Mini-Crisis in Cyprus Fails to Alarm Investors

Is it apathy or did everyone leave for spring break? While the average spread of the Morningstar Corporate Bond Index widened 3 basis points to end the week at +137, the credit market never felt very threatened by the negative news last week. Similarly, the average spread of the Morningstar Eurobond Corporate Index widened 2 basis points to +137. For the most part, the credit markets were unfazed by the news out of Cyprus and likewise indifferent to the lower-than-expected earnings and weak guidance from  FedEx (FDX) (BBB+) and  Oracle (ORCL) (AA). The Federal Reserve's statement was a non-event as the Federal Open Market Committee intimated that it would continue along its same course of easy money and does not appear to be poised to make any changes in the near term. The Fed did slightly reduce its projections for GDP growth by reducing the top end of its projection range by 0.2%, to 2.3%-2.8%. In addition, the Fed reduced its projection range for the unemployment rate to 7.3%-7.5% and decreased its expected PCE inflation to a range of 1.3%-1.7%.

Cyprus surprised the world last weekend when it announced that it would "tax" bank depositors as part of a EUR 10 billion rescue package to recapitalize its banking system. The plan was to raise EUR 5.8 billion through a levy of 6.7% on deposits under EUR 100,000 and 9.9% on deposits over EUR 100,000. This plan received a tremendous amount of pushback. While the absolute amount of money is small in the grand scheme of things, the precedent could affect future bailouts in the rest of the eurozone. In addition, if the ordinary depositors in the Cyprus banks are impaired, it could set off another run on the peripheral banks. Although we don't have any special insight into how the situation will develop, the absolute size the bailout is minuscule compared with the potential negative shock to the eurozone. Therefore, we think policymakers will resolve the situation such that depositors with less than EUR 100,000 in their accounts, which are guaranteed by the government, will not suffer losses. Protecting the deposits of the average citizen will go a long way to minimize the risk of starting bank runs in other countries. In addition, the European Union will probably try to resolve the crisis without forcing Cyprus to leave the eurozone, as that would set a dangerous precedent. Italian and Spanish 10-year bonds ended the week at 4.52% and 4.85%, respectively. The yields on both bonds declined as investors surmised that the turmoil in Cyprus will be contained and Spain successfully auctioned off EUR 4.5 billion of new bonds.

The S&P dropped 0.80% during the first two days of the week and the VIX moved as high as 15.4, yet both reversed course by the week with stocks only losing 0.2% for the week and the VIX settling down to 13.6. As we opined last week, complacency seems to be reaching new highs. With plenty of liquidity sloshing around looking for a home, any day with positive news--or even a day with a lack of news--allows asset prices to levitate. It takes decidedly negative news to derail this seemingly impervious market, and even then the markets have quickly brushed off bad news and regained lost ground. The extraordinary level of global central bank easing appears unlikely to end anytime soon. With so little risk priced into the credit markets, one trader mentioned that his accounts seem to be positioned somewhere between really long credit and "I'm as long credit now as I was in 2007!"

While many market participants are more concerned about increasing risk positions than hedging downside, it appears to us that being long credit is becoming a crowded trade. This past week, Bloomberg ran an article that the vilified collateralized debt obligation market was showing some signs of life as a few new deals were priced. However, we view the corporate bond market to be fully valued at current spread levels. While we agree that the strong technicals in the market can push us slightly tighter, we don't foresee credit spreads tightening toward the historically tight levels experienced before the 2008-09 credit crisis.

U.S. Economy Further Diverges From Eurozone Economy

Economic indicators in the United States continued to portend further economic growth. For example, Markit's flash Purchasing Managers Index held relatively steady at 54.9 (a level above 50 indicates expansion) and the housing market and leading indicators registered gains and initial unemployment claims declined. Conversely, the composite PMI for the eurozone fell to 46.5 from 47.9, indicating the economic region will continue to be mired in recession for the first quarter. France appeared to take the brunt of the slowdown as its PMI fell to 42.1 from 43.1, its lowest in four years. Markit highlighted, "The decline signaled an acceleration in the rate of contraction of business activity for the second consecutive month to the steepest experienced for four months." Discouragingly for Europe, Markit sees further degradation for the eurozone economy: "Looking ahead, two key indicators suggest that business activity trends could disappoint again in April." China, however, appears to be on the mend from its slowdown last fall as the country's manufacturing PMI rose to 51.7 from 50.4. For the near term, we think bonds of issuers with following attributes will outperform:

• High exposure to U.S. markets, where we anticipate modest economic growth will continue
• Limited exposure to the eurozone, especially the peripheral countries where austerity measures hamper economic recovery
• Exposure to the emerging markets, where economic growth continues to be positive, albeit moderating

Companies that have the wherewithal to expand capital expenditures and infrastructure investments to take advantage of competitors that lack the wherewithal to reinvest in their businesses.

Click to see our summary of recent movements among credit risk indicators.

New Issue Notes

St. Jude's Initial Price Talk Looks Attractive (March 21)
Cardiac medical device maker  St. Jude Medical (AA-, wide moat) is in the market issuing 10-year and 30-year notes. The proceeds will be used primarily to redeem notes due in 2014 and 2019, which have $1.2 billion in principal outstanding. This issuance follows new debt offerings by two other major medical device makers-- Medtronic (MDT) (AA-, wide moat) and  Stryker (SYK) (AA, wide moat)--this week. Initial price talk on St. Jude's new 10-year and 30-year notes of 125 and 145 basis points over Treasuries looks attractive to us. We compare that with Medtronic, also rated AA- by us, which issued new 10-year and 30-year notes at 88 and 98 basis points over Treasuries, respectively, on Tuesday. Medtronic's new 10-year and 30-year notes were recently indicated at 90 and 102 basis points over Treasuries. Given the similarities in their credit profiles, we view fair value for St. Jude's new 10-year and 30-year notes around 90 and 105 basis points over Treasuries.

In the health-care industry, we often rate top-tier firms higher than the agencies due to our differentiated rating methodology. We rate St. Jude three notches higher on average than the agencies, and we think this difference relates to our placing more emphasis on economic moats than on size when rating companies. While the agencies generally view the larger Medtronic more favorably than St. Jude, we see them as very similar credits. Therefore, if St. Jude's new notes are priced at wider spreads than Medtronic's new notes, we believe investors would obtain better relative value by investing in St. Jude rather than Medtronic. However, we still view  Zimmer's (ZMH) (AA, wide moat) notes as the most attractive in the medical device industry since they typically offer more spread than device-making peers' notes. Zimmer's 2019, 2021, and 2039 notes were recently indicated around 118, 131, and 160 basis points over Treasuries, respectively. Given Zimmer's higher rating, we would find Zimmer's notes more attractive than St. Jude's even if they price at similar spreads.​

Stryker's New Notes May Offer Attractive Value Relative to Medtronic (March 20)
On Wednesday, medical device maker Stryker  (AA, wide moat) announced it is issuing new 5-year and 30-year debt, which follows Medtronic's (AA-, wide moat) offering Tuesday. The proceeds on Stryker's offering will be used for general corporate purposes, including acquisitions and share repurchases. While those activities could be viewed as negative for debtholders, they would have to be much larger than expected to move the needle on Stryker's credit rating. For example, Stryker recently announced the $685 million acquisition of Trauson, a Chinese orthopedic player in the value segment, which we view as a good strategic move for the firm. Also, the firm's board recently increased the amount of open-share repurchase authorizations to $1 billion from about $595 million authorized in the fourth quarter.

In the health-care industry, we often rate top-tier firms higher than the agencies due to our differentiated rating methodology. We rate Stryker three notches higher on average than the agencies, and we think this difference relates to our placing more emphasis on economic moats than on size when rating companies. This methodology difference probably plays into our higher rating on Stryker than Medtronic, too, while the agencies generally view Medtronic at the same level or better than Stryker. Since we award both forms with a wide moat and Stryker holds a large net cash position compared with Medtronic's big net debt position, we believe Stryker is a modestly stronger credit than Medtronic. We have not heard initial price talk on Stryker's new notes yet, but if Stryker's new notes are priced at similar or wider spreads than Medtronic's new notes, we believe investors would obtain better relative value by investing in Stryker.

In terms of bond valuation, we view fair value for Stryker's new 5-year and 30-year issues around 55 and 95 basis points over Treasuries, respectively. This fair value estimate compares with Medtronic's new issuance at +63 for its 5-year and +98 for its 30-year on Tuesday. Overall, we still view Zimmer's (AA, wide moat) notes as the most attractive in the medical device industry. While less liquid than Medtronic's and Stryker's new notes will likely be, Zimmer's notes offer more spread than its device-making peers' potentially because the agencies have rated Zimmer well below its peers, despite the similarities in their credit profiles. Zimmer's 2019, 2021, and 2039 notes were recently indicated around 101, 129, and 157 basis points over Treasuries, respectively.

U.S. Steel's New Issuance Should Compensate Bondholders For Near-Term Operational Risks (March 20)
 U.S. Steel (X) (BB-, no moat) is planning to issue $250 million of 8-year senior unsecured notes that are callable after 4 years, along with $250 million senior convertible notes due 2019. We think the proceeds of the new issuances will be used to boost the company's liquidity ahead of its $863 million of convertible bonds due next year. The company has indicated its intent to focus on retiring near-term maturities.

We think the new straight bonds should price in the similar neighborhood with U.S. Steel's existing 2022 bond, which is now indicated at a yield to worst of 6.5% to the call date of March 15, 2020. While this yield is roughly 125 basis points outside Steel Dynamics' (STLD) (BB+, narrow moat) new 10-year issuance last week, we think the gap is justified due to the two-notch rating differential between the two credits, in addition to a much higher business risk U.S. Steel has compared with Steel Dynamics' domestic-centric business model. Both of them are justifiably wide compared with the Merrill Lynch BB index, which currently indicates a yield of about 4.3% and an option-adjusted spread of 340 basis points over Treasuries. U.S. Steel also trades appropriately wide of the Merrill Lynch High Yield Index, which yields 5.6%. We believe the convertible bonds could be attractive considering that the stock's trading at a 40% discount to our $33 equity fair value estimate.

While we applaud U.S. Steel's move to bolster its liquidity through debt and convertible issuances, there are still some downside risks in its near term. U.S. Steel's European business may face further pressure due to the lingering recession, and the company's relatively high-cost structure translates into heavy reliance on the U.S. cyclical economic upturn--a force that's largely out of management's control at this point. While we believe the company should generate better earnings in 2013 thanks to the raw material cost relief, it may take another one to two years before it can realize any significant credit improvement in its balance sheet.

Medtronic Refinancing Existing Obligations With New Debt Issuance (March 19)
Diversified medical device maker Medtronic (AA-, wide moat) is in the market today with new 5-year, 10-year, and 30-year notes; the proceeds (around $3 billion by early estimates) are earmarked for refinancing existing obligations. Initial price talk is around 75, 100, and 115 basis points over Treasuries for the 5-year, 10-year, and 30-year notes, respectively, and appears slightly cheap, in our opinion. We view fair value for Medtronic's new issues around 60, 85, and 105 basis points over Treasuries, respectively, for the new 5-year, 10-year, and 30-year notes. While device makers have not been active in the new issue market recently, we saw similarly rated drug makers-- Allergan (AA-, wide moat) and  GlaxoSmithKline (GSK) (AA-, wide moat)--come to market in the past two weeks. Pricing on those new issues informs our fair value estimates for Medtronic's new issues. Allergan's new 5-year and 10-year were recently indicated around 51 and 82 basis points over Treasuries, respectively. Last week, Glaxo's new 10-year and 30-year notes were recently indicated at 84 and 100 basis points over Treasuries, respectively.

We still view Zimmer's (AA, wide moat) notes as the most attractive in the medical device industry. While less liquid than Medtronic's new notes will likely be, Zimmer's notes offer more spread than Medtronic's notes, if investors can find them. Zimmer's 2019, 2021, and 2039 notes were recently indicated at 126, 135, 162 basis points over Treasuries, respectively.

Capital One's New 5-Year Looks Attractive (March 19)
 Capital One Financial (COF) (A-, narrow moat) announced Tuesday that is issuing new benchmark 5-year notes out of its banking subsidiary, Capital One, National Association. Although we do not rate Capital One, National Association, we view it as a similar credit risk to its holding company, Capital One Financial. Initial price talk is a spread in the area of 80 basis points above the Treasury curve, which we view as attractive. In late February,  Fifth Third Bancorp (FITB) (A-, narrow moat) issued 5-year notes out of its banking subsidiary at a spread level of +72, and today those notes are trading with a spread in the high 60s. Given that we rate both holding companies the same, and we view the Fifth Third notes as fairly valued, we recommend the Capital One notes all the way down to a spread of 68 basis points above the Treasury curve.

From a credit perspective, we like Capital One's sound business model, overall size as a credit card issuer, and conservative balance sheet. Our issuer rating is one to two notches higher than the rating agencies. Capital One is one of the largest issuers of Visa and MasterCard credit cards in the U.S. and one of the top 10 depository institutions in the country. Its earnings continue to benefit from lower loss provisions and improved margins. Given the size of its bank, Capital One has the best funding profile when compared with competitors like American Express and Discover, which we expect will benefit margins and reduce its dependence on the capital markets. Although we are negative on Capital One's recent purchases of ING Direct and HSBC's U.S. private-label credit card business, we do not think these purchases will have a meaningful impact on the creditworthiness of the firm.

CenturyLink's First High-Yield Issuance Looks Interesting (March 18)
 CenturyLink (CTL) (BB+, narrow moat) reportedly plans to issue $500 million of 7-year notes. The offering is CenturyLink's first as a full-fledged high-yield issuer. The firm threw in the towel on its investment-grade rating from Moody's and Fitch last month, instituting a $2 billion share-repurchase program and raising its leverage ceiling to 3.0 times EBITDA versus a prior target range of 2.0-2.5 times (leverage at the end of 2012 stood at 2.7 times). We would expect this offering to price at or a bit above 5% based on levels on the firm's existing bonds. CenturyLink's 6.15% notes due in 2019 were recently indicated at a yield of about 4.9% (367 basis points over comparably dated Treasuries) while its 6.45% notes due in 2021 trade at a yield of about 5.6% (+395 basis points). At a yield of 5% or higher, we think the new bonds look attractive, as they offer a nice bump in yield versus the typical BB rated issuer--for reference, the Merrill Lynch BB Index currently stands at a yield to worst of about 4.28%, or a spread of about 335 basis points over Treasuries.

CenturyLink faces a small debt maturity next month, but its most pressing obligation is a $750 million bond at subsidiary Qwest that comes due in June. Qwest has maintained an investment-grade rating, and management has said that it would like to refinance debt at the Qwest level. The planned issuance at the parent level is probably an indication that management would like to accelerate its share repurchases in response to weakness in the share price. The buyback is expected to be completed by the end of 2014. Even with the planned share repurchases, we expect that CenturyLink will be able to reduce leverage over the next couple of years. The firm also cut its dividend about 26% at the same time that it put the buyback in place, reducing its payout to $1.3 billion annually. We believe revenue will begin to stabilize heading into 2015 as growth in newer businesses, like Web hosting, overtakes losses in traditional phone services revenue. This revenue shift will hurt profitability, but we also expect that cost-cutting opportunities will diminish the impact of this shift on margins. With capital spending holding flat versus 2012, we believe CenturyLink can generate around $3 billion in cash flow annually through 2014, falling to about $2.6 billion in 2015 as the firm begins paying taxes.

A significant acquisition is the biggest threat to this debt-reduction scenario. Management has said it doesn't need to do another deal to achieve its revenue and cash flow goals but would consider any acquisition that aids revenue growth or enhances its competitive position. The new 3.0 times leverage ceiling certainly provides management with much greater flexibility to pursue another transaction than it had before. However, we expect CenturyLink will be cautious, pursuing only those deals that increase its ability to fund the current dividend payout over the long term. We believe that current yields on the firm's debt adequately compensate investors for the risk that leverage ticks modestly higher as a result of M&A activity.

Click here to see more new bond issuance for the week ended March 22, 2013.