New Bond Issue Market Remains Unusually Active
New issue supply was easily swept up as investors continue to pour money into corporate bond funds.
As opposed to the typical August slowdown, the new-issue market remained relatively active last week. For corporations under Morningstar's rating coverage, $21.5 billion of new bonds were priced over the course of the week.
Typically, new issuance slows down in August, as it's seasonally one of the quietest months of the year as investors head to the beach for the final days of summer; however, investors have cash that needs to be put to work, and all-in interest expense remains near all-time lows, prompting issuers to take advantage of the liquidity and low rates while they are available. This supply was easily swept up as investors continue to pour money into corporate bond funds.
The average spread on the Morningstar Corporate Bond index tightened 5 basis points to +176 last week, and the average spread on the Morningstar Eurobond Corporate Index tightened 13 basis points to +190 last week. The average spread within the Eurobond Index continues to be wider than the U.S. Corporate Index, but may continue to tighten faster than the U.S. Index during this cycle of "risk-on" attitude. This could allow for some outperformance by investors with the ability to switch between dollar- and euro-denominated assets. However, for long-term investors, we continue to highlight our preference for U.S. dollar-denominated corporate bonds over euro-denominated bonds, as we still think the problems in Europe are far from over.
One of the reasons that corporate bonds are in such high demand is that as U.S. Treasury rates continue to bounce around all-time lows, the credit spread has become an increasingly larger percentage of income and total return. For example, with the average spread for BBB+ rated bonds at +165, the amount of income an investor will receive is more than double that of the 10-year Treasury bond at 1.60%. Corporate credit spreads have now recouped all of the widening we experienced since April, when Spanish bonds first began weakening in earnest. In fact, corporate credit spreads are now at the tightest levels over the past year, even though the yields on both Spanish and Italian debt are higher now than in April.
Spanish Debt Gives Back Some of Its Recent Gains
Spanish debt gave back some of its recent gains as the yield on the two-year bond rose 23 basis points to 4.19%, and the yield on the 10-year bond rose 6 basis points to 6.91%, taking the 10-year yield perilously close to breaching the 7% level. While these yields are well below where they peaked in July, they are still trading at a significant spread over where German bonds trade, indicating the market continues to price in a high probability of default. While Spain can roll over maturing debt and finance its deficit for now, if interest rates remain at these levels, the nominal growth rate of the Spanish economy will need to grow rapidly, otherwise these yields will be unsustainable for the country to remain solvent over the long term.
New Issue Commentary
Sprint Taps the Debt Markets Again, This Time at Fair Value (Published August 9)
Sprint (S, rating: B+) was back in the bond market looking to issue eight- and 10-year notes, its third debt issuance in the past year. The firm ultimately issued $1.5 billion of 7.0% notes due 2020, a spread of about 565 basis points over Treasuries at par. We believe the new bonds offer fair, but not overly compelling, value. The firm's debt has appreciated nicely since it reported second-quarter earnings in late July. The 2016 notes currently trade at about 500 basis points over Treasuries, down from a peak of more than 1,100 basis points over Treasuries last November. The 2016 notes and the new offering rank behind the $4 billion in guaranteed notes the firm has issued recently ($3 billion due in 2018, $1 billion due in 2020). With the typical B-rated issue trading around 575 basis points over Treasuries, according to Merrill Lynch, Sprint debt is now trading in the right ballpark, in our view.
This latest offering will likely fuel speculation that Sprint is up to something substantial on the strategic front. Keith Cowan, the firm's executive responsible for strategic planning and a former Clearwire (CLWR) director, is leaving the company at the end of September. At the same time, the number of options and potential threats around Sprint's future strategic direction continues to grow. Satellite television operator DISH Network (DISH, rating: BBB-) is in the process of developing a wireless strategy as it waits for an FCC ruling related to its spectrum holdings. DISH reported Aug. 8 that it has built a $400 million position in the debt of a single firm, widely suspected to be Clearwire, Sprint's next-generation network partner. Earlier in the year, Sprint reportedly made a run at MetroPCS (PCS, rating: BB-) only to back out shortly before a deal could be finalized. We believe a Metro acquisition would make sense for both firms. Less likely, Sprint could also be interested in Leap Wireless (LEAP, rating: B-), which has struggled recently and seen its stock sink to new lows. Also, T-Mobile USA (DTEGY) continues to underperform, posting another net drop in customers during the second quarter. We view a tie-up with T-Mobile as Sprint's best long-term option, but any deal faces regulatory and technical hurdles.
Sprint has no immediate need for additional cash, although the firm may merely have taken advantage of the relatively low yields available to it today to gain flexibility and reduce liquidity risk. The firm ended the second quarter with $6.8 billion on the books, no remaining debt maturities in 2012, and only $773 million coming due in 2013. Based on our latest cash flow projections, we expect that Sprint will be able to manage its cash burn through completion of the Network Vision project and still cover debt maturities through 2014. The solid margin gains seen in the second quarter give us renewed confidence in the potential Network Vision has to substantially improve Sprint's cost structure. The firm has, however, posted similar margin improvement in the past only to subsequently regress. Poor execution or competitive pressure could easily cause another retreat in Sprint's financial performance. Under our bear-case scenario, Sprint would run out of cash attempting to repay its 2014 maturities absent a draw on the $1 billion vendor financing line it recently obtained. Adding cash at decent rates today could buy Sprint valuable time and flexibility in the future should problems crop up as Network Vision is fully deployed.
Baxter to Tap Market at Fair to Modestly Attractive Levels for Investors (Published August 8)
On Wednesday, Baxter International (BAX, rating: A+) announced plans to issue $750 million in 10- and 30-year notes. The proceeds will be used for general corporate purposes, and we don't anticipate changing our A+ credit rating for the firm based on this debt offering. The agencies currently rate Baxter A3/A+/A, so our rating remains above average. Given our differentiated rating, we wouldn't be surprised to see Baxter's notes priced slightly wider than the average A+ rated firm; 10-year notes from A+ rated firms in the Morningstar Corporate Bond Index recently traded around 85 basis points wider than Treasuries. With Baxter's 2020 notes recently trading around 104 basis points wider than Treasuries, we think its new 10-year notes may come to market at a modestly attractive level, even if they follow the trend of pricing slightly inside existing notes like many new offerings have in the last couple of weeks. If Baxter's new 30-year notes are priced like its existing notes, though, we'd likely deem them only as fairly valued for an A+ rated firm; for example, Baxter's 2037 notes regularly trade around 120 basis points above Treasuries. We'd point investors to Amgen's (AMGN, rating: AA-) new 2043 issue, instead. Those notes recently offered a spread of around 190 basis points above Treasuries, which we'd deem as highly attractive for the AA- rated firm.
Our A+ rating for Baxter is informed by its competitive advantages in injectable therapies and its manageable debt load. Baxter built its narrow economic moat on being a reliable provider of essential, life-saving injectable therapies. Even in some of its more commoditylike products, Baxter's innovative capabilities have built advantages over peers by making therapies more convenient and safer for users to administer. Baxter's leadership position in difficult-to-produce bleeding disorder therapies helps it generate robust economic profits. The company's efforts in its target niches have been well received by end users, and more than 70% of its sales come from products in number-one or -two market positions. The firm's financial position remains solid, too, with net debt of about $3 billion at the end of June. Since we believe the firm can generate at least $2 billion in free cash flow annually for the foreseeable future, we don't think Baxter will have any trouble managing that debt load while also funding its dividend, repurchasing shares, and making tuck-in acquisitions.
Frontier's New Issuance Should Offer Good Value (Published August 8)
Frontier Communications (FTR, rating: BB) is in the market looking to sell $500 million of 10.5-year notes. While likely not nearly as attractive as the firm's May debt issuance, we expect these notes will also offer good value. Frontier placed $500 million of nine-year notes in May with a 9.25% coupon, equal to a very generous spread of 774 basis points over Treasuries. This spread was roughly 100 basis points wider than where Frontier's 8.5% notes due 2020 were trading prior to the offering. The firm has since reported decent second-quarter results, calming fears surrounding a systems conversion undertaken earlier in the year. Similar conversions, which touch billing and customer service systems, have tripped up phone companies in the past. Frontier also showed some signs of revenue stabilization, and continued cost-cutting pushed margins to the widest level seen since the firm acquired a swath of assets from Verizon (VZ, rating: A-) in 2010. As a result, Frontier's debt has risen sharply in price recently, and we expect demand for the new notes will be stronger than it was for the May offering.
The 9.25% notes, due in 2021, have traded sharply higher to yield 7.1%, a spread of about 570 basis points over Treasuries. In addition, the firm's 8.75% notes due 2022 are even tighter, currently yielding 6.9%, or 530 basis points over Treasuries. Even at these tighter spreads, Frontier debt is trading wider than the typical BB rated issue, which currently trades around 420 basis points over Treasuries according to Merrill Lynch's indexes. We also continue to like Frontier relative to peer Windstream (WIN, rating: BB-). Windstream's 7.5% notes due 2023 currently trade at +580 basis points to a 2019 call date, or an option-adjusted spread of about 500 basis points over Treasuries. Frontier bondholders don't have to worry about call provisions, and unlike Windstream, Frontier currently carries no meaningful secured debt.
This latest debt offering will fill another hole in Frontier's debt maturity schedule while raising cash to ensure that it can meet large debt maturities in 2015. Frontier's decision earlier this year to cut its dividend payout nearly in half should enable the firm to reduce leverage. Management aims to cut net leverage to 2.5 times EBITDA versus 3.2 times currently, with the hopes of reaching that target in late 2014. We believe that timeline is aggressive given the pressure on the business, but we still believe management's commitment to reducing debt is a positive for creditors.
Avoid MetLife's New 30-Year (Published August 8)
MetLife (MET, rating: BBB-) announced Wednesday that it plans to issue $500 million of new benchmark 30-year notes. No information has been given on price guidance yet. MetLife's current 30-year trades with a spread above Treasuries of approximately 135 basis points, so we would expect this new deal to price in the area of 150 basis points above Treasuries.
We would recommend avoiding these bonds at this level, or any level less than 300 basis points. As compared with the rating agencies, who rate MetLife in the low A range, we take a much harsher view of the company, and life insurers in general. We believe it is difficult for a life insurance company to achieve an economic moat, and especially hard for a large life insurance company, as the products they sell have been commoditized. Adding to this difficulty is the long life cycle of the products, which means that effect of underpricing or poor risk management may not show up for years into the future. This phenomenon can allow one market participant to act irrationally for an extended period of time, forcing other market participants to match pricing just to stay in business. While MetLife does try to set itself apart by pursuing corporate customers with its diverse product portfolio, we still do not believe it possesses an economic moat.
Also, the business model for life insurers requires the companies to be more leveraged to their investment portfolios as compared with the average property and casualty insurer. MetLife's leverage is high even for a life insurance company, as its investment portfolio is more than 8 times the size of its equity base. This leverage causes MetLife's operating performance to be more volatile and less predictable, and highly correlated to capital markets--three conditions that are bad for credit investors. For those investors looking to invest in insurance companies, we recommend avoiding life insurers and looking to sound property and casualty names like Allstate (ALL, rating: BBB), whose 30-year bonds trade approximately 5 basis points wide of MetLife.
Time Warner Cable's New Offering Likely Too Tight (Published August 7)
We expect Time Warner Cable's (TWC, rating: BBB-) planned 30-year note issuance to price very unattractively. The firm's existing 5.5% notes due in 2041 currently trade at about 180 basis points above Treasuries. The typical BBB- issue within the Morningstar corporate bond index, which has an average of roughly 10 years to maturity, trades at about 287 basis points above Treasuries. Adjusted for maturity, TWC's notes are trading more in line with a weak A- rating, which we believe is far too tight for a firm that is managing to a net leverage target of 3.25 times EBITDA. The firm generates very strong cash flow, but it is making heavy use of share repurchases to hold leverage at its target. Management plans to return more cash to shareholders via dividends and buybacks than the firm generates during 2012. We like TWC's competitive position and the stability of its business, but we wouldn't own its debt at current levels.
Among TWC's peers, we favor Comcast (CMCSA, rating: BBB+). Comcast enjoys a similarly strong competitive position and has been outperforming TWC in terms of customer and revenue growth recently. Comcast has the added complexity of its NBC Universal joint venture, but we think the combination of content distribution and creation will provide benefits over time. More importantly, Comcast has managed its balance sheet far more conservatively, with consolidated net leverage at 1.8 times EBITDA. The core cable balance sheet, which excludes NBCU, is leveraged 1.7 times. Comcast's debt also trades well tight of the index, making it unattractive in absolute terms. But, we’d rather hold its 4.65% notes due 2042, currently at a spread of about 142 basis points above Treasuries, than TWC's 30-year notes.
BB&T's New 5-Year Should Price Attractively (Published August 7)
BB&T (BBT, rating: A-) announced Tuesday that it plans to issue $500 million of new benchmark 5-year notes. No information has been given on price guidance yet. BB&T's current 5-year trades with a spread above Treasuries of approximately 95 basis points, so we would expect this new deal to price in the area of 100 basis points above Treasuries. We think these bonds make sense at that level, given that PNC's (PNC, rating: A-) 5-year trades approximately 15 basis points tighter. We would recommend BB&T's 5-year all the way down to a spread of 90 basis points.
From a credit perspective we are very comfortable with BB&T. The company's primary focus and source of funding is low-cost deposits, which fund more than 70% of assets and more than 100% of loans. We think the company's plan to acquire BankAtlantic will help it continue to grow in the Florida market--still a region with appealing demographics where BB&T already has a large presence. Combining higher interest income from loan growth and lower expenses, thanks to a larger deposit base, will help the bank keep its interest margins at reasonable levels. While the company did perform well in the crisis, it did experience a pick-up of nonperforming assets. Recently, the bank has done well in reducing these assets as the percentage of nonperforming assets (excluding covered assets) to total assets has fallen below 1.5%.
Big Rewards Available in Celgene's New Offering (Published August 6)
Last Monday, Celgene (CELG, rating: A) announced its intentions to issue 5- and 10-year notes for general corporate purposes. We don't anticipate cutting our rating based on this issuance, and we believe it will be attractive given our differentiated view versus the agencies. We currently rate the firm A compared to the agencies at Baa2/BBB+.
We see this narrow-moat firm's large net cash position and high cash flows from patent-protected Revlimid as a key part of our credit rating. We'd note that Revlimid's patent expires in 2019, so elevated risk remains for debt due outside of that time frame, but we think investors should be aware of Celgene's positive moat trend and pipeline prospects that could push its advantages well beyond that time frame. For example, its multiple myeloma therapy pomalidomide has been filed with regulators, and this potential blockbuster stands to receive U.S. approval in February of next year. We also expect the firm to generate a large amount of data on its late-stage pipeline in the coming months, particularly for apremilast in psoriatic arthritis and psoriasis, and for Abraxane in pancreatic cancer and melanoma. Success with these products could lead to high cash flows and a wider moat in the long run. The firm appears to be accessing low-cost funding to help push those products over the development finish line and into marketing success with this new issuance. However, if those products fail, Celgene could also use proceeds from this new issuance to make acquisitions.
In terms of valuation, we expect Celgene's notes to be priced at a wide spread compared to its A rating. For example, 10-year issues from A rated firms typically trade around 95 basis points above Treasuries. However, Celgene's 2015 issue recently traded at Treasuries plus 110 while its 2020 issue traded at Treasuries plus 180. We'd expect similarly wide spreads in Celgene's new issues, which we'd find attractive for investors who can tolerate Celgene's pipeline-related risks. For investors seeking less risky but still attractive, long-term biotech notes, we'd point to Amgen's (AMGN, rating: AA-) 2022 issue, which traded around 140 basis points above Treasuries, or more than 50 basis points wider than what we'd expect from a AA- rated firm.
We Aren't Interested in Omnicom's Follow-On Bond Deal (Published August 6)
Omnicom (OMC, rating: BBB+) is pricing a $250 million follow-on to its existing 3.625% notes due 2022. The firm had issued $750 million in April at a spread of 170 basis points above Treasuries. With the bonds last trading around 140 basis points above Treasuries, we expect the new notes to be priced at a premium. This appears rich to us, with the BBB+ index at 166 basis points above Treasuries. While we like the long-term position that Omnicom has carved out in the advertising industry, we believe its bonds are more attractive for investment when the short-term outlook for the ad industry looks weak.
We expect the transaction will fund share repurchases. The firm has taken on additional debt over the past year in order to reward shareholders, increasing share repurchase activity. Leverage has ticked up slightly from 1.7 times at year-end to 2.1 times (pro forma for the new issuance). That said, management appears committed to maintaining balance sheet strength, and an improving advertising environment should boost earnings and bring leverage down below 2 times by year-end. Additionally, with no major debt maturities until 2016 and more than $1.5 billion in cash on the books, Omnicom's five-year cash flow cushion is more than 2 times our base cash expense and obligation forecast, and we do not believe the company will have trouble funding its obligations.
Whisper Talk on Altria's New Issue Is Attractive, Likely Will Tighten (Published August 6)
Altria (MO, rating: BBB) announced it is commencing a cash tender offer for up to $2 billion of its existing long-dated, high-coupon debt and also reported it will issue new notes to fund the tender offer. The new issue consists of 10-year and 30-year bonds. The whisper talk is 140 basis points above Treasuries on the 10-year and 180 basis points above Treasuries on the 30-year. Considering Altria's existing 4.75% Senior Notes due 2021 were last trading around 123 basis points above Treasuries and yielding 2.60%, the whisper talk appears cheap, and we expect it likely will tighten up to where the existing 2021s are trading when official guidance is provided. The 40-basis-point spread between the 10-year and 30-year seems a little wide to us and should tighten to 25 to 30 basis points.
If the new notes are priced at a 15-basis-point concession to the existing bonds, we expect they will quickly trade up on the break. But we continue to think there is significantly more upside in Lorillard's (LO, rating: BBB) notes. For example, Lorillard's 6.875% Senior Notes due 2020 are currently indicated at 252 basis points above Treasuries, resulting in a 3.69% yield.
The wide credit spread on Lorillard's notes compensates investors for heightened credit risk as the FDA undergoes an investigation of the menthol category. Lorillard derives substantially all of its cash flow from menthol products. We continue to believe 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 2011). A ban also would 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, especially just before a presidential election. While we don't know when the FDA may provide its rulings on the menthol sector, we continue to believe that less Draconian measures, such as tighter selling and marketing regulations, are a higher-probability outcome.
Once the FDA releases its conclusions, and assuming our opinion is correct, we expect credit spreads for Lorillard's bonds will tighten significantly. In our view, the bonds have an attractive risk/reward profile. We think Lorillard bonds could tighten about 100 basis points to +150 (25 basis points behind Altria). As a comparison, Philip Morris' (PM, rating: A-) 2.90% Senior Notes due 2021 are trading around 86 basis points above Treasuries resulting in a 2.34% yield. While notes in the tobacco sector may appear expensive compared with the average spread within the BBB rating bucket of the Morningstar corporate bond index (currently at +223 basis points above Treasuries), issuers in the consumer defensive space typically trade much tighter than the index would suggest.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.