Credit Outlook: Sector Updates and Top Bond Picks

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Banks
Since the second quarter of 2012, we have opined that credit spreads for U.S. banks would outperform the broad corporate market. This opinion was based on our forecast that the credit metrics for U.S. banks would continue to improve over the course of the year, but the credit spreads for banks were trading wider than equivalently rated industrials. We held this view over the past three quarters, and our outlook proved to be correct, as U.S. banks did outperform over that time period. For example, on March 29, 2012, Morningstar’s Financial Corporate Bond Index was 70 basis points wide of the Morningstar Industrial Corporate Bond Index, where it currently is just 6 basis points wide.

Due to the heightened political risk in Italy and the continual deterioration of Italian and Spanish bank loan portfolios, we have become increasingly pessimistic in our outlook for the credit risk of peripheral banks. As such, we expect credit spreads of European banks will likely widen, which may then lead to widening credit spreads among U.S. banks. We, therefore, are changing our outlook to a neutral view.

The recent election results out of Italy failed to produce a clear winner and resulted in a potentially unstable government. This normally would not be that large of a concern, but the election called into question the willingness of the Italian people to adhere to austerity measures required by the European Central Bank. There are beliefs in the market that the strong showings from the coalition led by former Prime Minister Silvio Berlusconi, as well as the coalition led by Beppe Grillo, are essentially a referendum on an anti-euro platform. While the anti-euro stance in Italy could be exaggerated, the election may have put the problems of Europe back on center stage as far as the markets are concerned. We remain skeptical that the markets will receive the desired clarity out of Italy in the near term. Even if this is achieved, we think the continuing growth in nonperforming loans in Spain and Italy will most likely lead the markets to further question the stability of many European banks.

At this point, we advise investors who had heeded our recommendation to now begin reducing overweight positions in the financial sector to neutral. Although we think there is a strong probability that U.S. bank spreads may widen from European contagion, we do not recommend underweighting any names. Instead, investors should look to go overweight financials on market dips. In a downside scenario, where European sovereign and banking issues return to the forefront, we see a potential widening of approximately 100 basis points for regional banks and 150 basis points for the six large U.S. banks.

As we have pointed out in earlier research pieces, U.S. banks have greatly improved their balance sheets over the past several years. For U.S. banks, the percentage of nonperforming assets to total assets and the percentage of allowance to nonperforming assets are near their pre-2008 levels, while the ratio of tangible common equity to tangible assets is greater than their pre-2008 levels. U.S. banks should be able to weather a European crisis, even if it results in a U.S. recession.

Contributed by Jim Leonard

Basic Materials
Our pessimistic view for China's sustainable growth trajectory for the next decade remains unchanged. A lower headline GDP growth rate, driven by a decidedly less robust gross capital formation and a higher reliance on private consumption, would mark a stark turn of fortunes for basic commodity producers under our coverage.

Metal and mining companies, in particular, have enjoyed a joyful ride in the past decade, but we think the tide is turning. As Chinese fixed asset investment slows down, the lofty commodity prices would follow suit. Chinese demand on base metals, steel, and metallurgical coal is one of the key drivers supporting their respective global pricing; a lack of which (both in terms of absolute levels and growth rate) would become painfully obvious for metal and mining, steel and metallurgical coal producers, particularly those that are sitting at the higher end of the production cost curve.

Companies such as Cliffs Natural Resources (rating: BB+) is a prime example for this trend, and we expect further deterioration in its credit quality in the intermediate to long term. While the bond market seems to think the recent $1 billion equity raise can stabilize its credit quality, we want to point out that the equity raise does little to remediate the fundamental issues facing this company. As a high-cost producer, Cliffs is particularly sensitive to the slides of iron ore prices. With mounting debt load after years of acquisitions and heavy capital expenditures, the company has limited cushion to absorb low iron ore prices on an ongoing basis.

Although life would be less rosy for low-cost metal producers, their credit quality may not take the brunt of a gloomy Chinese economy. Southern Copper (rating: BBB+) and Vale (rating: BBB+) are in this camp. Both companies are sitting at the bottom quartile of the global cost curves, and we expect them to generate sufficient cash flows for both maintenance and expansionary capital expenditures in this environment. As high-cost marginal players experience financial troubles, low-cost producers like Southern Copper may even see their competitive position enhanced.

As spring rolls around the corner in the Northern Hemisphere, we think agricultural chemical companies will become the bright spot in our basic material land. Despite headlines related to the massive drought in the U.S. last summer, farmer incomes remain more than healthy. The eye-popping crop insurance payments across the Midwest all but wiped the poor harvest, and high crop prices translate into strong incentives for farmers in the coming growing season. We expect companies such as Potash Corporation of Saskatchewan (rating: A), Monsanto (rating: A+) and DuPont (rating: BBB+) will benefit from high planted acres and strong demand for crop inputs.

Contributed by Min Tang-Varner

Consumer Cyclical
The focus remains on balance sheets for consumer cyclical companies, as many firms highlighted during their earnings calls this past quarter. In our view, this could create some opportunities for a bond investor, as lingering economic concerns may push credit spreads wider, given that we expect the preponderance of management teams to continue to be mindful of leverage and internal targets throughout 2013. For some firms, such as R.R. Donnelley (rating: BB), this means repaying debt ahead of maturity in light of operational headwinds. Despite soft results, R.R. Donnelley has brought leverage down slightly to 2.8 times from 2.9 times at the end of 2011. Management announced that it was bringing its leverage target down to 2.25 times to 2.75 times from 2.5 times to 3 times.

However, for many other companies, this means coming to the debt market to keep leverage stable amid robust earnings growth. Such companies that we expect to issue debt in the coming quarters are home superstores Home Depot (rating: A) and Lowe's (rating: A). Both firms intend to return a great deal of cash to shareholders, but plan to do so within the constraints of previously stated leverage targets.

Macy's (rating: BBB) also continues to post solid results and may issue debt to keep in a certain range. Stronger earnings and lower debt levels brought lease-adjusted leverage down to 2.2 times (from 2.4 times in the prior-year period), which management stated was at the low end of internal targets.

Although we would prefer Limited Brands (rating: BB+) to reduce its debt load as we view its leverage as high for a cyclical firm, management did not appear to want to add additional leverage to the balance sheet. The firm stated in its recent earnings call that it believes the current amount of leverage (mid-3 times range) is appropriate. This level is higher than most of its retail peers, and keeps its credit rating below investment grade, in our opinion. In our view, Limited Brands' excessive shareholder-friendly activities (share repurchases and special dividends) pose the greatest risk to its bondholders.

Contributed by Joscelyn MacKay

Consumer Defensive
Consumer spending has held up surprisingly well thus far this year in spite of the recent payroll tax increase (which amounts to about 1% of disposable income) and rising gas prices (which has increased $0.40 per gallon since the beginning of the year). In order to address these pressures, as well as austerity measures across Europe, management teams have renewed their focus on new product innovation and brand extensions.

Innovation plays well in this environment, as value-added products serve to differentiate branded offerings from lower-priced private-label items. In addition, consumer product firms have taken a play from their emerging-markets handbook and have been launching smaller package sizes at lower price points to appeal to cash-strapped consumers.

For the sector, we expect 2013 sales growth to only marginally exceed nominal GDP growth rates, and operating income growth will range in the mid- to high-single digits. However, if further strains are placed upon the consumer, we could experience another round of channel shifting, as consumers have become adept at searching out the best deal. As evidenced by their changing behavior over the past few years, consumers have shown a willingness to shift beyond traditional grocery stores in search of a bargain. Despite this, retailers still depend on leading brands to drive traffic in their stores, and we don't anticipate that this will change.

Pent-up demand for M&A activity persists, and financing in the debt markets is cheap and readily available. A lack of organic growth opportunities and mounting cash balances should put more pressure on management teams to deploy capital. Within the consumer defensive sector, instead of larger transactions, we believe it is more likely that firms will continue putting excess cash to use by building out their distribution platforms at home and abroad--pursuing smaller, bolt-on transactions. Firms like Mondelez (rating: BBB) (which likely has its sights set on emerging-market players), Hershey (rating: A+) (which is targeting sales of $10 billion by 2017, an unlikely achievement without the benefit of acquisitions), and Sysco (rating: A+) (which has been quite active on the deal front for the last several quarters) all have suggested that they are targeting smaller businesses.

Although mentioned several times at CAGNY as another potential takeover candidate, we doubt that Campbell Soup (rating: A-) will go the way of its packaged food peers over the near term. Campbell is still undergoing its turnaround, as efforts to reignite its struggling U.S. soup business have been slow to take hold. We think it will take a few more quarters before we can gain confidence that new products (expected to approach 50 this year, including 32 in its soup business alone) are gaining traction with consumers. Also, we think that part of the appeal with Heinz was its globally diversified distribution platform, as the firm generated 60% of its revenue outside the U.S., whereas Campbell derives about 30% of its sales outside of North America.

Contributed by Dave Sekera

Health Care
Recent events--including sequestration in the U.S. and ongoing weakness in Europe--highlight how developed markets are becoming tougher to navigate for health-care companies. As a result, we are seeing more initiatives to boost growth through acquisitions and emerging-markets expansion. Also, as shareholders wait for that growth, many firms are placating them with higher dividends and share repurchases. We believe those strategies and the availability of cheap money in this historically low interest rate environment are leading many health-care firms to at least maintain debt leverage, despite weakening prospects in their core markets.

In the U.S., ongoing efforts to reduce the deficit should put direct pressure primarily on service and life sciences companies. Service providers, such as HCA (rating: B+) and Tenet (rating: B), will likely face considerable pressure to keep costs in check, and that pressure could lead hospitals to push back more on suppliers, including medical device companies. Since most of the medical device makers we cover operate with light leverage, we do not expect their credit ratings to take much of a hit due to pressures related to hospital economics. However, we continue to see medical device firms pursue emerging-markets growth and increase returns to shareholders through dividends and share repurchases, which may cut into debt repayment cushions at these companies. In life sciences, firms with sizable exposure to government spending, including Illumina (rating: BBB-) and Life Technologies (rating: UR/BBB), face weaker near-term growth prospects due to deficit reduction efforts, which may make them more likely to sell out to potential acquirers. In fact, Life Technologies remains on the auction block, and we think a leveraged buyout is more likely than a strategic buyer, which highlights the downside risks for Life debtholders.

Even ongoing weakness in Europe has not led to widespread balance sheet deleveraging in the health-care industry. In fact, GlaxoSmithKline (rating: AA-) recently offered new notes with the proceeds earmarked toward refinancing existing indebtedness and boosting its cash balance, highlighting Glaxo’s comfort with its current leverage position and potentially pointing to future acquisitions or returns to shareholders with its inflated cash position. We have also seen companies, such as Smith & Nephew (NR), with its acquisition of Healthpoint, quickly reduce balance sheet cash to make acquisitions that could boost growth prospects rather than stockpiling cash to gird for further European weakness. Going forward, AstraZeneca (rating: AA) still appears to have the most incentive in the large pharmaceutical industry to make a diversifying acquisition or return value to shareholders due to weak growth prospects associated with its large patent cliff and weak pipeline.

Contributed by Julie Stralow

Energy
As we look to the second quarter, we see three issues that could affect credit spreads in the energy sector: the continued normalization of natural gas storage levels, new ultra-deepwater drilling contract announcements, and potential changes to Venezuela's approach to foreign energy companies.

An industrywide reduction in natural gas-focused drilling over the last year coupled with an 8% increase in heating degree days compared with last year have brought down natural gas storage levels. As of mid-March, the amount of natural gas in storage is 19% lower than last year's level. Although storage volumes remain 11% above the five-year average, this is a vast improvement compared with this time last year, when storage levels were over 50% above the five-year average.

Given current trends, we reiterate our bullish take on natural gas prices, as U.S. natural gas production is likely to decline in 2013. With roughly 60% of its production coming from natural gas, but only 20% of its 2013 production hedged,  Devon Energy should benefit from higher prices. Spreads on Devon bonds have moved wider recently due to weak quarterly results, but as storage levels continue to improve, we believe spreads should begin to compress.

In the oilfield services sector, we anticipate the announcement of new contracts for ultra-deepwater drilling rigs. Consensus opinion of both company managements and industry analysts is that demand remains healthy and that tender activity is strong. Unfortunately, this has not translated into contract announcements. The delay is blamed on increased regulatory requirements, but with over 20 uncontracted UDW rigs scheduled for delivery over the next two years, we await fresh data points to confirm the consensus opinion. As spreads on  Rowan Companies debt have tightened significantly and are close to their all-time tight levels, we believe there is risk of spread widening should consensus opinion about the UDW market be wrong.

While speculation about the future of the oil industry in Venezuela post-Chavez abounds, we do not anticipate that any potential changes within Venezuela will create a windfall for companies such as  ExxonMobil and  ConocoPhillips , whose assets were nationalized by Chavez. Even if Venezuela increases its ties with major energy companies, the scale of these operations relative to the size of companies involved creates limited potential for spread compression.

Contributed by David Schivell

Industrials
With recent economic data continuing to point toward a slow and steady recovery in the U.S., we would expect balance sheets and credit metrics to remain relatively stable across the industrial landscape over the next quarter. Data out of China also suggests renewed growth, helping support this view, while Europe remains weak. Although cash balances continue to grow, shareholder-friendly buybacks and dividends remain the preferred use of cash, not debt reduction.

Looking across some of the key subsectors that we follow, fundamentals generally look good for the rail sector, though low natural gas prices continue to adversely affect utility coal volumes. The Eastern rails, Norfolk Southern (rating: BBB+), and 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 Kansas City Southern de Mexico, which continues its push to investment grade at the rating agencies. KCSM was recently upgraded to investment grade by S&P and with Fitch already at BBB-, Moody's remains the lone holdout, with a Ba1 rating. Although Morningstar doesn't separately rate KCSM, we maintain a BBB- rating on parent company Kansas City Southern (rating: BBB-).

In the agricultural and construction equipment sector, long-term fundamentals generally remain positive; however, weakness in Europe and slower growth in emerging markets are near-term headwinds. In addition, with crop prices off their highs, lower crop cash receipts could crimp new equipment demand from North American farmers. We generally view the sector as fairly valued at this time, but continue to recommend the bonds of AGCO rating: BBB-), given its relatively wide spreads for what we view as investment-grade risk.

The defense sector was no longer able to escape the grips of sequestration, which was kicked down the road on Jan. 1 but finally implemented on March 1 when Congress could not negotiate a deal to stop it. As such, a half-trillion dollars of defense spending cuts are mandated to take place over the next decade.

Our ratings, adjusted after the Budget Control Act of 2011, have already factored in some impact from sequestration. However, most defense companies did not include any impact from sequestration in their 2013 guidance, so we expect downward revisions during first-quarter earnings calls. Still, we expect the credits to remain stable as international sales and exposure to the booming commercial aerospace sector will mute the impact to many names. While most of the sector trades directionally in line with our ratings, we still see the best value in BAE Systems (rating: BBB+), which generates less than half its revenues from the U.S. and trades at a healthy spread concession to the A-rated defense credits.

The auto sector keeps humming along domestically with monthly SAARs now consistently in the 15+ million range, supporting our mid-15 million unit full-year forecast. However, European registrations remain very weak, keeping both the OEMs and suppliers at bay. Nonetheless, we see perhaps the best value in the crossover suppliers where we see moats emerging, including rising-star candidate Delphi (rating: BBB), which issued an attractive new $800 million senior note during the quarter. We also note positive moat trends at Tenneco (rating: BB) and TRW (rating: BBB-), the latter of which also priced new high-yield bonds at attractive levels.

Contributed by Jeff Cannon and Rick Tauber

Tech & Telecom
Last quarter we wrote about the effect that the purported death of the PC industry was having on spreads across the tech sector. Since then, the two firms most heavily associated with PCs have moved in opposite directions. Dell (rating: UR-/A+) announced plans to go private in a deal led by founder Michael Dell. With a big dose of leverage set to hit the books if the deal closes, Dell bonds have gapped wider: its 4.625% notes due 2021 have widened more than 100 basis points to +310. On the other side, Hewlett-Packard (rating: BBB+) has continued to use cash flow to reduce leverage. HP's 4.05% notes due 2022 have tightened about 70 basis points to +210 over the past three months. We believe HP credit has the potential to tighten further from here.

The Dell deal has caused takeover chatter around the tech industry to increase, but we don't believe the transaction signals a return to rampant deal making across the sector. Dell’s buyout is facing considerable shareholder dissention from the likes of Carl Icahn, claiming that the deal substantially undervalues Dell's equity. Dell's shares were certainly depressed before rumors of a deal began swirling--its enterprise value was hovering around 2.5 times EBITDA, an exceptionally low multiple even with the challenges Dell faces. Providing a bigger premium to shareholders would only increase leverage and further restrict Dell's strategic flexibility. The issue with tech in general and Dell specifically is that it is often tough to get comfortable with the longer-term outlook for cash flows, making it difficult to add significant leverage to balance sheets. No other tech firm across our credit coverage universe looks as cheap as Dell did three months ago. Also, few firms have a major shareholder and founder to build a leveraged transaction around. For HP, in particular, we believe the firm is simply too large to consider an LBO, especially with the rebound in its share price.

The U.S. telecom sector has had a fairly quiet start to 2013 following a busy end to 2012. We expect action to heat back up shortly. Regulators have signed off on the merger of MetroPCS (rating: BB-) and Deutsche Telekom's (rating: BBB-) T-Mobile USA unit. As with Dell, this deal is facing some shareholder opposition and we still wouldn't be surprised to see  Sprint (rating: BB-) jump in with an offer for MetroPCS before shareholders vote on the transaction. Sprint also has its hands full with its network upgrade, closing its transaction with Softbank, and completing its purchase of Clearwire. As these strategic moves reach a conclusion, we expect the action will return to the competitive field as Sprint and T-Mobile attempt to better compete with giants AT&T (rating: A-) and Verizon .

Verizon Wireless has also been at the center of deal speculation. Media reports have swirled that Verizon (rating: A-) and Vodafone (rating: BBB+) are finally nearing an agreement to resolve the ownership of Verizon Wireless. Verizon has repeatedly made it known that it would like to own Vodafone's 45% stake in Verizon Wireless, but it has never been able to reach an acceptable agreement with Vodafone. An outright purchase of Vodafone's stake would be hugely expensive--likely in excess of $80 billion--and would trigger a massive tax bill for Vodafone. The form of any deal isn't known, and a wide range of possibilities exist, including the sale of a small portion of Vodafone's stake or the outright merger of the two firms. We believe that the status quo remains the most likely outcome of any negotiations given the myriad issues the firms would have to resolve.

Contributed by Mike Hodel

Utilities
Two U.S. Environmental Protection Agency regulations continue to cloud the sector's near- to medium-term landscape. Coal plant retirements and increased capital investment are two likely outcomes from final versions of the EPA's Cross-State Air Pollution Rule, or CSAPR, and the air toxics rule, or MATS. Even though CSAPR was fully vacated in August 2012 and the U.S. Court of Appeals (D.C. Circuit) denied the EPA's petition for a rehearing in January 2013, we continue to believe this rule will be revised rather than advanced up to the Supreme Court. Additional environmental rules could follow in 2013 specifically addressing water cooling intake (nuclear and gas plant impact) and coal fly ash disposal (coal plant impact). We believe these rules will likely raise costs for consumers and place increased rate pressure on regulated utilities. Additionally, we believe President Obama's re-election will provide continued support for carbon emissions regulations.

Despite environmental-compliance risks, we view fully 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 historically low interest rates), we urge bond investors to approach investment-grade utilities with caution. Specifically, we advise investors to focus on shorter to medium-term duration as any potential rise in interest rates in 2013 could quickly erode spread outperformance given historically tight trading levels. Moreover, we believe investors seeking yield should tread lightly when considering opportunities at diversified ParentCos. Elevated downgrade risks exist particularly at these entities given continued weakness at their unregulated GenCo subsidiaries.

We expect high-quality fully regulated utility issuers to maintain their elevated pace of debt market issuance in 2013, taking advantage of low rates to refinance and/or pre-finance up to $85 billion of projected maintenance and rate base growth capital investments. We expect environmental capital expenditures also to be a significant component of debt-funded capital expenditures, though 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 the 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 continue to face high uncertainty 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 cool 2013 summer could push gas prices, currently hovering around the $3.50-$3.60/mmBtu mark, back down close to historic lows ($1.91/mmBtu). Furthermore, we revised our midcycle power prices downward to reflect a $5.40/mcf midcycle gas price (versus $6.50/mcf), negatively affecting independent power producers’ projected margins. Although, we note declining natural gas storage levels totaling 2,083 billion cubic feet (as of March 1st) are now only 15% above their five-year average storage level of 1,814 billion cubic feet (and down 7% year-over-year). Moreover, we believe coal prices will generally remain under pressure in 2013 as a myriad of environmental regulations stymies coal demand.

As such, we continue to expect merchant power producers to experience elevated liquidity constraints, especially within diversified utilities that own older coal plants in need of control upgrades. As expected, reorganization at  Edison International's (rating: BBB-) merchant generation company, Edison Mission Energy, was the first casualty following Dynegy Holding's 2011 bankruptcy (2012 fourth-quarter emergence). We also believe  Ameren Corp's (rating: BBB-) March 14 announced merchant generation sale of Ameren Energy Resources Generating Co. to Dynegy reflects the changing diversified utility landscape (shedding merchant generation) despite our belief that select coal generation should garner much higher asset values in the future ($ per kW).

On the other hand, the industry's broad desire to accumulate regulated assets fueled M&A activity in 2012, although we expect this pace to moderate in 2013. Representative deals that closed in 2012 include all-stock mergers between Northeast Utilities (rating: BBB) and Nstar; Exelon (rating: BBB+) and Constellation Energy; and Duke Energy (rating: BBB+) and Progress Energy. Additionally, independent power producer NRG Energy (rating: BB-) acquired peer GenOn Energy in 2012 for $1.7 billion in an all-stock transaction highlighting greater scale (NRG's retail expansion), generation fuel and revenue diversity, and reduced liquidity needs. Although we view GenOn as the weaker performer of the two (albeit with great operating leverage upside), NRG announced that it will reduce leverage by $1 billion, principally at GenOn, of which $686 million has been paid down in December 2012.

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 (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 Rating	Maturity	Coupon	Price	Yield	Spread to Treas
Zimmer	ZMH	AA	2021	3.38%	$102.25	3.07%	144
SABMiller	SAB	A	2035	5.88%	$116.88	4.65%	171
Delphi Automotive	DLPH	BBB	2023	4.36%	$105.25	4.16%	260
Pepco Holdings	POM	BBB	2032	7.45%	$125.88	5.30%	260
Regions Financial	RF	BBB-1	2018	7.50%	$123.50	2.60%	174
Data as of 3-18-13. Price, yield, and spread are provided by Advantage Data, Inc. 1Morningstar's credit rating is applicable at the holding company level. The 7.50% subordinated notes due 2018 are issued by Regions Bank, an entity we do not rate but consider a similar credit risk.

Zimmer (rating: AA)
We think Zimmer is an absolute and relative valuation play. The firm's 2021 issue appears to be priced like a 10-year issue from a BBB+ rated firm, which we believe is too pessimistic for a company of this credit quality. We believe the market is anchoring on the agencies' A-/Baa1 ratings, which may display a size bias. Given Zimmer's top-tier position in the very attractive orthopedic device industry, we think the firm has dug a wide moat, which overrides its modest top line in our rating methodology. Also, we believe Zimmer represents an attractive relative value compared with Stryker, another orthopedic firm that we rate AA. However, Zimmer's 2021s are currently indicated at spreads around 30 basis points wider than Stryker's 2020s, and we think investors should take advantage of this relative spread differential. Investors may want to consider Zimmer's other issues, too; in addition to the highlighted issue, it has 2014s, 2019s (which are indicated about 20 basis points wider than Stryker’s 2020s), and 2039s outstanding.

SABMiller (rating: A)
SABMiller issued several benchmark-size bonds to finance the acquisition of Foster's Group. While leverage did increase appreciably to finance this acquisition, we believe the firm will quickly repay debt and return to pre-acquisition leverage by 2015. We have previously opined that the existing trading levels for SABMiller were cheap for the rating and relative to its competitors in the beverage sector, such as Anheuser-Busch Inbev (BUD) (A-). BUD's 2.50% senior notes due 2022 are indicated at +100, whereas SAB's 3.75% senior notes due 2022 are trading at +120, and SAB's 4.95% senior notes due 2042 are indicated at +125. As leverage at SAB declines, we think the notes will continue to tighten toward Anheuser-Busch InBev levels. SAB's 2035s look particularly attractive as it trades significantly wider than the on-the-run bonds. In addition to the notes being cheap on a relative value basis compared with the beverage sector, they are currently trading at spreads that would indicate a strong BBB+ rating.

Delphi Automotive (rating: BBB)
(Note that the yield and spread above are to the par call on 2/15/21. The bonds are also subordinated to secured term loans.) This new $800 million senior unsecured bond was used to reduce a substantial amount of secured bank debt layered ahead of the bonds in the capital structure. As a result, Moody's upgraded the bonds to its corporate rating of Ba1, while S&P changed its outlook to positive on its BB+ rating. We believe Delphi can attain investment grade status with at least one of those two agencies, which, along with Fitch’s BBB-, would place it in the investment grade market. We have maintained our BBB rating despite the new debt issuance, which improved the firm’s maturity schedule and our Cash Flow Cushion score, and our recent upgrade of Delphi’s moat to narrow from none. The latter improved our Business Risk score. European headwinds remain the primary concern in 2013, but we believe Delphi’s global footprint and variable cost structure will allow it to navigate these challenges successfully, maintaining leverage near 1x. Delphi trades over 100 basis points wide of suppliers BorgWarner (BBB+) and Johnson Controls (BBB+), which we view as very attractive.

Pepco Holdings (rating: BBB)
Pepco Holdings is the parentco/holdco of three regulated electric and gas utility operating subsidiaries servicing roughly 2 million customers in Maryland & District of Columbia (Potomac Electric Power Co), Delaware (Delmarva Power), and New Jersey (Atlantic City Electric). Historically, Pepco operated a significant unregulated retail energy supply and wholesale generation fleet (Conectiv Energy), however, Pepco now only generates 5% to 10% of its operating income from these unregulated businesses. In general, Pepco Holdings’ utilities operate in average to slightly below-average regulatory jurisdictions hindered largely by regulatory/cost recovery lag resulting from historical rate setting test years. As a result, Pepco could file more frequent rate cases, although exposing itself to higher degrees of regulatory uncertainty in an attempt to maximize its average allowed ROEs. On the other hand, Pepco benefits from decoupling at Potomac Electric Power (two-thirds of distribution revenues), which minimizes lost revenue due to weather-related disruptions. Unlike many of its East Coast peers, Pepco’s system fared relatively well from Hurricane Sandy’s aftermath, which caused roughly $45 million to $65 million of flood damage primarily to Atlantic City Electric’s system. However, we believe Pepco will in large part be able to recover these costs via rate base over time. For a regulated BBB utility, we believe Pepco’s 2032s provide very attractive risk-adjusted spreads and trade roughly 116 basis points wide of the average Utilities’ BBB rated issuers in the Morningstar Corporate Bond Index. They also trade about 75 to 120 basis points wide of similar duration paper issued by comparably rated regulated utility peer parentcos, such as DTE Energy and Xcel Energy. While we note Pepco’s bonds trade at a high dollar price, we believe 50 basis points of spread tightening potential exists relative to utility peers on top of providing attractive positive carry.

Regions Financial (RF) (rating: BBB-)
Before the credit crisis, Regions was focused on expanding the business through acquisitions. Management, however, failed to consider the risk the company was taking as the concentration in construction loans grew. When the housing market bubble burst, Regions was left with billions in bad loans, and it is still trying to work through them. Since early 2008, Regions has written off more than $9 billion in loans, or virtually all of its original tangible equity. Regions had been recovering at a slower pace than its more conservative peers, but it has made significant progress over the past year. Nonperforming assets/total assets is now below 3%, and while we still would like to see that number get below 1.5%, it's a considerable improvement from the almost 5% of early 2010. While the company's recently closed sale of Morgan Keegan hurt its diversification score, ultimately the sale was a credit positive because the transaction helped Regions repay its outstanding $3.5 billion in Troubled Asset Relief Program money.

Due to a lack of sufficient supply of senior holdco paper, we recommend investors look to Regions 5-year bank subordinated debt. We contend that for U.S. banks, subordinated debt at the bank operating subsidiary should trade tighter than, or at the very least the same as, senior debt of the holding company. Given our outlook on the improving credit trend for Regions, we believe that we could upgrade Regions one to two notches this year as we also assess the impact of the sale of Morgan Keegan. Therefore, we believe that these bonds could end up trading 20 to 30 basis points wide of names like Fifth Third Bancorp (FITB) (rating: A-) or BB&T (BBT) (rating: A-) at the five-year point of the curve. With five-year credit spreads of those names trading at approximately 80 basis points, we think Regions has a lot of spread-tightening potential.

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