Credit Outlook: Sector Updates and Top Bond Picks
Get our sector-by-sector take on the bond market, plus our five best bond ideas.
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The recent ruling by the German Constitutional Court, which effectively allows the European Stability Mechanism to operate, removes a great deal of near-term risk for global banks and large U.S. banks with European exposure. In simple terms, by allowing the ESM, the German court has removed the short-term possibility of a eurozone break-up created by the inability of peripheral eurozone countries to fund their sovereign debt at reasonable levels. Although there are a still lot more issues to be addressed by the European Union and the European Central Bank in regard to peripheral sovereign debt funding, there a very few hurdles that need to be cleared in the near term.
Due to European sovereign debt risk, global banks and large U.S. banks have traded with credit spreads at considerably wider levels than their ratings would have indicated. With near-term risk removed, we expect a general tightening of credit spreads for global banks, and we expect even greater tightening for the large U.S. banks. For example, Morgan Stanley (MS, rating: BBB) trades with a 10-year credit spread of approximately 325 basis points. We put Morgan Stanley on our High Grade Best Ideas List back in April 2012, when its 10-year spreads were trading in the 380-basis-point area. Although Morgan's spreads have been quite volatile over that time, as we warned all large bank spreads would be, there has been a general spread tightening for Morgan Stanley. Over the near and medium term we expect that trend to continue with the ability for Morgan Stanley's 10-year spread to be almost 100 basis points tighter than today's levels. We expect a similar tightening across all the large banks, but with less magnitude than Morgan Stanley.
While the markets applaud the removal of near-term risk for the eurozone, the long-term prospects are still troubling. Europe, in general, continues to slide into recession with the most troubled nations, such as Spain and Italy, being the hardest-hit. Most of the large global banks have reported considerable increases in the balance of nonperforming loans in Spain and Italy, and we expect this trend to continue. Although much of the recent attention has been placed on sovereign debt, the continued deterioration of the economies of the peripheral countries will force the market to focus to the status of the loan portfolios of these banks. As such, we continue to be wary of the long-term fundamentals of these banks, and for credit investors looking for exposure to large banks, we recommend staying with the large U.S. banks. Also, even if it appears that near-term risks have been removed, any unexpected negative shock to the world economy would have immediate and dramatic negative consequences for large European banks due to the fragile status of the eurozone economy.
Contributed by Jim Leonard
We can't help but feel many basic materials bonds have gotten ahead of themselves in the recent rally. Consider the case of iron ore miner Cliffs Natural Resources (CLF, rating: BBB-). We placed the firm's 4.875% 2021 issue on our "Bonds to Avoid List" at the beginning of August, noting that, despite strong trailing 12-month credit metrics, as a relatively high-cost producer, Cliffs wasn't particularly well-placed to cope with another leg down in Chinese steel demand, which we viewed as the biggest risk to iron ore prices. At the time, the bonds traded at a spread of 343 basis points over Treasuries (also known as a t-spread and written as T+343) and the price of iron ore stood at $117 per ton, down from $135 per ton a month prior. During the course of August, iron ore prices plunged further, bottoming out at $89 per ton and sending spreads on Cliffs' 2021 issue 63 basis points wider to T+406 basis points.
The story began to turn for Cliffs in early September when Washington, Brussels, and Beijing came out guns blazing, the latter being the most important for Cliffs given the centrality of Chinese fixed-asset investment to iron ore demand (China consumes about two thirds of global seaborne shipments). On Sept. 7, China's National Development and Reform Commission announced approval for a variety of big-ticket infrastructure projects, sending iron ore prices up 15% in the next couple days to $101.75 per ton before fading slightly to $97.75 per ton as of Sept. 14. Cliffs bonds have tightened in sympathy with iron ore prices, but in our view, far too much given prevailing fundamentals. Spreads now stand at T+328 basis points, 15 basis points tighter than a month ago, despite the fact that iron ore, which accounts for 90% of Cliffs' revenues, now trades at prices $20 per ton lower than month-ago levels.
Looking ahead to the fourth quarter, we continue to favor the bonds of companies that can comfortably weather a sharp and sustained slump in commodity prices. With this in mind, we prefer low-cost producers like Southern Copper (SCCO, rating: BBB+) and Vale (VALE, rating: BBB+) over comparably higher-cost operators like Cliffs.
Contributed by Dan Rohr and Min Tang-Varner
As we enter the final quarter of 2012, consumer cyclical spreads are generally tightening with the rest of the credit market. Demand for paper is strong, and new issues have priced tight--and in some cases inside--of existing bonds. For instance, O'Reilly Automotive (ORLY, rating: BBB)had 10-year bonds trading around 250 basis points over Treasuries before its new 10-year issuance in August. The new deal priced at 200 basis points over Treasuries and traded in further to around 180 basis points over Treasuries in the secondary market. We expect this demand for bonds to push in spreads for solid consumer cyclical names with little expectation of headline risk such as Macy's (M, rating: BBB), which we upgraded during the quarter on continued improving leverage.
Still, we believe consumer cyclical bonds could be volatile as we expect to see decelerating or softer results in many of our names amid a continued slow and choppy economic recovery. We don't expect underlying credit qualities to be materially impaired in most cases. Many consumer cyclical firms have the ability to redeploy cash from planned share repurchases or capital expenditures toward debt reduction in the case that weaker earnings raise leverage in the near term. We believe the preponderance of management teams are cognizant of leverage targets and committed to maintaining stable balance sheets. Lowe's (LOW, rating: A) and R.R. Donnelley (RRD, rating BB) are just a two examples of firms (on opposite ends of the credit spectrum) that have made comments regarding the desire to manage to a leverage target.
However, we remain concerned with companies that do not have such flexibility. In particular, we are keeping an eye on credits in sectors facing secular decline such as electronics-- Best Buy (BBY, rating: BBB-)and RadioShack (RSH, rating: CCC).Best Buy has been able to maintain lease-adjusted leverage in the mid-2 times range, but we are concerned that the firm's declining fundamentals will push leverage upward and lead us to downgrade the credit rating. We downgraded our issuer credit rating for RadioShack to CCC from B- as strong headwinds continue to negatively affect the firm. We now expect lease-adjusted leverage to rise to nearly 9 times at the end of 2012, up from 5.3 at the end of 2011. More importantly, we fear RadioShack might not be able to repay its convertible bond next May. We're pleased the dividend was suspended in order to preserve cash, but we remain concerned about the firm's liquidity.
Contributed by Joscelyn MacKay
Drought conditions across the United States, as well as severe weather conditions in other agricultural-export nations such as Russia, are placing more pressure on commodity costs. Elevated soft commodity costs will put additional pressure on gross margins as consumers remain vigilant about maximizing their limited income amid continued economic uncertainty, particularly in developed markets where high unemployment levels and austerity measures constrain discretionary spending. Consumers in emerging markets will likely feel a disproportionate amount of the rising commodity costs as food expense represents a much larger portion of household budgets than in the developed world. However, we note that higher input costs will affect firms throughout the consumer defensive space to varying degrees. Firms that we believe have a wide and narrow economic moat will have substantially greater ability to pass through cost increases, support their brands with targeted marketing spend, and invest in product innovation. Relative to firms with these long-term sustainable competitive advantages, firms whose portfolios consist of second- and third-tier brands will likely struggle. For example, an issuer such as ConAgra Foods (CAG, rating: A-), which we believe has a deteriorating narrow economic moat, might have a difficult time competing with branded products that are owned by larger companies with greater financial resources. In addition, ConAgra will likely face greater competition from private-label offerings, especially in categories where consumers consider price rather than brand when making their purchase decisions.
Mergers and acquisitions in the consumer defensive sector continue to highlight global acquisition momentum in the faster-growing emerging markets. For example, Anheuser-Busch InBev (BUD, rating: A-) agreed to purchase the equity stake of Grupo Modelo that it does not already own. Grupo Modelo is the leader in the Mexican beer market with 59% market share, and its Corona brand sells almost twice the volume of the second-largest brand. Following the acquisition, ABInBev will own five of the top six beer brands and seven of the top 10 beer brands in the world. While Corona is already distributed in 180 countries and is the number-one import brand in 38 of them, we believe it will benefit from ABInBev's global distribution platform and lead to further growth. After adjusting for the sale of the Crown joint venture and pro forma for expected synergies, it appears that ABInBev is paying about 11 times enterprise value to EBITDA, which seems reasonable to us. Further, Heineken (HEIA, rating: A-) agreed to buy Fraser and Neave's entire stake in Asia Pacific Breweries . Beer making is a scale business, and we believe that these brewing behemoths will benefit from increased control of their operations in Latin America and Asia.
Contributed by Dave Sekera
At the time of our last outlook, the concern in the energy sector was the confluence of the U.S. production surge from unconventional oil and natural gas plays and the softening demand picture from both Europe and China which caused a roughly 20% decline in oil and natural gas prices in the second quarter. Highlighting how volatile commodity prices can be in a tightly supplied market, global oil prices bounced back 20% this quarter as the market's concern about European and global demand appears to have been allayed. The outlook for natural gas improved nicely as warmer-than-average summer temperatures coupled with coal-to-gas switching led to a 24% increase year over year in natural gas-fired power generation. These factors helped drive spot natural gas prices up 60% from the April low to around $3 per mcf and reduced natural gas storage levels from a peak of 60% above the five-year average to only 11%. As exploration and production firms have shifted drilling programs toward oil in response to low natural gas prices, we anticipate that the short-term supply pressures on natural gas will begin to abate during the coming quarters, returning the market to healthier prices in future years.
As the fourth quarter approaches, we look for E&P companies to update 2013 capital spending and production plans. We anticipate more negative news for producers and services firms that are involved in North American natural gas. Conversely, we expect continued positive news for services companies that are active in the offshore deep-water market and E&P companies that produce a higher percentage of crude oil relative to natural gas and natural gas liquids.
In the E&P space, we continue to favor Apache (APA, rating: A+) due to its solid balance sheet and the fact that oil accounts for 45% of total production. We remain cautious on natural gas- and liquids-focused EOG Resources (EOG, rating: A) as we project the company to be moderately free cash flow negative from 2012 through 2014 because of its drilling program. In the oilfield services sector, Cameron International (CAM, rating: A-) should continue to perform well as a result of the company's improved capital structure and its strong Macondo-driven order backlog. We were cautious on Rowan (RDC, rating: BBB-) at the start of the third quarter as the company is making a strong move into the ultra-deep-water market. As Rowan and peers in the drilling market have announced contracts with favorable day rates in the third quarter, our concern about Rowan's ability to find projects for its yet-to-be contracted newbuild rigs has been alleviated. Rowan's 4.875% notes due 2022 recently traded at 265 basis points over Treasuries, offering significant yield pickup over peers and the possibility of spread compression. Management has indicated that producers are very interested in signing contracts for Rowan's rigs. If Rowan can secure these deals, we expect the market to react positively to the news.
Contributed by David Schivell
We suspect capital-allocation practices and the U.S. presidential election will dominate health-care headlines in the fourth quarter. From a capital-allocation perspective, many well-heeled firms are facing weak earnings-growth outlooks, which are testing the patience of shareholders. So with cash-rich balance sheets and borrowing costs at historic lows, we'd expect health-care firms to continue actively seeking ways to fill gaps in profitability growth by making debt-funded acquisitions, increasing share repurchases, and increasing dividends to appease shareholders. During the past quarter, health-care firms were particularly active on the M&A front with the following key transactions: Bristol Myers (BMY, rating: AA+) teamed up with AstraZeneca (AZN, rating: AA) to buy Amylin; WellPoint (WLP, rating: BBB+) leveraged up, enough to make us cut our rating one notch, to buy High Yield Best Idea Amerigroup (AGP, rating: BBB+); GlaxosmithKline (GSK, AA-) bought Human Genome Sciences; and Aetna (AET, rating: UR-) announced plans to buy Coventry (CVH, NR). We wouldn't be surprised to see more M&A activities like those or other shareholder-friendly capital-allocation practices during the next quarter, especially if mature health-care firms are not able to boost earnings-growth prospects through internal means. In fact, our recent "Spread-Widening Events Possible in Big Pharma Niche" piece highlighted AstraZeneca and Pfizer (PFE, AA) as most likely to use practices that are unfriendly to debtholders to fill their profitability gaps in that key niche. And overall in the health-care industry, we continue to warn investors that such activities create a negative credit trend, all else being equal.
Also this quarter, all eyes will be on the U.S. presidential election. Existing initiatives will likely continue if the Democrats retain control of the White House. However, if Republicans take back the White House, industry leaders may gain more hope of increasingly pro-business regulations in the future. For example earlier this year, the House passed a bill repealing the medical-device tax that is scheduled to be enacted in 2013. But with President Obama in office and threatening a veto, the bill went nowhere. We suspect a Republican president would be much more amenable to a tax repeal like that, which could boost the long-term earnings power at device firms we cover roughly 5% to 10%. Similar pro-business actions could emerge if a change of U.S. leadership is made in November.
Contributed by Julie Stralow
The fundamental outlook across industrials remains mixed, and current spread levels are starting to look somewhat rich, albeit buoyed by continued strong demand from investors looking to put ample amounts of cash to work. Across the key subsectors that we follow, fundamentals still look good for the rail sector, though low natural gas prices will adversely affect utility coal volumes over the near term. Although spreads across the sector remain relatively tight, within the sector we still like the bonds of Union Pacific (UNP, rating: A-) given its exposure to cheaper Powder River Basin coal and attractive relative value. In the agricultural and construction equipment space, fundamentals have improved out of the downturn, though slower growth is anticipated in the emerging markets and leverage has ticked higher for several names following debt-financed acquisition activity. In addition, drought conditions in the U.S. could crimp new equipment demand from farmers over the near term. We generally view the sector as fairly valued at this time, but like the bonds of AGCO (AGCO, rating: BBB-), given its relatively wide spreads for what we view as investment-grade risk.
The fourth quarter promises to be an exciting one for the defense sector with the upcoming presidential elections and pending outcome of sequestration. If the full budget cuts as mandated by the law from the Budget Control Act of 2011 are enacted, defense companies could see sharp declines in orders almost across the board. We see this as putting pressure on credit metrics and spreads, which supports our cautious view of the sector as it trades comfortably inside the Morningstar Industrials Index. Complicating matters is the recent announcement that EADS (EAD, rating: A-) is in talks to merge with BAE Systems (BA., rating: BBB+). This could set off additional M&A activity which might have uncertain credit implications. We generally prefer lower-rated credits which might benefit from being acquired such as Alliant Techsystems (ATK, rating: BB+) or those which we believe have a ratings floor such as L-3 Communications (LLL, rating: BBB-).
One sector that continues to show positive momentum is homebuilding. During the quarter D.R. Horton (DHI, rating: BB+) reported a 32% increase in the value of net sales orders for its third quarter. This was followed by Toll Brothers' (TOL, rating: BBB-) third-quarter results which included a 66% increase in signed contracts. Horton's management statement that the firm "transitioned from defense to offense" highlights the sentiment in the sector and portends more strength in the coming quarter. QE3 is another measure to support the sector as mortgage rates look to be low for the foreseeable future. Both Horton and Toll tapped the debt markets during the quarter to take advantage of cheap capital and ramp up liquidity ahead of further investment. Horton printed the lowest coupon in high yield ever, with a 4.375% 10-year senior note which we view as rich. Overall, we continue to prefer the suppliers to this sector as they offer better value. This includes USG (USG, rating: B-) and Owens Corning (OC, rating: BBB).
Contributed by Jeff Cannon and Rick Tauber
Technology & Telecommunications
While pockets of strength remain, the broader technology outlook for the remainder of 2012 has weakened further during the past quarter. Three months ago, large-cap tech firms like Cisco Systems (CSCO, rating: AA), Dell (DELL, rating: A+), and Hewlett-Packard (HPQ, rating: A) had begun to warn of softness ahead. These firms' outlooks haven't changed, and weakness has since spread to other corners of the sector. Specifically, semiconductor makers, which had seen improving business trends in the second quarter, have since become more cautious. In early September, Intel (INTC, rating: AA) cut its third-quarter revenue outlook about 8% versus a previous outlook provided two months earlier. The firm attributed the reduced forecast to weaker-than-expected processor demand, as computer manufacturers manage chip inventories in the PC supply chain. We don't expect the imminent release Microsoft's (MSFT, rating: AAA) Windows 8 operating system will provide much of a lift to enterprise technology spending over the near term, as firms have become more deliberate about staging new software investments than in past upgrade cycles. In addition, macroeconomic uncertainty is likely to cause businesses to remain cautious in making major spending decisions.
While credit spreads across the technology sector have tightened during the past quarter, most firms have merely matched the moves of the Morningstar Corporate Bond Index. As a result, the buying opportunities that we saw three months ago remain in place. Cisco's 4.45% notes due 2020, for example, have tightened about 26 basis points since mid-June, nearly identical to the move in the average spread on AA rated issuers in the index. The bonds continue to trade wider than we'd expect given our rating. Juniper Networks (JNPR, rating: A) provides one notable exception to the tightening trend. Its 4.6% notes due 2021 have actually widened 13 basis points to trade at 241 basis points over Treasuries. Although Juniper faces a number of challenges, we believe this level is very attractive for a firm that continues to generate positive cash flow and carries far more cash than debt.
In contrast to technology, the telecom sector has generally seen credit spreads tighten more than the index. Solid operating performance recently, especially in the wireless sector, has lent support to the view that telecom provides a reliable stream of steady cash flow. Both Verizon Wireless (VZ, rating: A-; VOD, rating: BBB+) and AT&T's (T, rating: A-) mobile business posted record margins during the second quarter, as the pace of phone upgrades among customers slowed to levels not seen in some time. However, heavy sales of the new iPhone will push phone subsidy costs up sharply during the second half of 2012, putting pressure on wireless margins. The threat that Apple's (AAPL, rating: NR) growing power poses to the telecom industry is one of several risks that leave us wary of chasing telecom yields. The state of the carriers in Europe clearly demonstrates that telecom is not immune to swings in the economy or the increase in competition that can accompany slowing growth.
Contributed by Mike Hodel
Two environmental regulations the U.S. Environmental Protection Agency finalized in 2011 continue to cloud the sector's near-term landscape. Coal plant retirements and increased capital investment are two likely outcomes we expect from final versions of the EPA's Cross-State Air Pollution Rule, or CSAPR, and the air toxics rule, or MATS. While CSAPR was fully vacated in August 2012 after having been stayed in December 2011, we believe the EPA will revise the rule rather than advance it up to the Supreme Court. Additional environmental rules could follow in 2013 addressing water cooling and coal ash disposal. All of these likely will raise costs for consumers and put more rate pressure on regulated 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 historically tight spreads on higher-quality utilities facing lackluster earnings growth and the prospect of falling allowed returns on equity, we urge bond investors to approach investment-grade utilities with caution while focusing on a longer-duration yield orientation.
We expect high-quality utilities 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. Environmental capital expenditures will be a significant component of debt-funded capital expenditures, though also highly dependent on the severity of ongoing regulatory rulings, implementation timelines, 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 allowed ROEs below 10%, limiting creditors' margins of safety as this regulatory lag diminishes.
Unregulated independent power producers face high uncertainty during the next quarter and into 2013. Power prices will remain severely strained as long as natural gas prices remain low. Excess natural gas supply and an unseasonably warm 2012 winter have pushed gas prices to historic lows which remain below the $3/mmBtu mark. High natural gas storage levels of 4,239 billion cubic feet continue to rise and are 3% above where they were a year ago. As such, we continue to expect merchant power producers to experience elevated liquidity constraints, especially within companies that own older coal plants in need of control upgrades. Restructuring at Edison International's (EIX rating BBB-) merchant generation company, Edison Mission Energy, is the first casualty following Dynegy Holding's 2011 fourth-quarter bankruptcy filing and expected emergence by Oct. 1, 2012. Ameren's (AEE, rating BBB-) merchant generation company, Ameren Energy Generation Company, also faces margin contraction and possible liquidity constraints as it awaits its final emissions implementation ruling from the Illinois Pollution Control Board in late September.
The industry's broad desire to accumulate regulated assets, whereby offsetting and/or shedding merchant power plants, has fueled M&A activity thus far in 2012 and we expect this pace to continue through the remainder of the year. Representative deals that have closed year to date include all-stock mergers between Northeast Utilities (NU, rating BBB) and Nstar; Exelon (EXC, rating BBB+) and Constellation Energy; and most recently Duke Energy (DUK, rating BBB+) and Progress Energy.
In July, independent power producer NRG Energy (NRG, rating: BB-) announced it had agreed to acquire GenOn Energy (GEN, rating: BB-) for $1.7 billion in an all-stock transaction slated to close in the first quarter of 2013. Rationale for this transaction includes greater scale (highlighting NRG's retail expansion), generation fuel and revenue diversity, as well as reduced liquidity needs. Although we view GenOn as the weaker performer of the two, NRG announced that it will reduce leverage by $1 billion, principally at GenOn, following the merger.
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 ongoing regulatory action in Ohio that could force American Electric Power (AEP, rating: BBB+) to divest its power generation business from its transmission and distribution business by 2014.
Contributed by Joe DeSapri
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. Following is a sample of a few issues from our monthly Best Ideas publication.
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 with the yield pickup along the curve.
|Top Bond Picks|
|Ford Motor Credit||F||BBB-||2021||5.875%||$112.75||4.14%||262|
|Data as of 09-17-12. Price, yield, and spread are provided by Advantage Data, Inc.|
Celgene (CELG, rating: A)
Celgene offers the biggest reward opportunities in the top-tier biopharmaceutical niche. With its narrow moat and positive moat trend, we see the potential for spread-tightening events in Celgene's future, too. Celgene aims to introduce new products, which could widen its moat and extend its advantages well beyond key drug Revlimid. That drug represents about two thirds of the firm's current sales. Importantly for long-term investors, we remain confident in Revlimid's prospects even beyond its 2019 composition patent expiration due primarily to its controlled distribution, which may make it difficult for generic firms to even gain access to Revlimid to determine bioequivalence. However, spread tightening will only happen, in our opinion, if Celgene can find a new growth driver. Positively, we see promising pipeline prospects in its near future. For example, Celgene's new multiple myeloma therapy pomalidomide has been filed with regulators, and this potential blockbuster looks set to receive U.S. approval in February. 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 may provide tightening catalysts, as well.
Ford Motor Credit (rating: BBB-)
Ford Motor Company (F, rating: BBB-) reported weak second-quarter results in July that were driven by difficulties in its international operations. The European market continues to be the biggest source of weakness, and we expect this to continue for the foreseeable future. However, we continue to have a robust view of the North American market, which drives the bulk of Ford's sales and cash flows. The company continues to generate positive free cash flow, and its net debt position improved slightly during the quarter. Ford Credit continues to perform reasonably well, though net profits are also down from the prior-year period. Nonetheless, we believe Ford and Ford Credit are solidly positioned in investment-grade as the company is in a much stronger position to handle market weakness. We would recommend all of Ford and Ford Credit bonds though we highlight the benchmark bond at Ford Credit, which now offers spreads about 35 basis points wide of the Morningstar BBB- index. These bonds also trade about 150 basis points wide of similar maturities at Daimler's (DAI, rating: BBB+) and Volkswagen's (VOW, A-) finance subsidiaries, which we view as very attractive. We believe spreads can tighten at least 50 basis points during the next few quarters as the company generates stable or improving operating performance.
Fifth Third Bancorp (FITB, rating: BBB+)
Last year, Fifth Third was able to repay its preferred stock and associated warrants from the Troubled Asset Relief Program and was able to improve both its regulatory and actual capital levels. The bank's Tier 1 capital ratio is a now a healthy 12% and stands in line with peers. More impressive is Fifth Third's ratio of tangible equity/tangible assets, which is now greater than 9%, as we calculate it, and better than the average for its peer group. The company has done a good job of improving its credit quality as it has been able to reduce its percentage of nonperforming assets. To be sure, its nonperforming loan balance is currently less than half of its peak level from 2009. Also, its percentage of reserves to nonperforming loans is now more than 150%.
ArcelorMittal (MT, rating: BBB-)
ArcelorMittal's extremely liquid 10-year bonds trade well below our assessment of fair value. At a yield approaching 7%, investors can garner a decidedly speculative grade return for what remains, in our view, investment-grade risk. While cognizant of the macroeconomic headwinds that cast doubt on a near-term recovery in ArcelorMittal's profitability and could trigger further deterioration in its credit metrics, we do not believe these cyclical risks are sufficient to merit a speculative grade rating when weighed against the firm's still-moderate leverage, geographically diverse revenue streams, limited near-term refinancing needs, and ample liquidity. Despite very challenging market conditions, ArcelorMittal's leverage remains reasonable, a testament to the firm's asset quality and diverse revenue mix. As of June 30, 2012, net debt stood at $22.0 billion, roughly 2.6 times trailing 12-month EBITDA of $8.5 billion, affording plenty of "headroom" under the 3.5 times net debt/EBITDA covenant set forth by the company's credit facilities. We expect profitability to remain comparably weak through year-end, before improving in 2013 on a slight increase in steel shipments, a better supply/demand balance for steel, lower iron ore and coal prices, and benefits from the company's asset-optimization program. The net debt/EBITDA ratio would fall to 1.9 times by year-end 2013, holding net debt steady at $22.0 billion.
We suspect the uncertain macroeconomic environment in Europe accounts for the cheapness of the bonds. While a deep and lengthy European recession would undoubtedly delay the recovery in consolidated profits we expect for 2013, the downside risk is muted by the company's geographic diversification: Europe accounted for 16% of consolidated EBITDA in the past 12 months. Given significant prevailing macroeconomic uncertainty, we view ArcelorMittal's modest refinancing needs and strong liquidity as critical components of its underlying credit quality. At June 30, 2012, total maturities remaining in 2012 stood at $1.2 billion and 2013 maturities at $3.8 billion. Financial flexibility is further enhanced by $14.8 billion in total liquidity, composed of $4.5 billion in cash and $10.3 billion in available credit lines.
Safeway (SWY, rating: BBB)
Credit spreads widened across the supermarket sector after Supervalu (SVU, rating: UR-) announced preliminary fiscal second-quarter financial results in the middle of July that came in well below management's outlook, suspended its earnings outlook and its dividend, and announced the initiation of a review for potential strategic alternatives. We think credit spreads widened more than deserved and will tighten to more normalized levels. Although Kroger (KR, rating: BBB) is a better-run company and has modestly better credit metrics, we think the spread between Kroger's and Safeway's bonds is too wide. Kroger's 3.40% 2022 senior notes last traded around +153. Historically, similar-dated Safeway bonds traded 25-30 basis points behind Kroger, and we expect Safeway's bonds will tighten toward Kroger's credit spread over time. Toward the end of April, Safeway was rumored to be a leveraged buyout target, which pushed the spread substantially wider. We doubt the firm will be purchased in a leveraged buyout transaction, and even in that instance, these bonds are protected by a change-of-control provision that would allow bondholders to put the bonds back to the company at 101 (near the current price). Safeway's bonds are also cheap compared with 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.
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David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.