Plenty of Cheap Debt to Go Around
U.S. banks have repaired their balance sheets and have ample credit capacity available to provide commitment letters supporting M&A activity.
Since the reports emerged that Dell (A+/UR-) may be subject to a leveraged buyout, bond investors quickly dusted off their LBO handbooks and began to play some defense in their portfolios.
Bonds of those issuers that historically have been identified as LBO candidates were soon offered out into Wall Street, but activity in the secondary market became very sketchy. Trading in those names dried up, as sellers were unwilling to lower their offers enough from pre-Dell announcement levels to entice buyers. Neither sellers nor buyers had enough conviction to find a middle ground in which to cross bonds. In the merger and acquisition community, private equity sponsors are reportedly ramping up their due diligence teams as they scour for targets, and the leveraged finance teams at the large multinational banks are updating their pitch books.
Morningstar's equity and credit analysts have finished their semiannual Merger & Acquisition Insight, which we will publish this week. In this report, we highlight firms that we think are takeover candidates as well as firms that are likely strategic buyers. Our credit analysts scoured the bond covenants of potential takeover targets and conducted an upside/downside analysis to highlight those bonds that are most at risk of suffering large losses in an LBO scenario, as well as identify those bonds that may improve from being acquired by a larger, investment-grade corporation.
Credit Markets Primed to Finance M&A
The credit markets are primed to support a greater amount of merger and acquisition activity this year for both strategic acquisitions and a resurgence in leveraged buyouts. With financing capacity returning to the capital markets, debt is plentiful and cheap. U.S. banks have repaired their balance sheets and have ample credit capacity available to provide commitment letters supporting M&A activity and are increasing their appetite for the wider spreads offered by leveraged deals to help offset contracting net interest margins. In addition, the market for collateralized loan obligations has been heating up. For 2013, CLOs are forecast to raise as much as $35 billion of new capital. The new issue markets for both investment grade and high yield have been especially active thus far this year and are wide open to both repeat as well as first-time issuers. Mutual funds have received significant inflows of new cash that needs to be put to work. Credit spreads are near their lowest levels since the 2008-09 credit crisis, and with interest rates bumping along their lows, the all-in yield to finance acquisitions is at a historic low.
While LBOs appear poised to increase, we continue to think that strategic deals will outweigh financial transactions in 2013. Strategic transactions are becoming increasingly attractive to management teams as corporations are sitting on significant amounts of cash that need to be deployed, operating margins are near their highs and will be difficult to expand further, and organic growth is difficult at best in the current tepid economic environment. Considering net debt leverage is generally low at most corporations and debt is cheap, most issuers have plenty of bandwidth to finance deals. One trend we think will increase this year is a hybrid buyout in which private equity sponsors are teaming up with strategic buyers. Within these transactions, each party can bring to bear its own strengths such as monetizing real estate assets, effecting organizational change, or enhancing operational efficiency.
Considering the average dollar price of bonds in the Morningstar Corporate Bond Index is almost 113 and longer-dated bonds with higher coupons can reach well over 120, there is significant downside price risk in an LBO situation, even for bonds with change-of-control provisions, which typically offer downside protection at 101. In addition to the downside risk from leveraging transactions, we expect that in this low-growth environment, management teams will continue to look to financial engineering (that is, spin-offs, asset sales of noncore businesses, and debt-funded share-buyback programs) to enhance shareholder value as well as ward off hostile leveraged buyouts. Depending on the structure and size of spin-offs, bondholders could be impaired as the remaining cash flow and assets may not provide as much coverage as the combined entity. Asset sales where the proceeds are used to repurchase stock or pay a special equity dividend will also probably result in credit deterioration for bondholders. We recommend that investors scrutinize covenant packages before they purchase bonds to understand if there are any limitations or restrictions on these types of financial engineering.
Financial Credit Spreads Tightest to Industrials Since February 2008
For all practical purposes, trading stopped early Friday as investors turned their attention to the Icahn/Ackman debacle on CNBC. Spectators quickly took sides with one activist or the other and the Street cheered on their favorite protagonist as the verbal sparring heated up. The final tally for Friday's bout wasn't revealed, but we're anxiously awaiting Round 2. For the week, the credit markets lagged the seemingly bulletproof equity market which continued its daily melt-up. The average spread in Morningstar's Corporate Bond Index tightened only 1 basis point last week to +134. However, this level is near the tightest the index has been since November 2011 and about where it was in September 2007 when the S&P 500 was at 1,525 (not too far above Friday's close). As earnings season swung into full gear, the new issue market took a breather as investors turned their attention to earnings reports. While there were numerous Yankee bond issues priced by several European banks, there were very few domestic issuers that came to market.
The differential in credit spreads between the financial sector and the industrial sector continued to tighten, and at a 15-basis-point spread, it is the tightest the two sectors have traded to each other since February 2008. In our First-Quarter 2013 Outlook, we opined that the financial sector would outperform the industrial sector this quarter, and we continue to hold that view. 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. However, we do not believe the percentage of reserves to nonperforming loans will continue to improve. 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.
New Issue Notes
The Most Attractive Price Talk of the Year: First American Financial's 10-Year Notes (Jan. 24)
First American Financial (FAF) (BBB+) announced today that it is issuing new 10-year notes. The initial price talk is a spread in the area of low 300 basis points above the Treasury curve. At that price talk we think these bonds are extremely attractive. We have a more favorable credit view of First American than many rating agencies, as we rate it BBB+ where many rating agencies rate it a low BBB. Our credit view reflects the company's excellent cost controls and lower reliance on debt financing when compared with its largest competitor. In the wake of the real estate collapse, title premiums fell 18% in 2007 from the previous year and another 19% in 2008. In response, First American embarked on dramatic cost-cutting measures that allowed it to produce an underwriting profit in each of the past three years. Going forward, First American's margins will be among the best in the industry even if the housing market continues to languish, which is important, as the firm depends almost entirely on its title insurance stream of revenue. Also, we think First American will experience significant margin expansion when real estate markets return to normal. First American has virtually the same financial metrics as larger rival Fidelity National Financial (FNF) (BBB), with one exception: lower debt. The rating agencies also rate Fidelity National Financial low BBB and their bonds are quoted with a spread of 240 basis points above the Treasury curve. Last year, First American Financial was on our equity Best Ideas list for much of the year and was recently removed after the share price nearly doubled. We still think very highly of the company and would recommend these notes all the way to a spread of the low 200s.
PNC Issues 3-Year and 10-Year Notes Out of PNC Bank (Jan. 23)
PNC Financial Services Group (PNC) (A-) announced today that it is issuing new 3-year fixed- or floating-rate senior notes and 10-year fixed-rate subordinated notes out of its banking entity, PNC Bank. Although we do not rate PNC Bank, we view it as having a similar credit profile to PNC Financial Services. Initial price talk is a spread in the area of 125 basis points above the Treasury curve for the 10-year sub notes.
We have a favorable view of PNC from a credit perspective because of the bank's proven banking operations and sound capital position. The bank performed well during the credit crisis and has maintained its conservative profile. We do, however, view its notes as fairly valued. PNC's holding company 10-year notes trade with a spread above Treasuries in the 105 area. Given the recent pricing history, we would generally expect bank sub notes to trade with a much wider spread than the 20 basis points being offered in the initial price talk, so on that basis, we would view this new offering as fairly valued to rich. Given PNC's overall strong credit profile, however, we believe that there is little effective difference in the overall risk of these two notes. For those investors searching for yield, these notes make sense considering you pick up 20 basis points going from senior holdco to subordinated bank notes. We acknowledge that this may not be the current market opinion, given some of the actions by the FDIC during the credit crisis (for example, Washington Mutual). We believe, however, that the currently strong capital position of regional banks makes the probability of any crisis happening in the near term extremely low, and therefore, the actions that occurred during the credit crisis are negligible.
Sector Pick Tenet Refinancing Senior Secured Notes (Jan. 22)
On Jan. 22, Tenet Healthcare (THC), (B) announced plans to issue $850 million in senior secured notes maturing in 2021 to refinance its 10% senior secured notes due in 2018 (about $831 million payment on $714 million in principal) and other senior secured debt, such as its credit facility. Initial price talk of 4.5%-4.75% on the new issue suggests that these notes may offer an attractive relative value in the high-yield health-care services industry.
We often compare Tenet with another large hospital chain, HCA Holdings (HCA) (B+), and Tenet's notes typically offer higher yields than similar HCA notes. For example, Tenet's 6.75% senior unsecured notes due in 2020 were recently indicated at 5.87%, or a spread of 460 basis points over Treasuries, while HCA's 5.875% senior unsecured notes due in 2023s are only indicated at 5.13%, or 326 basis points over Treasuries. Because we believe Tenet and HCA's credit ratings may converge over time because each have similar business risks and capital allocation strategies, high-yield investors may want to take advantage of the current relative yield differential between the notes.
We believe fair value on Tenet's new senior secured notes is in the range of 4.375%-4.625%, or about 290-315 basis points over Treasuries. Last fall, Tenet issued 4.75% senior secured notes due in June 2020 at the same time as its 6.75% senior unsecured notes due in February 2020. Recently its 4.75% senior secured notes due in 2020 were indicated at a yield of 4.27%, or a spread around 295 basis points over Treasuries, and we use that as a benchmark for Tenet's new notes. In comparison if Tenet's new notes are priced as we expect, we'd see them as modestly attractive relative to HCA's senior secured notes. HCA's 6.5% senior secured notes due in 2020 were recently indicated around 4.19% and a spread of 292 basis points over Treasuries while its 2022s were recently indicated around 4.53% and a spread of 280 basis points over Treasuries.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.