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Quarter-End Insights

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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For both large U.S. banks and U.S regional banks, this last quarter was much more of the same from a balance sheet perspective. Nonperforming loans as a percentage of total loans continue to drop, tangible common equity continues to build, and the deposit base for most banks continues to grow. We expect this trend to continue for the next few quarters, with the only major caveat being a severe breakdown in fiscal cliff negotiations, which would likely lead to a recession in the U.S. The momentum of recovery for U.S. banks is so strong that minor problems, or even actually going over the fiscal cliff for a few days, should not weaken it. One metric that we do expect to stop its improving trend is the percentage of reserves to nonperforming loans. For many banks this figure is at or near the high of precrisis levels, allowing banks to release reserves in an effort to boost net income. The boost to net income is needed as an offset to falling net-interest-margin levels as overall fixed-income yields continue to drop. Given the recent actions and comments from the Federal Reserve, we expect falling all-in yields to persist as the latest round of quantitative easing will remain into the foreseeable future, which will force further compression in the net-interest-margin for banks.

The banking sector did see one dramatic change in this last quarter, compared with the last few quarters, and that was spread volatility. Spreads for the banking sector were comparatively stable and tightened slowly throughout the quarter. For example, the Morningstar financial index tightened 36 basis points to 159 from 195 compared with the Morningstar industrial index, which only tightened 14 basis points from 150 to 136. For many investors, the higher spread levels of the financial industry compared with similarly rated industrials, especially for the large six U.S. banks, were too hard to ignore, and investors were willing to expose themselves to greater possible volatility in the search for higher yields. Possible negative headlines from the fiscal cliff negotiations, or any further European sovereign debt concerns, could bring a dramatic spike in volatility back to the financials sector. We expect, however, that Congress will eventually reach some reasonable compromise and that the European Central Bank will be able to contain any possible European flare-ups over the short term. We, therefore, expect the spreads of large U.S. banks to tighten during the next quarter as the spreads are generally 25 to 50 basis points wide of the general index. It should be noted, however, that the long-term problems of Europe are far from being solved, and there is always the possibility that the European Union loses control of the situation in the near future. Such an event would cause the credit spreads of equivalently rated banks to widen further and faster than industrials.

Contributed by Jim Leonard

Basic Materials
The bond market has certainly adopted our view that Chinese economy has indeed slowed down measurably in 2012, but we think spreads of high-cost metal and coal producers will face additional challenges in 2013. Consider the case of iron ore miner  Cliffs Natural Resources (CLF, rating: BBB-), whose 4.875% 2021 issue was placed on our "Bonds to Avoid List" at the beginning of August. The bond went from T+360 basis points in early August to T+396 basis points on Dec. 11 (while the underlying BBB- Morningstar Industrial Index moved roughly 10 basis points in the opposite direction), which underscores the market's worry that Cliffs' relatively high-cost structure makes the company particularly vulnerable as iron ore prices take another leg down. Although the iron ore market has stabilized somewhat compared with the rapid slide in prices in the past summer (which we would argue might be short-lived), we think the company will continue to face mounting challenges in both its iron ore and metallurgical coal operations, hence, further spread widening. Considering the company's heavy debt load after years of acquisitions and capital expenditures, we think the current spread comes up short in compensating bondholders for the significant downside risks facing this company.

Although our view on metallurgical coal demand is less than rosy, we are gradually warming up to thermal-coal producers, particularly the Powder River Basin, or PRB, coal companies such as  Cloud Peak (CLD, rating: BB+). Even though the scorching summer did little to help our global food production, it was more than ideal to get the overflowing domestic steam-coal inventory situation under control. Heading into 2013, we think coal producers are facing a much more benign pricing environment, particularly as natural gas prices rebound from their nadir. This environment is in stark contrast to the few years prior to 2013. We think PRB coal producers should have an easier time generating positive cash flows in 2013, which ideally should be used toward repairing their battered balance sheets, granting them some much-appreciated breathing room should steam-coal prices head downward again.

The weak global economy is not doing much favor to any of the steel companies under our coverage. An uncertain demand picture is pressuring steel companies' profit generation in 2013 despite some reprieve from raw-materials prices. Order books look quite sparse at this point compared with years prior, which bodes ill for the credit quality of the industry.

Looking ahead, 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+),  Vale (VALE, rating: BBB+), and Cloud Peak over comparably higher-cost operators like Cliffs and Appalachian coal producers such as  Arch Coal (ACI, rating: UR-/B) and  Alpha Natural Resources (ANR, rating UR-/B+).

Contributed by Min Tang-Varner

Consumer Cyclical
After a stellar 2012, we don't expect to see material additional spread tightening in 2013 among our consumer cyclical names. We expect solid, stable credits that target a certain capital structure will outperform the sector, as there are a number of names facing fundamental headwinds or self-inflicted wounds.

We are monitoring the tenuous credit situations as they unfold at  J.C. Penney (JCP, rating: B),  Best Buy (BBY, rating: BB-), and  RadioShack (RSH, rating: CCC). Positive results from the turnaround effort continue to elude J.C. Penney, and we believe it will be some time before the firm's efforts bear fruit. J.C. Penney's earnings have declined sharply, which has driven lease-adjusted leverage to 14.4 times from 4.4 times at year-end 2011, despite a $230 million reduction in debt.

Best Buy and RadioShack are facing severe fundamental headwinds, including the inability to defend market share from Amazon, mass merchants, and key vendors such as Apple as well as the dilutive impact that digital distribution will have on productivity. Best Buy's margin compression, coupled with weaker sales, has pushed lease-adjusted leverage, which is now 3.3 times from 2.7 times at year-end 2011. However, the firm's debt maturities are manageable as the five-year cash flow cushion is greater than 1 times our base-case expense and obligation forecast. RadioShack is burning cash as it continues to post operating losses, and we have concerns with its longer-term liquidity.

We are also mindful of companies rewarding shareholders at the expense of the balance sheet, such as entertainment companies  Time Warner (TWX, rating: BBB+) and  Discovery Communications (DISCA, rating: BBB). We recently downgraded our issuer credit rating for Discovery Communications to BBB from BBB+ as the firm has been continually rewarding shareholders at the expense of its balance sheet strength. Discovery has issued $1 billion in debt this year and repurchased more than $1 billion in shares. As a result, the firm's leverage has ticked up to just over 3 times as of Sept. 30 from 2.3 times at year-end 2011. Additionally, Time Warner's net leverage has increased to around 2.5 times in its third-quarter (management's target), from the 2 times level that it has been at during the past few years. Thus far in 2012, Time Warner has spent $2.8 billion in share repurchases and dividends, relative to $1.9 billion in free cash flow. Entertainment peer  Disney (DIS, rating: A+), on the other hand, has returned cash to shareholders in earnest, yet maintained a stable credit profile.

Contributed by Joscelyn MacKay

Consumer Defensive
The drought last summer in the U.S., as well as severe weather conditions in other agricultural-export nations, has driven prices for many agricultural commodities well above historical averages. 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 wide or narrow economic moats will have substantially greater ability to pass through cost increases, support their brands with targeted marketing spend, and invest in product innovation. We expect firms with wide economic moats and strong brand equity, such as  SABMiller (SBMRY, rating: A),  McCormick (MKC, rating: A+), and  Diageo (DEO, rating: A-), are best-positioned to be able to both defend volumes and market share as well as pass through price increases. Relative to firms with these long-term sustainable competitive advantages, companies whose portfolios consist of second- and third-tier brands will likely struggle.

In the consumer defensive sector, sluggish growth has limited opportunities for organic growth, leading management teams to identify nonorganic ways to grow their businesses or reward shareholders. For example, after repeated attempts,  ConAgra (CAG, rating: A-/UR)--which has been on our Bonds to Avoid List--was finally successful in its attempts to acquire  RalCorp (RAH, rating: BBB+/UR). ConAgra paid 12 times fiscal 2012 adjusted EBITDA on an enterprise value basis for the private-label manufacturer--a hefty price, in our view. Although the largest by far, this is the sixth acquisition ConAgra made this year and considering the private-label segment remains fragmented, we suspect ConAgra isn't done with acquisitions yet.

 Dean Foods (DF, rating: B+) announced that it would spin-off its WhiteWave-Alpro business in its attempt to increase shareholder value. As this segment is a much higher-margin and higher-growth business than the firm's remaining segments, management believes this segment will garner a higher multiple in the equity market. Dean plans on using proceeds from this spin-off along with proceeds from the sale of its Morningstar (unrelated to Morningstar, Inc. the publisher of this article) division to repay debt and reduce leverage. Although we are encouraged by the reduction in leverage, we are concerned that the volatility inherent in Dean's remaining businesses would negatively affect the firm's credit metrics during downturns. Beyond strategic acquisitions and spin-offs, a number of firms such as Campbell Soup (CPB, rating: A-) and  Brown-Forman (BF.B, rating: A+) declared special dividends. Depending on the outcome of the negotiations to resolve the fiscal cliff, if tax rates on dividends are increased, it could lead to a slowdown in dividend growth and prompt issuers to favor share repurchases. In a best-case scenario for creditors, it may prompt management teams to reinvest cash flow in their businesses to further organic growth.

Contributed by Dave Sekera

As we suggested in our outlook for the fourth quarter, strength in the offshore deep-water market helped drive spreads tighter for oilfield services companies, while exploration and production firms, such as  Devon Energy (DVN, rating: BBB+), which had lackluster production gains, experienced significant spread volatility. The initial reaction in the E&P space following lower production growth and third-quarter earnings that missed estimates was to widen spreads, but we view the discipline companies have shown by not chasing production growth as a credit positive.

Natural gas drilling has been scaled back across the industry, and production from existing wells has declined, pushing gas storage levels down from 11% above the five-year average at the start of the fourth quarter to only 5% now. We recently updated our analytical approach to estimating the marginal cost of domestic natural gas production, which lowered our 2015 estimate from $6.50 per thousand cubic feet to $5.40 per mcf. Despite our lower 2015 estimate, given current trends, we reiterate our bullish take on natural gas prices, as U.S. natural gas production is poised to decline in 2013 and storage levels are closer to normal.

We believe supply and demand will begin to normalize in the first half and thus shift our attention away from concerns about near-term spread movements for natural gas-focused E&P companies toward those companies which will benefit the most from higher natural gas prices. As the market becomes comfortable with Devon's disciplined drilling and weaker LTM credit metrics, we believe there is potential upside in Devon's debt. The company has roughly 20% of its 2013 natural gas production hedged, which allows the company to substantially benefit from higher prices. In high yield, both  Cimarex Energy (XEC, rating: BBB-) and  Range Resources (RRC, rating: BBB-) will benefit from higher prices, though we favor Best Idea Cimarex, as we believe Range debt already reflects higher prices. Cimarex has a minimal hedging program such that higher prices will reverse the recent trend of capital expenditures outstripping operating cash flow. Cimarex's concentrated portfolio and low equity valuation make it an attractive valuation target, adding additional return potential as natural gas markets improve.

Contributed by David Schivell

Health Care
With President Obama re-elected, we suspect health-care players will focus on the implementation of the Patient Protection and Affordable Care Act and results of the fiscal cliff negotiations going forward. Specifically, the PPACA may usher in paradigm-shifting changes in the managed-care industry, which is the primary cause for the current consolidation wave in this niche. For example, last quarter,  Humana (HUM, rating: BBB) agreed to buy Metropolitan Health Networks (). In the third quarter,  WellPoint (WLP, rating: BBB+) agreed to acquire  Amerigroup (AGP, rating: BBB+),  Aetna (AET, rating: BBB) announced plans to buy Coventry (), and  United Health (UNH, rating: A-) agreed to buy the top health insurer in Brazil, Amil. These moves are all efforts to gain scale and diversify revenue to offset expected negative consequences of the PPACA in the sector. For example, the act will create state-based exchanges through which individuals and small businesses can purchase standardized health insurance policies, receive government subsidies to offset premiums and cost sharing, and determine Medicaid eligibility. We think these exchanges and other PPACA-related changes might result in heightened rivalry and new entrants to the managed-care industry, including accountable care organizations (ACOs) which may become insurance entities themselves one day. Although a long-term threat, this shift is beginning to take shape now and could affect our view of managed-care organizations going forward. Also, with the fiscal cliff looming, caregivers are facing 2% reimbursement cuts on U.S. entitlement programs (Medicare and Medicaid) if sequestration is implemented. That would directly squeeze profitability of health-care providers, including the highly leveraged hospital chains we cover, such as  HCA (HCA, rating: B+) and Tenet Healthcare (THC, rating: B).

On the higher end of the credit-quality spectrum, we suspect capital-allocation practices will remain in focus, as many firms are facing weak earnings-growth outlooks that are testing the patience of shareholders. With cash-rich balance sheets and borrowing costs near historic lows, we'd expect health-care firms to continue seeking ways to fill gaps in profitability growth by making debt-funded acquisitions, increasing share repurchases, and increasing dividends to appease shareholders. For example, in the Big Pharma niche, we'd highlight  AstraZeneca (AZN, rating: AA) as the most likely to use practices that are unfriendly to debtholders to fill its profitability gap.

Contributed by Julie Stralow

Across the industrial landscape, balance sheets and credit metrics generally held steady during the past quarter. However, spread levels began moving wider late in the quarter, likely affected by the uncertainty surrounding the outcome and potential economic impact of the pending fiscal cliff. As an  SAIC (SAI, rating: BBB+) executive noted on a recent conference call, "As we continue to accelerate toward the fiscal cliff, from our perspective the fog is getting thicker." If the full budget cuts as mandated by sequestration 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 already trades tight. During the quarter, however,  Raytheon (RTN, rating: A-) issued 10-year bonds at a spread of +90 which we viewed as rich relative to  Lockheed Martin (LMT, rating: A-) and  Northrop Grumman (NOC, rating: A-) and well inside the Morningstar Industrials Index. We generally prefer lower-rated credits which might benefit from being acquired, such as  Alliant Techsystems (ATK, rating: BB+).

Across other key subsectors that we follow, fundamentals still look good for the rail sector, though low natural gas prices continue to adversely affect utility coal volumes. The Eastern rails,  Norfolk Southern (NSC, rating: BBB+) and  CSX (CSX, rating: BBB+) are most affected given their exposure to high-cost Appalachian coal. 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. We also like the bonds of  Kansas City Southern (KSU, rating: BBB-) as it continues its push to investment grade at the Nationally Recognized Statistical Rating Organizations. Within the waste management space, we think the bonds of both  Waste Management (WM, rating: BBB+) and  Republic Services Group (RSG, rating: BBB+) look attractive relative to other defensive sectors, such as the rails. Continued growth in the U.S. economy should lead to gradually improving margins and stable credit metrics for both names. In the agricultural and construction equipment sector, fundamentals have improved out of the downturn; however, weakness in Europe and slower growth in emerging markets are near-term headwinds. In addition, the drought conditions experienced this past growing season could crimp new equipment demand from North American farmers. 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.

One sector that continues to show positive momentum is auto. The monthly U.S. SAAR reached a new high for the year at 15.5 million units in November after a similarly strong October. We believe that robust domestic demand will continue during the next several quarters as pent-up demand remains strong and the fleet is aging. This will support our investment-grade Best Idea Ford Motor Credit (rating: BBB-) as well as the junk-rated auto dealers and auto suppliers. In November we published a report on  Delphi (DLPH, rating: BBB) whose junk-rated bonds offer very attractive spreads in the low-300s relative to our much more constructive view of the credit. We also like  Tenneco (TEN, rating: BB) for more pure junk buyers as the firm's 2020 bonds offer yields around 4.75%.

Contributed by Jeff Cannon and Rick Tauber

Tech & Telecom
The purported death of the PC has driven a wedge into the technology sector. Spreads across much of the sector have followed the broader credit market during the past three months, ending the period more or less unchanged. Firms with heavy PC exposure, on the other hand, have dramatically underperformed:  Dell's (DELL, rating: A+) 4.625% notes due 2021 have widened 35 basis points to +207,  Hewlett-Packard's (HPQ, rating: BBB+) 4.05% notes due 2022 are out 55 basis points to +280, and  Intel's (INTC, rating: AA) 3.30% notes due 2021 have moved 29 basis points wider to +107. We believe that the death of the PC has been exaggerated and that these firms have the ability to manage through the maturation of this market.

We believe HP bonds are particularly attractive, and the firm is on our investment-grade Best Ideas list. HP posted an 11% drop in PC sales during fiscal 2012 (ended in October), but the firm still managed to post a 5% operating margin in this segment, down only 1 percentage point from the year before. The nice thing about the PC business is that HP doesn't have to invest heavily in research and development, and costs are highly variable. We expect PC sales will continue to fall into 2013 as more consumers turn to tablets and other devices, but we also believe that HP's PC business will remain profitable. Of course, HP's problems extend beyond PCs, and the firm is working to turn around a struggling services business and integrate a poor software acquisition. Ultimately, though, the diversity of HP's businesses provides creditors with a hedge should a precipitous decline in PC demand actually materialize.

Perhaps nothing illustrates the irrational disdain investors have for the PC market as clearly as the early-December debt issuances at Intel and  AT&T (T, rating: A-). Intel's 10-year notes priced at a spread of +115 basis points over Treasuries, 10 basis points wider than AT&T's 10-year issuance that priced two days later. Following the new debt issuance, Intel holds $21 billion in cash and investments versus about $13 billion in debt (less than 0.6 times EBITDA). While Intel will certainly continue to buy back stock, the firm, if it chose to do so, could repay its entire debt load solely out of cash flow in about three years while also funding its dividend. AT&T also generates steady cash flow, but it carries far greater leverage today and recently indicated a willingness to take net leverage higher still to 1.8 times, excluding its sizable pension obligations, as it ramps up capital spending. AT&T's increased capital budget is in direct response to competitive pressures from Verizon Wireless, which has gained a clear lead in the race to build out LTE technology. AT&T also faces competitive threats from the industry's smaller players, as T-Mobile USA plans to gain scale through the acquisition of  MetroPCS (PCS, rating: BB-) and  Sprint Nextel (S, rating: BB-) has built a war chest via Softbank. AT&T is also increasing investment in its fixed-line networks to better compete with the cable companies. Although we expect both AT&T and Intel will successfully navigate the challenges in front of them, each still clearly faces risks to future cash flow. Given Intel's far stronger balance sheet, we just don't think relative spreads on the firm's bonds make sense.

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. Additionally, we believe President Obama's re-election will provide continued support for subsidized renewable energy investments in 2013.

Despite environmental-compliance risks, we view regulated utilities as a defensive safe haven for investors skittish about ongoing domestic and European-induced market volatility. As economic and geopolitical uncertainties begin to fade, we expect moderate spread contraction, particularly down the credit-quality spectrum. However, given historically tight parent company spreads on higher-quality utilities facing lackluster earnings growth and the prospect of falling allowed returns on equity (in line with low interest rates), we urge bond investors to approach investment-grade utilities with caution. Specifically, we advise investors to focus on a shorter-medium-term duration yield orientation as any potential rise in interest rates in 2013 could quickly erode spread outperformance given historically tight trading levels.

We expect high-quality parent company utilities issuers to maintain their elevated pace of debt market issuance in 2013, taking advantage of low rates to refinance and/or prefinance up to $85 billion of projected 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. In 2012, we note that several state regulators approved or proposed allowed ROEs below 10%, limiting creditors' margins of safety as regulatory lag diminishes.

Unregulated independent power producers face high uncertainty levels in 2013 and beyond. Power prices will remain severely strained as long as natural gas prices remain low. Excess natural gas supply and a potential unseasonably warm 2013 winter could push gas prices, currently hovering around the $3.50/mmBtu mark, back down to historic lows ($1.91/mmBtu). Furthermore, we recently revised our midcycle power prices downward to reflect a $5.40/mcf gas price (versus $6.50/mcf), negatively affecting projected margins. High natural gas storage levels of 3,804 billion cubic feet (as of Nov. 30, 2012) remain 5% above the five-year average storage level of 3,636 billion cubic feet. Moreover, we believe coal prices will generally remain under pressure in 2013 as environmental compliance stymies coal demand.

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 or reorganization at  Edison International's (EIX, rating: BBB-) merchant generation company, Edison Mission Energy, will be the first casualty following Dynegy Holding's 2011 fourth-quarter bankruptcy filing and 2012 fourth-quarter emergence.

The industry's broad desire to accumulate regulated assets, whereby offsetting and/or shedding merchant power plants, fueled M&A activity in 2012, but we expect this pace to moderate in 2013. Representative deals that closed in 2012 include all-stock mergers between  Northeast Utilities (NU, rating: BBB) and Nstar;  Exelon (EXC, rating: BBB+) and Constellation Energy; and  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 for $1.7 billion in an all-stock transaction. Rationale for this transaction includes greater scale (highlighting NRG's retail expansion), generation fuel and revenue diversity, and 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 any 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 2015.

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
Ticker Issuer
Maturity Coupon Price Yield Spread
to Treas
Amgen AMGN AA- 2022 3.63% $108.38 2.62% 105
Potash Corp POT A 2020 4.38% $116.00 2.46% 138
Cameron Corp CAM A- 2022 3.60% $104.50 3.04% 148
Mattel MAT A- 2020 4.35% $109.63 2.96% 176
Scana SCG BBB+ 2022 4.13% $103.88 3.62% 211
Data as of 12-12-12.
Price, yield, and spread are provided by Advantage Data, Inc.

 Amgen (AMGN, rating: AA-)
We still believe Amgen investors are getting a higher yield than warranted for this high-quality biotech issuer. The market and rating agencies don't appear to be giving Amgen credit for the cash it plans to hold on its books, which nearly offsets its recently inflated debt position even after large share repurchases and a dividend increase. Even if we strip out all of the cash from Amgen's balance sheet, we'd still only cut our rating by about two notches to A. However, Amgen's on-the-run 2022 notes trade about 30 basis points wider than the average A credit, revealing an opportunity for long-term investors. Of note, Amgen recently reported progress with several pipeline candidates; this progress gives us more confidence in its ability to replace lost sales on older products facing biosimilar competition, which should reduce Amgen's need to make a large acquisition that could deplete its cash resources. Also, while the market experienced some indigestion from Amgen's heavy issuance in 2011 and 2012, management announced in the second quarter that it had enough financing to fully fund its planned repurchase program. Therefore, we suspect Amgen will be a more modest debt issuer going forward.

 Potash Corporation of Saskatchewan (POT, rating: A)
Potash Corp. is the largest independent agricultural chemical company in the world. The company has a wide economic moat, fostered by its strategic potash assets that are by far at the lowest end of the global potash-production curve, long reserve life, and crucial role in setting global potash prices by leading negotiations between the Canadian exporting association (Canpotex) and foreign buyers. During the past seven years, Potash Corp. has embarked on significant capacity-expansion projects supported by its internally generated cash flows, and we expect the capital outlay to come to a close in the next 12-18 months. Although the additional capacity might not directly boost Potash Corp.'s near-term sales volume, we think the higher capacity should boost Potash Corp.'s share of exporting quota against its rivals (the exporting quotas among Canpotex producers are driven by capacity, much like Saudi Arabia's role in the Organization of the Petroleum Exporting Countries). In addition, weak crop harvests in the North American Corn Belt, along with elevated corn and soybean prices, provide an ideal environment for healthy farm economics, which should strongly support fertilizer prices for an extended period.

Potash Corp.'s prominent position in this industry should support its bond performance both on a relative value basis and a fundamental perspective. We still see compelling value for this rating, as the firm's enviable cost profile and low leverage would allow it to weather even a sharp and sustained drop in global economic growth. We also like Potash Corp. on a relative-value basis. For instance, the 2020 bonds are trading roughly 45 basis points wide of similar-dated debt of chemical peers such as  E.I. du Pont de Nemours (DD, rating: BBB+), which sports a two-notch-lower rating and a 2021 maturity bond indicated at a spread of 100 basis points over Treasuries, a gap we don't think is merited given our more favorable assessment of Potash Corp.'s underlying credit quality. In addition, Agrium AGU, another agricultural chemical company that is significantly smaller in size, has a 2022 bond that's trading at a spread of 152 basis points over Treasuries. We believe Potash Corp. should trade at least 25 basis points inside of Agrium.

 Cameron International (CAM, rating: A-)
Cameron's third-quarter earnings support our thesis that, after 20 years of low volumes of new deep-water drilling-rig deliveries, a surge in new rig orders to replace the aging fleet will benefit the company. Accounting for the recent acquisition of TTS Group, Cameron is now positioned to capture even more value from new deep-water rig construction. The recently announced OneSubsea joint venture with  Schlumberger (SLB, rating: A+) should allow Cameron to capture even more value from the deep-water market. OneSubsea combines Cameron's equipment design, manufacturing, and installation expertise with Schlumberger's reservoir knowledge and well-completions expertise to develop complete subsea production systems with the goal of increasing reservoir recovery from deep-water wells. As the JV improves Cameron's competitive position, we have raised Cameron's moat trend to positive from stable, supporting our positive outlook for Cameron's bonds.

The company is exiting a period of high capital expenditures that outstripped operating cash flows and should begin to generate significant positive free cash flow in the coming quarters. As such, we believe current gross leverage of 1.9 times on a LTM basis will decline to 1.2 times in 2014. Cameron's net leverage of 1.0 times on a LTM basis approaches that of larger peers Schlumberger at 0.6 times net leverage and  Halliburton (HAL, rating: A) at 0.5 times net leverage. Due to the firm's increasing free cash flow, we predict that net leverage will decline to 0.4 times by 2014. With the company's liability to the Macondo oil spill sufficiently ring-fenced, we believe spreads will continue to tighten in the coming quarters as Cameron monetizes its strong order backlog. Schlumberger and Halliburton are appropriate upside comps, with both trading roughly 55 basis points tight to Cameron, while peers  Ensco (ESV, rating: BBB) and  Noble (NE, rating: BBB-) are good downside comps, trading 25 and 30 basis points wide of Cameron, respectively. Additionally, the 3.60% notes trade flat with the Morningstar Industrial BBB+ index, offering potential outperformance on a risk-adjusted basis even if spreads move in line with the index.

 Mattel (MAT, rating: A-)
Mattel's bonds trade nearly 70 basis points wide of Morningstar's 10-year A- index, but also look compelling when compared with other A-, narrow-moat consumer cyclical names with similar leverage. Retailer  Nordstrom (JWN, rating: A-) and entertainment company  Viacom (VIAB, rating: A-) are two such examples, as they both have narrow economic moats and lease-adjusted leverage around 2 times. Nordstrom and Viacom have 10- and 30-year bonds that trade around 100 basis points and 145 basis points, respectively. Given resilient consumer spending in the toy category, we see no reason these two firms should trade that much tighter than Mattel's bonds of similar maturities.

 Scana (SCG, rating: BBB+)
Benefiting from leading regulated shareholder returns (mid-10%), Scana operates in a highly supportive Southeastern regulatory environment. Scana will further profit from a vast pipeline of infrastructure investments that will earn the firm its leading utility returns on equity. Scana's 2022s trade roughly 35 basis points wide of the average utilities' BBB+ rated issues in the Morningstar Corporate Bond Index. They also trade about 50-85 basis points wide of similar-duration paper issued by comparably rated regulated utility peers, such as  Duke Energy (DUK, rating: BBB+) and  Xcel Energy (XEL, rating: BBB+). We believe Scana's 2022 bonds represent a compelling positive carry opportunity that is positioned for upside upon the successful completion of two new units at its V.C. Summer nuclear power plant in South Carolina, expected in 2017-18. In the worst-case scenario, assuming Scana's nuclear plant is stalled or permanently derailed, we believe South Carolina laws will allow Scana to recover its capital investment as well as any stranded costs through rate-base increases. Last March, Scana successfully attained its combined license from the Nuclear Regulatory Commission. Clearing this last significant regulatory hurdle, Scana now has the right to construct and operate its planned V.C. Summer nuclear plants.

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