Assessing Sandy's Impact on the Bond Markets
Delayed by the storm, new issuance surged late last week. Plus, we examine the credit impact on utilities and munis.
The corporate bond market was essentially shut down last Monday and Tuesday and was dislocated on Wednesday. However, the new issue market came back with a vengeance on Thursday and Friday. The total amount of bonds priced for issuers we cover topped $19 billion, one of the largest two-day totals that we can remember.
While the market appeared to be able to handle this surge of new issues, this next week should be instructive as to the near-term outlook for the market. Abbott Labs ABT (UR-) subsidiary AbbVie is expected to issue more than $10 billion of notes in order to upstream cash to the parent company before being spun off into a stand-alone entity. This deal size is one of the largest investment-grade transactions, and how well the transaction is received and trades in the secondary market may affect the short-term direction of the corporate bond market.
Sandy's Severe Headwinds Drain Near-Term Cash, but Spare Coverage Ratios
As we assess the credit impact of Sandy across our sectors, we expect many utilities will face lost distribution and generation revenue that will affect fourth-quarter earnings, as well as lower near-term cash on the balance sheet. However, based on past storms and our initial conversations with management teams, we expect most regulators will allow utilities to defer and recover over time most of the storm costs from customers, resulting in minimal total long-term cash losses.
Regulators might also allow the utilities to securitize the expected rate increases, which would allow utilities to recapture cash more quickly. In such a scenario, utilities would issue rate-backed bonds to compensate them for system repairs. As such, we would expect book leverage to increase as utilities manage higher proportions of debt by passing all related principal and interest costs through to customers via rate increases. Cost capitalization and securitization would have no net impact on coverage ratios.
The most heavily affected utility is Consolidated Edison (ED) (BBB+), which we estimate could incur system repair bills and outage-related fines of several hundred million dollars. Most utilities in the region have usage-based rates and face lost revenue from outages. In addition to ConEd (of New York), the utilities affected most include:
For power producers in the region such as Public Service Enterprise Group, Exelon, FirstEnergy, Entergy (ETR) (BBB), and NRG Energy (NRG) (BB-), we expect the storm will reduce fourth-quarter earnings and near-term cash on the balance sheet. With transmission and distribution networks out of service, utilities' power plants won't be able to run even if they are operable, reducing gross margins. Minimizing the impact is the already low usage levels typical during the fall shoulder season.
Hurricane Sandy to Have Considerable Impact on New York's MTA Infrastructure
Contributed by Rachel Barkley, Municipal Credit Analyst
Hurricane Sandy had a severe effect on the New York Metropolitan Transportation Authority's infrastructure, compounded by the vast size and considerable age of the system. In a statement released shortly after the storm passed, MTA chairman Joseph Lhota described the storm as being the most devastating the system has faced in its 108-year history.
The MTA, a public benefit corporation of the state, is an umbrella system consisting of several subsidiaries and affiliates including subway, regional rail, and bus service as well as bridges and tunnels in the New York City metropolitan region. The MTA bridge and tunnel segment issues debt as a separate obligor (the Triborough Bridge and Tunnel Authority) although it is included in the MTA's consolidated financial statements as the MTA is financially accountable for the entity. The overall system serves as the largest transit and commuter network in the country with more than 8 million daily commuters. The service area is vast, consisting of New York City and seven area counties.
The system suffered unprecedented damage to its infrastructure during the storm. Flooding appears to have been the most prevalent cause of damage. Seven subway tunnels flooded as well as portions of the Long Island Rail Road, a component of the MTA, several tunnels, and garages housing equipment. Tracks that are not underground were scattered with debris that included, among other items, boats. Portions of the system lost power. The system is slowly coming back into service, with some portions requiring more time to be restored.
Capital needs of the system, which are already substantial with a $26.3 billion fiscal 2010-14 capital plan, will increase further as the system rebuilds and considers how to prepare itself for future storms. Morningstar expects the system to use a variety of revenue to fund these needs, including federal assistance as well as the likely issuance of additional debt issuance by the MTA.
In addition to the impact on the system's capital budget, the storm has had an impact on the system's operating budget. Chairman Lhota has estimated that the MTA lost $18 million each day the system was shut down. These losses continued through the week, despite portions of the system getting back up and running as fares were waived until through Nov. 2. Operating expenditures will probably be affected by crews working overtime to restore service and provide additional bus service until the system is fully operational.
The Federal Emergency Management Agency has agreed to reimburse New York City and New York State, which provide a significant portion of MTA funding, for the full cost of emergency public transportation and restoring power. Senators Chuck Schumer and Kirsten Gillibrand have called on FEMA to fully reimburse the area to the fullest extent of the law. FEMA is required to refund 75% of the cost for certain damages, but is able to reimburse as much as 90%-100% in the case of a major disaster.
However, Morningstar is concerned about recent comments made by the MTA's chief financial officer. In an article by Reuters, the CFO has stated that he is not anticipating the need for any additional borrowing due to the storm and expects the system to be fully reimbursed for its related operating and capital costs by FEMA and the system's insurance. Morningstar notes that any reimbursement may take time, and it is not yet known if it will cover all costs related to the storm. The system's situation is further complicated by its pressured financial profile with limited liquidity, which leaves the MTA with a minimal cushion to weather unforeseen events.
While we expect the system to experience some additional stress due to the storm, it has a number of positives for bondholders. The system's essentiality to the area has been highlighted as a result of the storm. Debt service coverage remains quite strong, aided by the gross lien pledge requiring the payment of debt service before operating or other expenses. Also, the system has a history of bouncing back from major events. Morningstar will continue to monitor the system over time to analyze the full extent of the storm on the system's credit quality.
Long-Term Credit Quality Should Remain Largely Stable After Hurricane Sandy
Contributed by Elizabeth Foos, Municipal Credit Analyst
Cleanup and recovery efforts continue after Hurricane Sandy ravaged the Caribbean and the East Coast of the United States early last week. Although the total financial cost of the storm will be massive and repair efforts will be lengthy, as with several previous natural disasters, bondholders should not expect significant long-term payment losses as a result. Short-term liquidity for municipalities will probably be strained as many deal with unbudgeted recovery costs, yet overall long-term credit quality should remain stable for most larger entities.
Immediate budget impacts for most include expenditures for employee overtime, evacuation efforts and emergency housing for displaced residents, and basic infrastructure repair. However, much of the affected area will qualify for substantial reimbursement from the Federal Emergency Management Agency and will be supported by state assistance, insurance payments, and charitable donations. This will benefit the stability of credit quality for many over the long term. For issuers such as New York City, the cleanup efforts and short-term economic losses will be stressful, yet significant outside support and the expected economic recovery will sustain credit quality.
Credit quality is likely to be more pressured for smaller entities without financial reserves, for those that experience significant long-term tax base and population loss, and for those that secure debt with special taxes such as sales tax revenue. Likewise, the credit quality of enterprise systems that can't deliver services, sustain revenue losses, and face costly repair of capital assets could suffer. Affected hospital systems, transportation systems, and port facilities will all probably face heightened pressures in the near to medium term. The Metropolitan Transit Authority suffered unprecedented damage to its infrastructure and is expected to see an increase in capital needs as well as a short-term loss of operating revenue. However, the gross lien pledge of MTA debt is strong and coverage is expected to remain high.
Although federal aid will cover a large part of the overall financial impact of the storm, it won't likely pay all of it. Also, according to statements by Gov. Andrew Cuomo, New York and its localities are picking up recovery costs until federal authorities reimburse them. Many issuers may turn to the markets for short-term borrowing for immediate cash flow needs and others may borrow for longer-term borrowing for rebuilding efforts. Certainly the human impact and cost of Sandy is great, but in our opinion the expected effect on long-term credit quality for most municipal issuers should be moderate.
Further Anecdotal Evidence of Rising Allocations to U.S. Corporate Bond Among Institutional Investors
Strong market technical factors continue to dominate in the U.S. corporate bond market as the seemingly insatiable demand for corporate bonds remains unabated. In addition to mutual fund inflows, combined with dwindling supplies of competing fixed-income securities such as mortgage-backed and Treasuries, we are seeing further anecdotal evidence of institutional investors reallocating investments from other asset classes into U.S. corporate bonds. For example, in the third quarter Aflac (AFL) (A-) demonstrated that it was serious about reducing its exposure to perpetual and subordinated securities in its investment portfolio, especially perpetual securities of European financials. Because a large percentage of its policies and profits were derived from Japan, the firm has needed to search out securities denominated in yen, and it built up a sizable position in European financials that had issued yen-denominated products. Year to date, the company has reduced its exposure to perpetual and subordinated securities as a percentage of the investment portfolio to 9.0% from 13.8%. For the entire portfolio, European exposure has been reduced to 22% from 29% year to date, by our calculations. Aflac has shifted its allocation away from Europe and into U.S corporate senior notes where it hedged out the currency exposure.
New Issue Notes
Aetna Funding Coventry Acquisition (Nov. 2)
On Friday, Aetna (AET) announced plans to issue about $2 billion in 5-year, 10-year and 30-year notes. The firm plans on using the proceeds to help fund its $7 billion acquisition of Coventry Health Care (CVH). In September, we downgraded our credit rating on Aetna to BBB from BBB+ based on its increasing leverage with that deal. Management estimates that debt/capital--the key leverage metric we look at with management care organizations--will rise to about 40% post-deal from the industry average of 30% pre-deal. And while we think the deal makes strategic sense, we still don't believe Aetna will possess an economic moat.
Aetna will remain the third-largest managed care firm in the United States by medical members. However, its members are spread throughout the country, and it typically doesn't garner enough scale in a particular geographic region to exert much pressure on local care providers. Also, Aetna's customer mix is skewed toward large employers, which can hurt its bargaining power on customer contracts as well. In general, we don't think Aetna operates as attractive a business as UnitedHealth Group (UNH) (A-) or WellPoint (WLP) (BBB+), which helps account for Aetna's lower credit rating than those key managed-care competitors.
Given that credit view and indicative pricing, we generally view Aetna's notes as unattractive, especially when compared to its higher rated peer WellPoint. For example in early September, WellPoint came to market with 5-year, 10-year, and 30-year notes, and those on-the-run WellPoint issues are currently indicated at respective spreads over Treasures of +80, +130, and +140 basis points. Aetna's on-the-run 2017s, 2021s, and 2042s are indicated around +80, +130, and +140 basis points over Treasuries respectively, too. If Aetna's notes are priced in line with WellPoint's similar-dated notes, we'd urge investors to consider investing in WellPoint's notes rather than Aetna's new issues due to WellPoint's better credit profile and long-term competitive position.
Verizon Issue Likely to Be Unattractive (Nov. 2)
Verizon Communications (VZ) (A-) is planning a wide-ranging debt offering, including 3-, 5-, 10-, and 30-year notes. We generally view the investment-grade telecom universe as overvalued and we don't expect the new Verizon notes will price favorably. Verizon's last 10-year debt issuance, its 3.5% notes due 2021, trade at about 62 basis points over Treasuries, far inside the typical A- rated issuer in the Morningstar Industrials Index, which offers a spread of around 110 basis points above Treasuries with an average of about 10 years to maturity. Among investment-grade telecom firms, we prefer Comcast (CMCSA) (A-). Comcast's recently issued 3.125% notes due in 2022 trade at about 85 basis points above Treasuries. While we understand that telecom carriers trade tight relative to the index given the steady, recurring nature of the cash flow they produce, we wouldn't be interested in Verizon's new notes unless they offered spreads comparable to Comcast's. Whisper talk on the Verizon 10-year offering is in the 80 basis points over Treasuries range. We wouldn't be surprised to see pricing end up closer to the existing Verizon bonds, though fears concerning storm damage in the Northeast could hold spreads somewhat wider. Still, even at the whisper level, we wouldn't find the new Verizon bonds attractive.
We recently increased our rating on Comcast one notch as the firm has steadily built financial strength over the past couple years. While Comcast isn't a broadly diversified as Verizon, we believe that Comcast's competitive position within the markets it serves is superior, as our wide moat rating on the firm suggests. Comcast has steadily taken market share in the consumer fixed-line telecom market over the past several years and is working its way into the business services market as well. We also like the fact that Comcast has a clear path to acquiring the portion of NBC Universal that it doesn't already own and that it has been allowing cash to build in anticipation of a future transaction. Verizon, on the other hand, faces a somewhat contentious relationship with Vodafone (VOD) (BBB+) over the future ownership of Verizon Wireless and the management of cash flow out of the wireless business. Verizon will be reliant on cash from Verizon Wireless to meet its dividend payout while maintaining its financial strength in the years to come.
Magellan Midstream Partners to Issue 30-Year Bonds (Nov. 2)
Magellan Midstream Partners (MMP) (BBB+) announced Friday that it plans to issues $250 million of 30-year bonds. We expect that the proceeds from this issuance will be used to fund the company's planned expansion of its crude oil pipelines and storage facilities. When we recently upgraded Magellan to BBB+, we anticipated that the company would raise debt to fund its growth program. Accounting for today's issuance, we project LTM leverage will be a conservative 3.5 times, which is well below management's long-term target of 4.0 times and amongst the lowest in the energy midstream sector. Magellan's expansion will generate stable, fee-based income from contracts with strong counterparties. We project that leverage will remain below 3.5 times during our forecast period, trending towards 3.0 times, as the company begins to recognize revenue from these expansions.
Magellan's 6.40% bonds due 2037 recently traded at a spread of +170 basis points above the 30-year Treasury, which we view as fair. Adjusting for the high dollar price of this bond and the company's disciplined management and conservative balance sheet, we would place fair value on a new 30-year in the area of 145 basis points above Treasuries.
Microsoft's Exceptional Strength Makes Its New Issue Attractive (Nov. 2)
Microsoft (MSFT) (AAA) is planning benchmark-sized issues of 5-, 10-, and 30-year notes, its first debt issuance in nearly two years. The software giant certainly doesn't need additional cash, but is likely looking to take advantage of currently low interest rates to replace the $4.25 billion of debt maturities it faces over the next couple years, continue adding long-term debt to its capital structure, and manage its domestic liquidity. Microsoft held $66.6 billion of cash and investments at the end of September, including nearly $9 billion held domestically, against about $12 billion in debt. Compared to its cash holdings and prodigious cash flow, the firm's debt load looks very modest. Despite posting relatively weak fiscal first-quarter results on soft global PC sales, Microsoft still generated nearly $8 billion of free cash flow during the period. The firm faces near-term uncertainty around the launch of Windows 8 and the Surface tablet, but regardless of the acceptance of these products, we expect Microsoft's long-term strengths in enterprise computing around Office and the Azure platform will remain in place. With its strong competitive position and rock-solid balance sheet, we award Microsoft the highest credit rating.
Given our view of Microsoft's credit strength, we believe spreads on the firm's bonds are very attractive and we would look seriously at any of the firm's new issues. Initial talk on the new 5-, 10-, and 30-year notes is around +45, +60, and +80 basis points over Treasuries, respectively. These levels compare very favorably to Microsoft's existing debt issues. Its 2.5% notes due in 2016, trade around +30 basis points, its 4.0% notes due in 2021 trade at about +55 basis points, and its 5.3% notes due in 2041 trade at about +75 basis points. These levels compare favorably with other large, but relatively weaker, software firms. Oracle's (ORCL) (AA) recently issued 2.5% notes due in 2022 trade at +68 basis points while Google's (GOOG) (AA) 3.625% notes due in 2021 trade at +63 basis points. We believe that Microsoft's notes should trade tighter than its existing notes would suggest. For example, we would view the new 10-year note as attractive all the way down to +40-45 basis points. That level would comparable to spreads on Johnson & Johnson (JNJ) (AAA), one of the other rare AAA issuers we cover. Its 3.55% notes due in 2021 trade inside of +40 basis points.
We'd Drive Investors Away From AutoZone's Bonds (Nov. 1)
AutoZone (AZO) (BBB), the category leader in the auto parts retail sector, is coming to market with a new $300 million 10-year deal and we expect the new notes to be expensive. The firm's current 10-year bonds (issued in April) trade at 123 basis points over Treasuries, well inside Morningstar's BBB 10-year Industrials index at 169 basis points over Treasuries. The auto parts retail sector generally trades tight to the rating, as the main players have continued to thrive amid uncertain economic conditions. The weak economy has boosted the auto parts retailers as there have been fewer new car purchases and consumers are keeping their vehicles on the road longer. O'Reilly Automotive (ORLY) (BBB) and Advance Auto Parts (AAP) (BBB-) both have 10-year bonds that trade around 40 tight to the respective indexes. Still, we'd recommend the auto parts retailers at these levels over another BBB retailer, Macy's (M), which has 10-year notes trading at 109 basis points over Treasuries. These levels reinforce our underweight stance on the retail sector, where we currently have no Best Ideas.
We expect the funds from the debt issuance to pay for share repurchases. From a credit perspective, AutoZone's strong margins and healthy free cash-flow generation are slightly offset by the firm's penchant for share repurchases. With high-single-digit revenue growth and modest margin expansion through the downturn, AutoZone's capital structure has been relatively stable despite taking on roughly $1 billion in debt to help fund $3.7 billion in share repurchases during the last two years. Lease-adjusted leverage is in the mid-2-times range and the firm's Cash Flow Cushion is well over 1 times. AutoZone's current $3.6 billion debt load is manageable, in our view. Even though we project a slowdown in top-line growth and margin gains during the next five years, the firm generates strong and stable cash flows, and we project free cash flow to average 10% of revenue over this period, which should allow AutoZone to comfortably service its debt obligations. As current debt matures, we expect AutoZone will continue to maintain leverage and issue further debt in order to fund share repurchases. During the next five years, we project AutoZone will repurchase about $3.8 million in shares, or 84% of free cash flow.
Capital One Issues 3-Year Notes (Nov. 1)
Capital One (COF) (A-) announced today that it plans to issue new 3-year fixed or floating-rate notes. There is no whisper on price guidance yet. It should be noted that we rate Capital One at A-, higher than the rating agencies, which tend to rate Capital One in the mid- to high BBB area. Our rating is driven, in large part, by Capital One's sound business model and conservative balance sheet. Capital One is one of the largest issuers of Visa and MasterCard credit cards in the United States and one of the top 10 depositary institutions in the country. Capital One's earnings continue to benefit from lower loss provisions and improved margins. Given the size of its bank, Capital One has the best funding profile when compared with competitors like American Express and Discover, which we expect will benefit margins and reduce its dependence on the capital markets. Given that Bank of New York Mellon's (BK) (A) newly issued 3-year note trades in the area of 30 basis points above Treasuries, and accounting for Bank of New York's higher rating and trust bank business model, we recommend the Capital One notes all the way down to a spread of 55 basis points above Treasuries.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.