Credit Rally Takes a Breather
Telecom, tech, and media credits weaken the most, while REITs, transportation, and insurance held up better.
The seemingly unstoppable rally in the corporate credit market took a breather last week. Credit spreads backed up 8 basis points, with the greatest widening occurring after the presidential election. The Morningstar Corporate Bond Index ended the week at +144.
The sectors that weakened the most were telecommunications, technology, and media, which widened 11-12 basis points. Real estate investment trusts, transportation, and insurance held up the best, as those sectors were steady to weakening 3 basis points.
We previously warned investors that the technology and telecom sectors were susceptible to weakness. In our fourth-quarter outlook published at the end of September, we opined that declining business capital expenditure spending would disproportionately affect the technology sector. Since then, the technology sector has been the worst-performing sector in our Corporate Bond Index. At the beginning of November, Morningstar's telecom credit analyst, Mike Hodel, warned investors that he viewed the investment-grade telecom universe as overvalued. Since then, the telecom sector has widened more than twice as much as the index.
Trading in the corporate bond market is returning to normal after Hurricane Sandy, but the depth of the market is still shallow. This lack of liquidity is most evident among larger institutional orders, which can easily swing trading levels. Many brokers continue to work out of disaster recovery sites, and some traders are either arriving later in the morning or are leaving earlier in the day in order to compensate for their disrupted commuting schedules. Trade flow over the past two weeks has shown a greater amount of selling among investors as portfolio managers sold existing holdings to free up cash to participate in the heavy new issue market.
The new issue market provided plenty of volume for investors to choose from, as we counted $29 billion worth of deals priced last week among the issuers we cover. This volume easily surpassed the prior week's $19 billion of new issuance. Issuers over the past week included AbbVie (NR), the planned pharmaceutical spin-off of Abbott Laboratories (ABT) (AA+/UR-), which placed $14.7 billion, making it one of the largest deals priced in the investment-grade market. Highlighting the heavy new issuance volume this year, including last week's volume, S&P reported that new issuance year to date has surpassed that of all of 2011. Syndicate desks were very quiet at the end of last week, which would typically mean that new issue volume this week will be on the low side, but we suspect a number of deals will pop up since market access will be very limited next week as investors take time off for Thanksgiving.
Political wrangling over the fiscal cliff began soon after the election results were finalized. Each side of the aisle held press conferences to position themselves for the upcoming fight. These negotiations will also need to resolve the debt ceiling, which is rapidly approaching and will probably be breached in the next few months if it is not raised. We expect the negotiations to resolve the fiscal cliff will dominate domestic headlines through the rest of the year. This is likely to increase the amount of volatility in the credit markets as each side uses the media to test ideas to gauge the markets' reaction and to try to corner the other party into capitulating on its positions.
Breaking the Silence: Negative Headlines Re-Emerging From Europe
Now that the barrage of headlines regarding the U.S. presidential election has died down, rumblings have begun to re-emerge out of Europe, which has been conspicuously silent.
Greece voted to implement a new round of austerity measures to satisfy requirements from the Troika to provide the overleveraged country additional bailout funds and allow further time to implement its structural reforms. Greece's most recent budget revealed that the country expects its debt load will rise to 190% of GDP next year. Greece is quickly running out of money and has a bond maturity due Nov. 16. It appears that the country will not receive another tranche of bailout funding before then; however, we expect the European Central Bank will allow Greek banks to pledge Greek treasury bills for collateral. This action would provide the funding needed to allow the banks to purchase this short-term debt.
Even after the severe haircut that private bondholders suffered, it appears that the country will not be able to meet its goal to lower debt to 120% of GDP by 2020. As the Greek situation deteriorates, eurozone leaders are positioning themselves to dodge taking losses on their loans and force other institutions to suffer write-downs if additional debt restructuring is required. For example, the ECB has already publicly ruled out taking losses on any of the Greek debt it has purchased.
ECB president Mario Draghi did not help matters when he finally admitted that the weakness in the peripheral nations was spreading into the core nations. For example, Germany's September industrial production dropped 1.8%, which was significantly worse than even the lowest economist estimates. Survey data such as the composite PMI index and consumer indicators such as retail spending continue to decline. The European Commission lowered its forecast for 2013 GDP growth in the eurozone to 0.1% from 1.0%, a disappointingly low growth rate considering consensus estimates for this year are for a 0.4% decline.
Final Votes on State Ballot Measures Affect Muni Credits Throughout Country
Contributed by Rachel Barkley, Candice Lee, and Elizabeth Foos, Municipal Credit Analysts
In addition to the presidential and regional political elections, voters throughout the country decided on ballot measures that could significantly affect the credit quality of state and local governments. As a follow-up to our piece published Oct. 22, we highlight significant results on ballot questions in five states. This is not an exhaustive list but emphasizes investors' need to remain current on the legal framework when considering investing.
Florida Retains Flexibility With Defeat of Revenue Limits
Amendment 3: Florida State Revenue Limitation (DEFEATED)
Florida voters rejected Amendment 3, one of 11 proposed amendments to the state constitution included on Florida's November general election ballot. Commonly referred to as the state revenue limitation amendment or the smart cap, the amendment would have revised the state's existing revenue limitation from one based on personal income growth to a new formula incorporating inflation and population growth. Any revenue collected in excess of the cap would have been required to be deposited into the state's budget stabilization fund until the fund equals 10% of general fund revenue. Additional revenue would then have been used to reduce school district property tax rates or be returned to taxpayers. Once in place, this cap would have required a supermajority vote of the legislature to be adjusted. The revenue growth limit included debt service revenue used to pay bonds after the beginning of fiscal 2013.
Morningstar notes that the current financial condition of the state is sound, highlighted by its proactive budgetary management in recent years and maintenance of healthy fund balance levels despite significant revenue volatility. However, if passed, Amendment 3 could have constrained the state's financial flexibility. We will continue to monitor the status of this amendment and the state's ability to manage its financial health.
Votes in Arizona Are Negative for Schools and Local Governments
Proposition 204: Arizona Sales Tax Renewal Amendment (DEFEATED)
Arizona voters rejected Proposition 204, a ballot measure to permanently increase the statewide sales tax. The measure was resoundingly defeated by a 2-to-1 margin, reflective of the anti-tax sentiment of the state's residents. The temporary 1-cent sales tax increase originally advocated by Republican Gov. Jan Brewer will be allowed to expire in 2013, but without this revenue source, the state will stand to lose as much as $1 billion annually. Because the majority of the revenue from the temporary sales tax went to fund school districts and institutions of higher education, we expect the expiration of this tax to result in cuts to these education programs at the state level.
Proposition 117: Arizona Property Tax Assessed Valuation Amendment (PASSED)
Arizona voters passed Proposition 117, a measure that caps the growth of annual property value assessments. Property tax revenue makes up a minuscule portion of the state's operating funds, and the Department of Revenue estimates that the measure will cost about $9 million of annual revenue. The larger effect will be felt at the local level, where property taxes make up a sizable portion of total operating revenue. Proposition 117 will replace the existing two-tier property tax system and create a flat 5% annual property assessment growth limit. Ad valorem taxes levied for debt service and special district improvements are exempt from this limit; however, cities, towns, school districts, and community college districts that once levied ad valorem taxes subject to a 10% annual assessment growth cap will now see that limit drop to 5%, regardless of market conditions. Given the declines in property tax revenue that local governments have faced already, this cap will make it more difficult for them to make up for lost revenue, even if market conditions improve considerably.
Changes to Illinois Pensions Still Flexible
HJRCA 49: Illinois Public Pension Amendment (DEFEATED)
Illinois voters rejected the proposed constitutional amendment that would have required a three-fifths majority vote in each governing body of the general assembly, local governments, school districts, or pension and retirement systems in order to increase pension benefits. Currently these benefits are usually changed with a simple majority vote. Requiring a supermajority vote would have made it more difficult for local entities to increase their pension liabilities by granting more pension benefits to retired workers. The proposal would have done little to change the current challenges faced by the state's pension system, which has one of the lowest funded ratios in the country, or those of other local governments currently struggling with large liabilities, yet it could have made it tougher to add to that burden with more benefits. Although the measure failed, we think it's unlikely that local governments will rush to raise benefits, and therefore costs, given the strained state of pension funding throughout the state.
Michigan Voters Reject All Statewide Ballot Proposals Keeping Status Quo
Proposal 12-1: Referendum on Public Act 4 of 2011, the Emergency Manager Law (DEFEATED)
Michigan voters defeated the referendum question commonly known as Prop 1, repealing the state's controversial Public Act 4 of 2011, Local Government and School District Fiscal Accountability Act. Public Act 4, which took effect March 16, 2011, established procedures for state intervention in financially stressed municipalities, including requirements for deficit-elimination plans, in-depth reviews of a municipality's financial profile by state officials, and the appointment of an emergency manager. The legislation allowed for earlier intervention than previous legislation and greatly increased the authority of EMs to make organizational and financial changes that may be necessary to avoid a Chapter 9 bankruptcy. An EM had the power to implement financial and operating plans; suspend the authority and compensation of managers and elected officials; modify or terminate collective bargaining agreements; sell, lease, or transfer the assets or responsibilities of the municipality; and recommend to the governor that the municipality file for Chapter 9 bankruptcy or disband.
With the defeat of the measure, questions remain regarding the operations of several entities being served by EMs assigned under law, including the cities of Allen Park, Benton Harbor, Ecorse, Flint, and Pontiac and public school districts in Detroit, Muskegon Heights, and Highland Park. Questions regarding which procedures and legislation are in effect with the repeal of Public Act 4 will also probably be contemplated by the courts in coming months. As Public Act 4 provided significant flexibility for state oversight for distressed municipalities, which largely aided credit quality, it will be important to follow legislative developments in the next several months to see what alternatives arise and how distressed entities move forward.
Proposal 12-2: Michigan Collective Bargaining Amendment (DEFEATED)
Proposal 2 was a voter-initiated constitutional amendment ballot measure seeking to grant both public and private employees the constitutional right to collective bargaining through labor unions. Had this measure passed, it would have shifted power to employees, and at the governmental level, it could have imposed limitations on financial flexibility vis-a-vis wage setting and hiring and firing procedures.
Proposal 12-5: Michigan Taxation Amendment (DEFEATED)
Proposal 5 was another voter-initiated measure that would have limited the state's revenue-generating capacity. The constitutional amendment would have required a two-thirds supermajority vote in both the House and the Senate in order for the state to enact new or additional taxes, expand the tax base, or increase tax rates. Proposal 5 would have made it very difficult for the state to address growing expenditure needs through expanded revenue, instead more likely forcing expenditure cuts or otherwise accumulate budget deficits or employ deficit financing, which would both be credit negatives. With this defeat, the state retains more flexibility to raise revenue and adjust budgets as necessary, which we think is supportive of higher credit quality.
New Taxes Passed in California Will Aid Current Budget Crunch
Proposition 30: California Sales and Income Tax Increase (PASSED)
California voters passed Proposition 30, which temporarily raises income taxes on high-income earners and the state sales tax to increase funding for state operations and public education. It is the first time since 2004 that California voters approved a tax increase on a statewide proposition.
The measure raises the state sales tax by a quarter of a cent, to 7.5% from 7.25%, beginning in January 2013 and increases income taxes for people who make at least $250,000 by up to 3 percentage points for seven years, retroactive to the start of 2012.
Prop 30 is projected to raise an average of $6 billion annually for the state's general fund and for education, preventing nearly $6 billion in promised automatic budget cuts, mostly to local public schools and the University of California system. Increased revenue for state and public education budgets will provide some breathing room and financial flexibility in the coming years, allowing many to avert a much more limited operating environment, especially for local schools. We believe this supports credit quality, but more reform is needed in order to maintain sustainable operations through the longer term.
Proposition 31: California Government Performance and Accountability Proposition (DEFEATED)
Had it passed, Proposition 31 would have required a whole host of reforms aimed at how government work is conducted in California. The measure would have established a two-year budget cycle at the state level, allocated additional state sales tax revenue to certain local governments, required performance reviews of state programs and performance goals in state and local budgets, prohibited the state legislature from spending more than $25 million on an expenditure without identifying offsetting revenue or spending cuts, and allowed the governor to cut the budget unilaterally in declared fiscal emergencies, among other things. Although we think additional transparency in government is needed, it is unclear if this proposal would have provided measures to increase credit quality.
New Issue Notes
Sprint's Latest Debt Offering Likely a Bit Rich (Nov. 8)
Sprint (S) (BB-) is in the credit market for the third time this year, looking to place a benchmark-size 10-year note offering. We are somewhat surprised to see the firm raising capital at this point given that it closed on the first tranche of funding from Softbank, a $3.1 billion convertible note, late last month. Sprint ended the third quarter with more than $6 billion in cash and now holds about $9.4 billion, which should provide ample liquidity to for some time, even as the Network Vision program begins to consume larger amounts of cash and the firm funds the recently announced asset purchase from U.S. Cellular (USM). The firm may be taking advantage of current low rates and reasonable spreads on its debt to refinance $2.3 billion of remaining Nextel bonds that mature in 2014 and 2015 while leaving its cash position untouched for the time being. The Nextel debt carries relatively high coupons, especially the 2015 notes, and is callable at par.
Based on trading levels for Sprint's existing notes, we expect this new offering will price slightly rich considering our recently upgraded BB- rating. The firm's most comparable issue is the 7.0% notes due in 2020 offered last August before the Softbank announcement at a spread of 571 basis points above Treasuries. These notes currently trade at 417 basis points above Treasuries to yield 5.4%. The firm's 11.5% notes due in 2021 trade at 505 basis points above Treasuries, but a very high dollar price ($134) likely weighs on these notes relative to the 2021s. The Merrill Lynch BB Index currently stands at an option-adjusted spread of 396 basis points above Treasuries, only slightly tighter (maybe 30 basis points) versus where we'd expect the new Sprint offering to price. We would want to see a spread of 450 basis points or more before getting interested in the issuance. Sprint still faces uncertainty as it contemplates a series of strategic decisions while also completing the Network Vision build.
Terex Announces Tender for 8% Subordinated Notes and Roadshows New Senior Offering (Nov .7)
Terex (TEX) (BB-) is expected to be in the market with an $850 million offering of senior notes due 2021 to fund the tender offer of its outstanding $800 million of senior subordinated notes due 2017. The new notes are expected to be split between a U.S. dollar tranche and a euro tranche. Management is currently in London meeting with potential investors. The refinancing of the 8% notes was expected and continues the company's reshaping of its debt profile on the heels of another strong quarter. Based on the news we've seen, the company is offering total consideration of 104.375 for the 2017 notes, a slight premium to the November call price of 104.000.
Terex's existing 6.50% senior notes due 2020 (subordinated to a $700 million secured term loan) were recently quoted around a yield-to-worst of 5.4% to the 2018 call date and an option-adjusted spread of +445. Taking into account our BB- issuer rating and the degree of subordination, these levels look fair to slightly rich to us when compared with the Merrill Lynch B Index, which currently stands at a YTW of 6.2% and an OAS of +529. They also appear slightly rich to similarly rated Allison Transmission (ALSN) (BB-), which has a 7.125% senior note due 2019 (subordinated to secured bank debt) that recently was quoted around a YTW of 5.5% to the 2017 call date and an OAS of +486. In our view, fair value for the new Terex 2021 senior notes would be in the area of 6.0%-6.25%.
For the third quarter, Terex reported continued improvement in year-over-year sales and profitability. Although both metrics ticked down sequentially, we remain impressed that the company's price increases and cost controls have boosted year-to-date operating margins to their highest level since 2008. Debt reduction has been a priority for management with significant progress realized during the quarter. Total debt was $2.1 billion at the end of the quarter, down more than $300 million from June as the company redeemed the $300 million of 10.875% senior notes and bought back 25% of its outstanding senior subordinated convertible bond. For the latest 12 months ended Sept. 30, total debt/EBITDA stands at 3.7 times, comfortable for our BB- rating, and is poised to show further improvement as EBITDA continues to recover. Pro forma for the new senior notes, leverage through the seniors will be about 3.6 times, up meaningfully from 2.0 times at the end of September. Net of $543 million of cash, total leverage is 2.8 times, close to management's target of 2.5 times net leverage over the cycle.
Dow Chemical's New Bonds May Be a Tad Too Rich for Its Underlying Credit Quality (Nov. 6)
Dow Chemical (DOW) (BBB) is tapping the bond market Tuesday morning with benchmark-size 10- and 30-year notes. The company is facing two years of heavy refinancing needs, with $1.8 billion of debt coming due in 2012 and another $2.9 billion due in 2014. Depending on the final size of this debt offering, we think Dow may need to tap the debt market again in 2013.
We think the new bonds may be rich compared with our BBB benchmark, but compared with peer chemical companies may present some value. The whisper talk on the 10-year tranche is 155 basis points above Treasuries, which is about 20 basis points outside of Dow's existing 2021 bond, a level we think may represent a spread to entice the bond market's interest. The company's existing 2041 bond is quoted at a spread of 149 basis points above Treasuries, giving 12 basis points to Dow's corporate curve between the 10s and 30s. While we think the existing bond prices may be a tad too rich for our liking (the BBB cohorts in the Morningstar Industrial Corporate Bond Index carry an average Treasury spread of 169 basis points), they may still offer some relative value compared with the ultratight spreads that Dow's chemical peers are sporting. For example, PPG Industries' (PPG) (BBB+) 2022 issue is quoted at 90 basis points above Treasuries, which is 47 basis points tighter than Dow's 10-year bond, a gap that is hardly justifiable given the one-notch rating differential.
We Don't Expect Interpublic's Bond Deal to Be Attractive (Nov. 5)
Interpublic Group (IPG) (BB) is coming to market with $800 million in 5- and 10-year paper today. We are currently more negative on the name than S&P and Moody's, and as a result will not likely find the deal attractive. The firm's current 10-year bonds are trading around 190 basis points over Treasuries, or at a yield around 3.5%. We view this as very rich as the typical BB credit in the Merrill Lynch Index yields 4.95% and the Morningstar BBB- 10-year Industrials Corporate Bond Index is around 240 basis points over Treasuries. This yield is much lower than another BB business services name, R.R. Donnelley (RRD) (BB), which has 7-year notes that yield almost 8%.
While we are pleased with Interpublic's $100 million in net debt reduction thus far in 2012 and comments regarding improving the balance sheet, the firm's soft earnings reports over the past couple of quarters have tempered our excitement. We believe Interpublic has slightly weaker long-term growth prospects and overall profitability than its peers. As of Sept. 30, the firm's lease-adjusted leverage is 3.9 times, flat from the end of 2011. From our perspective, this level is still indicative of a below investment-grade credit. Additionally, Interpublic's plans to increase share repurchases could limit cash available to debtholders, particularly as a $354 million debt maturity in 2014 looms.
With $1.2 billion in cash, Interpublic is likely taking advantage of low rates and high investor demand for paper. The cash from the debt issuance will likely help fund share repurchases, but the firm may call some of its upcoming maturities. On its recent earnings call, management highlighted that it can call its $200 million in convertible debt in March 2013 and that it can call $600 million in notes at 105 in July 2013.
Southern Copper's New 10s and 30s Should Price Attractively (Nov. 5)
Large and low-cost copper miner Southern Copper (SCCO) (BBB+) is in the market Monday. The firm is looking to issue new benchmark-size 10- and 30-year debt. We expect the bulk of the proceeds will be applied to the company's various brownfield growth projects, which should deliver solid returns on capital even in the comparably weak copper price environment assumed in our base-case forecast.
Initial price talk on the new 10-year note is "low 200s" with price talk on the 30-year in the "mid- to high 200s," which looks cheap to us and is in line with the company's outstanding issues of comparable maturity. Southern Copper's 5.375% notes due April 2020 are indicated by ADI at 221 basis points above Treasuries and the 6.75% notes due April 2040 are indicated at 272 basis points above Treasuries.
We'd peg fair value on the 10-year paper in the neighborhood of 160 basis points above Treasuries, reflecting prevailing spreads on the typical BBB+ industrial name (about 125-130 basis points) but adding a healthy premium to account for the fact that mining industry bonds are generally trading wide of the index at the moment. Closest comparable Freeport-McMoRan Copper & Gold (FCX), which we rate a notch lower at BBB and tends to trade a bit tight relative to other mining names, has 2022s indicated at 173 basis points above Treasuries, which we view as somewhat rich.
Moving from the 10-year to the 30-year bonds, we'd be willing to accept less incremental spread than we otherwise might on the basis that Southern Copper's unusually long-lived and low-cost assets afford the firm a structural competitive advantage that should persist for many years to come. This assessment of Southern Copper's competitive profile underpins our narrow economic moat rating.
AbbVie Coming to Debt Market (Nov. 5)
On Monday, AbbVie (NR), the planned pharmaceutical spin-off of Abbott Laboratories (ABT) (AA+/UR-), announced a new debt issuance to fund its split from the firm's medical product division, which will retain the Abbott name. We have seen reports that this new issuance could exceed $10 billion with part of the proceeds to fund a dividend back to Abbott for a tender offer on existing debt. The new AbbVie issues are expected to mature in 3-year, 5-year, 10-year, and 30-year increments.
While we have not rated the separate Abbott and AbbVie entities yet, we believe both entities will sport credit profiles in the low- to very-low-risk category. Currently, Morningstar's Industrial Index for the average A+ rated 10-year maturity is indicated around 72 basis points over Treasuries. Based on that index and trading of similar issues in the large pharmaceutical niche, fair value on the new AbbVie 3-year, 5-year, 10-year, and 30-year issues could be around 35, 50, 70, and 90 basis points over Treasuries. We are currently seeing much wider whisper numbers on the new AbbVie issues, though, probably due to initial agency ratings that look lower than we currently expect for a long-term view of AbbVie at Baa1/A. So overall, investors may see an attractive new issuance from AbbVie compared to what we believe is fair in the long run.
For comparison, recent new issuers in the large pharmaceutical niche include Novartis (NVS) (AA+) on the narrow end of the spectrum with its 2022s and 2042s indicated around 50 and 70 basis points over Treasuries, respectively; on the wide end of the large pharmaceutical spectrum (due to capital allocation risks), AstraZeneca's AZN (AA) 2019s, 2042s are indicated around 50 and 90 basis points over Treasuries, respectively. For another large health-care firm with an A+ rating, Baxter's (BAX) new 2022s and 2042 are indicated even tighter than Astra's notes around 55 and 65 basis points over Treasuries, respectively.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.