across much of the sector.
Spreads in the telecom sector remain far tighter than our ratings suggest is appropriate. AT&T's (T, rating: A-) 3.0% 2022 notes, for example, trade at about 100 basis points over Treasuries versus about 130 over for the typical A- credit in the Morningstar Corporate Bond Index. We don't expect any major changes across the U.S. telecom industry over the next quarter, but we believe the credit markets are currently assuming more stability over the longer term than is warranted. Capital spending needs have risen across much of the industry as carriers invest aggressively to keep pace with data traffic growth. The industry remains very mature, though, and squeezing more revenue out of existing customers has generally proven difficult. At AT&T, capital spending will likely remain elevated at 2011 levels. The firm's dividend payout ratio topped 70% last year, up from less than 60% in 2009.
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 we expect 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 environmental compliance risks, we view domestic utilities as a defensive safe haven for investors 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/ allowed ROE outlooks, we urge bond investors to approach investment-grade utilities with caution while focusing on a longer-duration yield orientation.
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. Environmentally driven capex will be a significant component of debt-funded capex, although also highly dependent on the severity of ongoing regulatory rulings and energy efficiency initiatives. Utilities are eager to secure financing ahead of potential allowed ROE cuts as regulators align their outlook with a sustained lower interest rate environment. Already this year, several state regulators have approved or proposed new rate case allowed ROEs below 10%, limiting creditors' margins of safety as this regulatory lag diminishes.
Unregulated independent power producers face high uncertainty over the next quarter. Power prices will remain severely strained as long as natural gas prices keep falling. Unfavorable excess natural gas supply and an unseasonably warm winter have pushed gas prices to historic lows. We continue to expect merchant power producers to experience elevated liquidity constraints, especially within companies that own older coal plants in need of upgrading. Recently announced restructuring at Edison International's (EIX, rating: BBB-) merchant generation company, Homer City, is the first casualty following Dynegy Holding's (DYN, no credit rating) bankruptcy filing in the fourth quarter of 2011.
The industry's broad desire to accumulate regulated assets whereby offsetting and/or shedding merchant power plants will fuel M&A activity over the upcoming quarter. Representative deals expected to close in the second quarter of 2012 include all-stock mergers between Northeast Utilities (NU, rating: BBB)/Nstar (NST, rating: A) and Duke Energy (DUK, rating: BBB+)/Progress Energy (PGN, rating: BBB+). On March 12, the all-stock Exelon (EXC, rating: BBB+)/Constellation Energy (CEG, no credit rating) transaction closed, creating the largest competitive power producer in the U.S. (35,000 MWH). We expect further industry consolidation to capture cost efficiencies, geographic diversification, and growth opportunities in new retail markets, particularly in Ohio. Along these lines, we highlight American Electric Power's(AEP, rating: BBB+) announced intention in late 2011 to separate its Ohio transmission and distribution business from its generation business by 2014.
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 | |
| |||||||
| Zimmer | ZMH | AA | 2021 | 3.375% | $99.47 | 3.44% | 116 |
| |||||||
| Symantec | SYMC | A+ | 2020 | 4.20% | $102.37 | 3.87% | 184 |
| |||||||
| SABMiller | SBMRY | A | 2035 | 5.875% | $106.96 | 5.35% | 224 |
| |||||||
| Citigroup | C | A- | 2017 | 4.45% | $105.22 | 3.26% | 211 |
| |||||||
| Scana | SCG | BBB+ | 2022 | 4.125% | $98.94 | 4.26% | 189 |
 | |||||||
| Data as of 03-20-12. |
Zimmer (ZMH, rating: AA)
Zimmer remains on our list as an absolute and relative valuation play. The firm's 2021 issue is trading more like a 10-year issue from a weak A-rated firm, which we believe is too pessimistic. Also, Zimmer stacks up as a similar credit to Stryker (SYK, rating: AA), another orthopedic firm that we rate AA. However, Zimmer's 10-year notes trade about 25 basis points wider than Stryker's 2020 issue, and we think investors should take advantage of this relative spread differential, which gives investors in Zimmer debt a higher reward opportunity for the risk. Even with a recently inflated debt position to enable accelerated share repurchases, Zimmer's net debt/EBITDA remains below 1, and we don't think the firm will have any problem meeting its obligations. Zimmer is a leader of the highly attractive and stable orthopedic device niche. Market share shifts at a glacial pace in this business, and we believe the fundamental attractiveness of this industry adds to the strength of Zimmer's credit profile.
Symantec (SYMC, rating: A+)
Symantec has a solid balance sheet and record of consistent cash flow generation. The firm carries $2.4 billion in cash against a $2.0 billion debt load currently. Despite heavy share repurchases and acquisition activity over the years, Symantec has typically carried more cash than debt. Free cash flow has been positive every year for more than a decade, typically running at about 25% of sales. The firm's 2020 notes offer an attractive spread relative to our A+ rating (+83 is more typical). The bond is also attractive relative to other wide-moat software firms with similar ratings. 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 (INTC, rating: AA) recently acquired McAfee, its closest peer.
SABMiller (SBMRY, rating: A)
SABMiller recently issued several benchmark-size bonds to finance the acquisition of Foster's Group. While leverage did increase appreciably to finance this acquisition, we believe the firm will quickly repay debt and return to preacquisition leverage by 2015. We have previously opined that the existing trading levels for SABMiller were cheap for the rating and relative to its competitors in the beverage sector, such as Anheuser-Busch InBev. We think technical market issues have kept the credit spread on SABMiller's bonds artificially wide. The credit market was well aware that SABMiller would access the capital markets to term out the bank financing used to complete the acquisition, and this overhang held the bonds back. Now that this overhang has been lifted, we think the notes will continue to tighten toward Anheuser-Busch InBev levels. In addition to the notes being cheap on a relative value basis compared with the beverage sector, they are currently trading at spreads that would indicate a strong BBB+ rating.
Citigroup (C, rating: A-)
Citigroup has placed its troubled assets associated with the housing bubble and financial market disruption into runoff mode. These troubled assets now represent less than 20% of total assets and are shrinking. The remaining assets are held at Citicorp and include global transaction services, a scaled-back investment bank, private banking, Citi credit cards, and its worldwide retail and commercial bank. We believe these remaining assets are strong, competitively advantaged businesses, and provide Citigroup with a narrow moat. During the last year and a half, Citigroup has raised its Tier 1 common ratio more than 250 basis points to 11.7%, and its capital ratios are now higher than any of the large U.S. banks. The company also has been able to reduce its nonperforming assets to less than 1% of total assets.
Scana (SCG, rating: BBB+)
Benefiting from leading regulated shareholder returns (11%), Scana operates in a highly supportive Southeastern regulatory environment. Scana will further profit from a vast pipeline of infrastructure investments that will earn it leading utility returns on equity. Scana's 2022s trade roughly 50 basis points wide of the average utilities BBB+ rated issuers in the Morningstar Corporate Bond Index. They also trade about 65 basis points wide of similar duration paper issued by comparably rated regulated utility peers, such as Duke Energy and Progress Energy. We believe Scana's 2022 bonds represent a compelling positive carry opportunity that is positioned for upside upon the successful completion of two new units at its V.C. Summer nuclear power plant (South Carolina), expected 2016. In the worst-case scenario, assuming Scana's nuclear plant is stalled or permanently derailed, we believe South Carolina laws will allow Scana to recover its capital investment as well as any stranded costs through rate-base increases.
Daniel Rohr, Joscelyn Mackay, Julie Stralow, Michael Hodel, Jim Leonard, Rick Tauber, Jeff Cannon, Min Tang-Varner, and Joseph DeSapri contributed to this report.
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