'Buy 'Em All First, Let Research Sort It Out Later'
Technical factors may dominate in the credit markets for now, but fundamentals overrule in the long run.
The rate at which the average corporate credit spread is tightening slowed last week. The Morningstar Corporate Bond Index tightened only 2 basis points to +154, and the average credit spread in the Morningstar Eurobond Corporate Index was unchanged at +164. These are the tightest levels the market has traded at since last July.
While corporate bond credit spreads appear poised to modestly tighten further in the near term, at this point, we believe the preponderance of credit spread tightening has run its course. The tightest average spread of our index since the 2008-09 credit crisis was reached in April 2010 at +130, just before Greece admitted its public finances were much worse than previously reported, thus beginning the European sovereign debt crisis. Since the beginning of 2000 the average credit spread in our index was +177, and the median credit spread was +164. However, while the average credit spread contraction has slowed, the demand for corporate bonds has not. The new issue market continued to dominate trade flow because it was the only avenue for investors to find a meaningful amount of bonds to purchase as dealer inventories remain near their lows.
One example of the activity in the new issue market last week is Ford Motor Credit Corporation, which we rate BBB-. The company issued 10-year bonds at a spread of +260 over Treasuries. The original whisper talk was +280, which was subsequently tightened to +265 when official price guidance was released. The issue immediately traded up in the secondary market and ended the week at +235. We were not surprised that the notes tightened, as we think fair value for the notes is +225, but 25 basis points in a day for one of the largest bond issuers is a very significant move over such a short period.
The current environment reminds me of prior periods in the mid-2000s, when demand for corporate bonds became so great that any time a new issue was announced, buy-side traders would place their orders irrespective of price talk and even before checking with their research analysts about the quality of the issuer. These traders knew that if they didn't immediately put in for the deal, the chances that they would receive a decent allocation were slim to none, as all of the deals were multiple times oversubscribed. During one of these periods, a buy-side trader I used to work with changed the tag line on his Bloomberg message screen to "Buy 'em all first, let research sort it out later." He recognized that the market was becoming so hot that even if the portfolio manager didn't want the bonds, the trader could easily flip the bonds into the secondary market and make a small gain as the credit spread tightened a few basis points. This highlighted the fact that fundamentals were taking a back seat to the market technicals as inflows into mutual funds were outpacing portfolio managers' ability to put the cash to work.
Technical Factors May Dominate for Now, but Fundamentals Overrule in the Long Run
Since the Fed's announcement that it was going to purchase mortgage-backed securities, the average credit spread of long-dated MBS has reportedly tightened more than 60 basis points. As the Fed ramps up its purchases MBS and continues Operation Twist (selling short-dated Treasuries and purchasing long-dated Treasuries), investors will have increasingly fewer fixed-income securities to choose from, which in the near term is likely to force credit spreads tighter as this new liquidity looks for a home.
While technical factors have dominated in the current environment, over the long term fundamental considerations will eventually hold sway as there are a number of domestic and global factors that could adversely affect issuers' credit strength during the fourth quarter. Norfolk Southern (NSC, BBB+) was the latest to announce that its quarterly profit would miss consensus expectations (joining Federal Express (FDX, BBB) and Intel (INTC, AA)) because of weaker coal and merchandise shipments and lower fuel surcharges. The uncertainty and outcome of the presidential elections and negotiations to mitigate the fiscal cliff will affect numerous sectors, with health care and defense being the most directly affected.
Globally, we are concerned that China's slowing growth and Europe's slide into a recession could pressure cash flow for those issuers with global operations. Gauging the economic outlook of any economy is tough enough, but is especially difficult for China. As such, our basic materials team monitors hard data to measure the resilience of capital infrastructure spending in China (the largest contributor to economic growth). One of the most concerning indicators of a potentially rapid slowdown is the dramatic decrease in the spot price of iron ore, which has dropped from $150 per ton earlier this year to as low as $88.50 before rebounding recently to $109.75.
In Europe, while the European Central Banks' outright monetary transaction program appears to limit near-term sovereign default risk, Spain and Italy are suffering the brunt of the recession, and their sovereign credit metrics continue to decline, which could call into question their long-term sustainability. We advise investors to be cautious in selecting which bond offerings they participate in, lest they be plagued with buyer's remorse if the market takes a turn for the worse. While we understand the pressure to put money to work and the desire to pick up additional yield, we recommend that investors continue to be careful.
Teachers Strike Ends, yet Financial Pressure Continues in Chicago
Contributed by Beth Foos, Municipal Credit Analyst
Delegates for the Chicago Teachers Union voted on Sept. 18 to suspend their strike that kept about 350,000 students in the nation's third-largest public school system out of classrooms for seven days. It was the first strike for Chicago teachers in 25 years. The vote came after CTU leadership and district officials announced a tentative three-year agreement that includes pay increases, a longer school day, and an updated teacher evaluation system, among other things. The new contract, which needs to be approved by the full union membership, is estimated to cost the cash-strapped school district an estimated $300 million over four years. It is unclear how the district, which faces significant financial pressure already, will pay for the increase. More operational changes are necessary as the district continues to contend with lower revenue and higher annual costs, including huge increases in required pension payments starting in 2014.
The strife is an extension of contentious negotiations over the past 10 months between CTU and Chicago Public Schools administrators. The new agreement includes salary increases of 3% in the current school year and 2% in the second and third years and additional bumps possible for teachers with more experience and advanced college degrees. Also, 30% of teacher evaluations will now be based on student test scores, as mandated by state law, and include a provision for appeals to a review board. The teacher workday has also been extended, and the district plans to hire more than 500 specialty teachers for music, art, and physical education classes to contend with the change. Half of all those and other hires are to come from a pool of currently laid-off CTU members, and a teacher must be recalled if there is an opening at his or her old school during the 10 months following the layoff. Even with this, principals will be the ultimate decision makers when it comes to hiring. Teachers are also allowed to "follow their students" to a new building if their current school is closed down and participate in a new wellness program. The new contract runs for three years with the option for a fourth and will cost an estimated $74 million annually.
How the district will pay for the salary increases and other changes is uncertain. In fiscal 2012, management implemented a 2.4% property tax increase to its property tax cap and $400 million in cost reductions by reorganizing programming, reducing administrative costs, and withholding a scheduled 4% pay increase for CTU members. Even with the changes, the board estimates it ended fiscal 2012 with an estimated operating deficit of $114.5 million in its general operating fund. The CPS board approved a $5.3 billion fiscal 2013 budget last month that uses most of its remaining financial reserves to help eliminate a $665 million operating deficit and does not include provisions for additional salary increases. In 2014, the district faces up to a $1 billion operating deficit partly due to a $338 million increase in the district's required pension payment, which is set by the state legislature.
With very slim financial reserves and flexibility and operating costs on the rise, there are few options left for balancing the budget in the next several years. Possibilities include school closures, layoffs, administrative changes, and more one-time actions such as restructuring debt. Officials have also cited more structural reform needed to the district's pension system to address fiscal pressures, although those changes require action at the state level. Investors should continue to monitor CPS budget updates and operating reforms closely in the coming months as they will be vital to the financial health of the district through the midterm.
New Issue Notes
Anglo American to Issue 5- and 10-Year Notes; Bonds Likely to Come Cheap Versus Our Rating (Sept. 20)
Diversified miner Anglo American (AAL, BBB) announced plans for a benchmark-size issuance of U.S. dollar-denominated 5- and 10-year notes (144A/Reg-S). Whisper talk initially suggested a spread in the low 200s on the 5-year notes and mid-200s on the 10-year notes, followed by guidance of 200 basis points above Treasuries and 250 basis points above Treasuries, respectively. At those levels, we'd consider the new bonds cheap for the rating, but not especially compelling relative to mining peers, where many names are now trading wide of spreads implied by their rating.
Our BBB rating, which sits one notch lower than the agencies', reflects Anglo's diverse asset base (ranging from platinum to coal to copper) and manageable leverage (gross debt/TTM EBITDA of 1.4 times, net debt/TTM EBITDA of 0.3 times). These positive qualities are offset by the extreme cyclicality that besets all mining companies and an ample helping of country risk associated with Anglo's significant South African presence, where its benighted platinum operations--the world's largest--continue to generate negative headlines and poor financial results.
If the new bonds were to price at levels commensurate with guidance, they'd represent a discount to the typical BBB-rated industrial name in the Morningstar Corporate Bond Index, which carries a spread of 193 basis points (average term: 11 years). This would not be atypical for mining, where we've seen bonds widen relative to the index over the past several quarters as the pace of Chinese economic growth, the linchpin of metal prices, has stumbled.
In light of the obvious headwinds facing mining, we'd peg fair value on Anglo's new 10-year notes at roughly 30 basis points wide of the BBB index, or about 225 basis points above Treasuries. In mining, we continue to prefer the bonds of low-cost copper producer Southern Copper (SCCO), which we rate a notch higher than Anglo at BBB+. Looking at bonds of roughly comparable maturity to the new Anglo bonds, Southern Copper's 5.375% notes due 2020 trade at a spread of 223 basis points above Treasuries or 75 basis points wide of the average BBB+ rated industrial in the Morningstar Corporate Bond Index, which carries a spread of 148 basis points above Treasuries.
Ford Motor Credit Offering 10-Year Notes (Sept. 20)
Serial issuer Ford Motor Credit (BBB-) is back in the market with a new 10-year benchmark-size offering. The firm previously tapped the market in June, July, and twice in January. We added Ford Credit's 5.875% senior notes due in 2021 to our best ideas list at the beginning of August at a spread of 315 basis points above Treasuries. These are now trading at a spread of 260. We believe there is further room for tightening and see fair value on the new 10-year deal at around 225 basis points above Treasuries as there could be further upward momentum in credit ratings.
In comparison, Daimler's (DAI, BBB+) finance subsidiary has a 2021 maturity issue indicated at a spread of 148, which we view as fair value. We believe Ford Credit should trade around 75 basis points wide of Daimler Finance. Volkswagen's (VOW, A-) finance subsidiary has a 2020 maturity issue now indicated at about 139 basis points above Treasuries, which we view as slightly cheap. As an additional reference, the Morningstar Industrials Index is currently at a spread of 247 basis points above Treasuries for the BBB- category, and we believe Ford Credit can migrate closer to the BBB category, where the index is now at a spread of 191.
We continue to maintain a U.S. light-vehicle SAAR forecast for 2012 of 13.8 million-14.2 million vehicles as substantially higher pent-up demand is being tempered by the fragile U.S. economic recovery. We prefer a slow and steady ramp-up in sales to a sharp increase, as this will allow the supply base to grow with demand in an efficient manner. Notably, August's sales came in at a SAAR of 14.5 million units, exceeding expectations. One other highlight was the strength in pickup trucks driven by an uptick in demand from contractors in the housing market. We believe North American-centric Ford will continue to benefit over several years from these trends in the marketplace.
Schneider's New Issue Will Probably Look Rich (Sept. 20)
Schneider Electric (SU, BBB+) is expected to come to market with a benchmark-size 10-year offering. Proceeds will be used for general corporate purposes, probably to refinance or term out existing debt as the company has a steady stream of debt maturities. At its core, Schneider is an energy management firm. Through its electrical distribution segment, the company has exposure to utilities firms, and its automation and critical power segments give it exposure to power consumers. We think Schneider's portfolio of businesses warrants a narrow economic moat rating. The company maintains strong relationships with customers, providing products and services with high switching costs. By focusing on products with tangible benefits to customers, Schneider typically avoids price wars with competitors.
In looking across the diversified industrial space for comps, we think Philips Electronics (PHG, BBB+) represents a good data point, given our similar ratings and the European domicile of both names. In addition, our BBB+ rating on both names is one notch lower than the nationally recognized statistical rating organizations. Philips has a 2022 bond that recently was quoted around a spread of 115 basis points above Treasuries, which looks a little rich to us relative to trading levels of higher-rated diversified names. United Technologies (UTX, A) and Honeywell (HON, A) have bonds in the 10-year part of the curve that recently were quoted around 75 basis points above Treasuries, which seems a little rich to us. Danaher (DHR, A) has a 2021 bond that was quoted closer to 85 basis points above Treasuries, which we view as closer to fair value. Adjusting for the two-notch difference in credit quality, we would place fair value for a new Schneider 10-year in the area of 130 basis points above Treasuries, but would not be surprised to see it price closer to Philips' levels.
Church & Dwight Issuing Debt to Fund Recent Acquisition (Sept. 19)
Church & Dwight (CHD, A-) is reportedly bringing a $400 million, 10-year bond offering to market. The firm recently announced that it had jumped back into the acquisition ring, acquiring privately held Avid Health, a leading player in the gummy vitamin and supplement category with brands such as Vitafusion and L'il Critters, for $650 million (2.8 times trailing-12-month sales and 11.2 times EBITDA). We weren't surprised to see the consumer product firm look to build up its personal-care business. With the inclusion of Avid, Church & Dwight gains a new platform, which is inherently risky, but the company has proved to be a prudent acquirer, so we aren't overly concerned. Pro forma for the deal, we anticipate that debt/capital will rise to 0.3 and debt/EBITDA will increase to 1.4 times. Based on our pro forma assumptions, we did not change our A- rating, which is two notches higher than both of the rating agencies. Church & Dwight maintains ample free cash flow (which amounted to 13% of sales in fiscal 2011) and a minimal debt load relative to its peers, and as such, we doubt its thirst for acquisitions has been quenched. We believe it is likely that the firm will continue to pursue small bolt-on acquisitions over the near term.
While we do not believe that Church & Dwight currently possesses an economic moat, we are cognizant that it is exhibiting the signs of an emerging moat, resulting in a positive moat trend. While Church & Dwight lacks the size and scale advantages of the dominant industry players, we believe its brand investments are gaining traction with consumers. We forecast improving returns on invested capital over our forecast period, which, in conjunction with continued solid credit metrics, forms the basis of our issuer credit rating.
Church & Dwight's only outstanding bonds, the 3.35% senior notes due 2015, are rarely traded, but valuation appears to be around 110 basis points over Treasuries. We have heard whisper talk on the new issue at +140, which sounds about fair value to us. Based on our view that the firm's credit quality is higher than the rating agencies give it credit for, and the unquenchable demand for new issues in the marketplace, we expect Church & Dwight's new issue will price at a level significantly tighter than a mid-BBB bond in the consumer defensive space. Our issuer credit rating on Clorox (CLX, A-) is the same as Church & Dwight and one notch higher than the rating agencies. Clorox recently issued 10-year notes that are currently trading in the mid-120s. Considering that Church & Dwight is a much smaller, less well-known company and will probably continue to make acquisitions, the new notes should trade at a discount to Clorox. We think a 10- to 15-basis-point range over Clorox would be fair. Other comparables include Heinz (HNZ, A-) 2.85% senior notes due 2022, which are indicated around +103, and General Mills (GIS, A) 3.15% senior notes due 2021, which are around +113. Across the broader market, the A- segment of the Morningstar Corporate Bond Index is currently at +128 and the BBB segment is +196.
Franklin Resources' New Notes Represent Solid Value for a Highly Rated Company (Sept. 19)
Franklin Resources (BEN, AA-) announced Wednesday that it plans to issue $500 million of 5- and 10-year notes. Whisper on price guidance is in the area of 100 basis points above Treasuries for the 5-year and 125 basis points for the 10-year. Pricing Franklin Resources is difficult, as it is easily the highest-rated asset manager we cover. Although not a perfect comparison, we think a similarly rated regional bank would issue inside 100 basis points for a 10-year note. Given the high quality of this issuer, we think whisper talk sounds attractive, and we would recommend the notes all the way down to a spread of 25 basis points tighter than whisper talk.
Our AA- rating reflects Franklin's diversified asset mix, broad client base, and manageable debt load, all of which leave it as one of the strongest asset managers we cover from a credit perspective. At the end of June 2012, the firm had approximately $700 billion in assets under management. Franklin's product mix is fairly diverse, with 40% of AUM dedicated to equity strategies, 15% in hybrid funds, and 45% in fixed income. While product distribution is weighted more toward retail investors (approximately 80% of AUM), who are not as sticky as institutional and high-net-worth clients, the firm has strong relationships with financial advisors. The firm scores well in our credit rating model as its debt/EBITDA ratio is about 0.3 times, its net debt/EBITDA is well below 0.0, and its EBITDA/interest expense is more than 50 times.
New Vodafone Notes Look Fair for Telecom (Sept. 19)
Vodafone (VOD, BBB+) is planning benchmark-size offerings of 5- and 10-year notes, with whisper guidance currently at 75 and 100 basis points over Treasuries, respectively. We expect actual pricing will come at tighter spreads than these, though. The firm's 1.625% notes due in 2017, which were issued last March, currently trade at +63 basis points, while its 4.375% notes due 2021 trade at around +93. Given the high dollar price on the 2021 notes and the heavy demand for new issues, we wouldn't be surprised to see Vodafone's new 10-year notes price at a similar spread. In the range of 90-100 basis points over Treasuries, we believe the new Vodafone 10-year notes would be slightly more attractive than comparable issues from either AT&T (T, A-) or Verizon (VZ, A-). AT&T 3.0% notes due 2022 trade at about +71 basis points and Verizon's 3.5% notes due 2021 trade at +73. In general, though, we believe telecom bonds continue to trade too tightly relative to other sectors.
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 1.9 times EBITDA.
We Like Whisper Guidance on J.P. Morgan's New 10-Year (Sept. 19)
J.P. Morgan Chase (JPM, A) announced today that it plans to issue new benchmark 10-year notes. Whisper on price guidance is in the area of 160 basis points above Treasuries, and given the considerable spread tightening in the financial sector over the past week, it is very possible that the final pricing could be meaningfully tighter. We think these bonds would be attractive if priced at the whisper guidance, and we would recommend them all the way down to a spread of +150. Anything tighter than +150, and we would recommend investors look to Citigroup (C, A-), whose 10-year trades with a spread of +170, allowing investors to pick up 20 basis points for just one notch lower of rating.
From a credit perspective, we like the company's stellar performance and reputation throughout the financial crisis, but we are wary of some of its mediocre credit metrics. In our view, J.P. Morgan Chase is the best managed of the three money center banks in the U.S., having avoided the risk management missteps that critically injured Citigroup and Bank of America (BAC, BBB) in addition to numerous peers around the world. We see no reason this excellent performance won't continue. J.P. Morgan's regulatory capital levels are sound for a bank of its size, with its Tier 1 capital ratio at 11.3% and its Tier 1 common ratio at 9.9%. The bank's actual capital levels, however, are a cause for some concern, as its tangible common equity/tangible assets ratio is just 5.9% as we measure it.
We Believe Kohl's New Bond Deal Will Be Attractive (Sept. 18)
Kohl's (KSS, A+) is coming to market with a new $300 million 10-year deal today. We believe the notes will be priced attractively relative to our rating, as it is three notches higher than those from S&P and Moody's. We believe Kohl's strong investment-grade rating is supported by the firm's moderate lease-adjusted leverage in the mid-1 times range. Thanks to double-digit operating margins, Kohl's continues to generate healthy free cash flow, which we estimate will average around 6% of sales annually. We view the firm's five-year Cash Flow Cushion of around 2 times our base-case expense and obligation forecast as strong. We expect Kohl's will use excess cash for share-repurchase activity and dividends. We are mindful of shareholder-friendly activities that may be detrimental to bondholders, as management has not ruled out adding a modest amount of leverage to buy more shares. Still, Kohl's is on track to buy back more than $1.2 billion of shares in 2012 without materially increasing leverage.
The firm's existing 10-year notes are trading around 153 basis points over Treasuries, or right on top of Morningstar's 10-year BBB+ index. Given the preponderance of demand for new paper, we wouldn't be surprised to see the notes price tight to the existing bonds, and we would be interested down to around 85 basis points over Treasuries (the level of Morningstar's 10-year A+ index). While they are not frequently traded, we would look to TJX (TJX, A) and Nordstrom (JWN, A-) as comparables. Both firms have lease-adjusted leverage that is roughly a turn higher than Kohl's, yet their bonds trade inside where Kohl's bonds trade. TJX has 2019s that are trading around 140 basis points over Treasuries, and Nordstrom has 2020s that are trading around 130 basis points over Treasuries. Even Macy's (M, BBB) 10-year bonds trade tighter than Kohl's at roughly 140 basis points over Treasuries. While not in the same sector, the home-improvement retailers trade well inside these levels, providing further support for our assessment of Kohl's appropriate level. With lease-adjusted leverage slightly higher than Kohl's at around 2 times, Home Depot (HD, A) and Lowe's (LOW, A) have 10-year bonds trading around 70 basis points over Treasuries and 100 basis points over Treasuries, respectively.
Kohl's has created a nice niche by providing a wider selection of brand-name apparel than discounters such as Target and by offering more convenient locations than mall-based chains like J.C. Penney. Additionally, the Kohl's store format is less costly to operate than that of department store chains that are mainly tied to malls, giving it an additional leg up over its closest competitors. Despite weak sales in 2012, store- and corporate-level efficiencies and lower-than-anticipated selling, general, and administrative expenses are driving solid earnings. We believe both operational and technological changes will result in long-term profitability improvements, potentially offering upside to our long-term forecast. One of the main drivers in our cash-flow-based valuation is the company's higher operating margins, as competitors such as J.C. Penney have noted that Kohl's is more efficient in a number of areas at both the store and corporate level.
We Expect Torchmark's New 10-Year Notes to Price Attractively (Sept. 17)
Torchmark (TMK, BBB+) announced that it is issuing $300 million of 10-year notes. No information has been given on price guidance yet, but Torchmark's current 10-year notes trade in the area of 310 basis points above Treasuries, so we expect this deal to price in the area of 325 basis points above Treasuries. At that level, we think these bonds would be very attractive, and we would recommend them all the way down to a spread of 250 basis points above Treasuries. Even at a spread of 250, Torchmark would trade approximately 100 basis points higher than the average life insurance company.
From a credit perspective, we like Torchmark's low-cost business model and conservative balance sheet. Torchmark sets itself apart in the hypercompetitive life insurance industry through its unique distribution channels and cost-conscious culture. Torchmark's intense focus on maintaining a low-cost structure is its most attractive feature. About 34% of Torchmark's life premium income comes from Globe Life, a subsidiary that primarily uses direct mailing, magazine inserts, and TV ads to sell individual life and supplemental health insurance to middle-income families in the Southeastern and Southwestern U.S. By relying on direct mailing, Torchmark is able to keep its operational costs down, as no commissions need to be paid to agents. Since Torchmark makes higher profits on life insurance products, it doesn't need to leverage its balance sheet to the same degree as competitors. Its leverage levels are more similar to those of property-casualty insurers, which carry much more conservative balance sheets than the average life insurance company. This higher average leverage of life insurance companies lends to Morningstar's generally negative outlook for the industry.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.