After Lagging the Equity Market, the Corporate Credit Market Finally Begins to Catch Up
The corporate bond market has been skeptical of the equity market's relentless march higher, but it appears that credit investors finally capitulated.
For most of the year, the corporate bond market has been skeptical of the equity market's relentless march higher as credit spreads have been range-bound for most of the year and were slightly wider year to date through the first week of April. However, it appears credit investors finally capitulated, as credit spreads ripped tighter last Monday and Tuesday. However, while the S&P 500 has run up 11.4% year to date, seemingly impervious to any negative headlines, the Morningstar Corporate Bond index has only tightened 2 basis points this year, much less than one would expect as the S&P hits new highs. In fact, all of the tightening year to date occurred last Monday and Tuesday, when credit spreads tightened 5 basis points across the board.
We have heard two different explanations of why the credit markets finally decided to strengthen along with equities. The first story is that fund managers have been sitting on cash, waiting for better levels (wider spreads) to begin putting money to work. These investors finally relented and began to bid up bonds, given the continual inflow of funds and the increasing percentage of cash in their portfolios. This buying pressure was further exacerbated by dealers who were reportedly short credit and needed to cover their positions as bonds began to rise. The other story is that there were large buyers emerging from Asia who were selling yen-denominated assets and using the proceeds to rotate into U.S. dollar-denominated assets, including corporate bonds. We don't know which narrative is accurate, but like any market chatter, there is probably a bit of truth to both.
Softer Industry News and Mixed Earnings Not Enough to Derail Credit Spreads
Last Thursday, IDC reported that worldwide PC shipments declined 13.9% in the first quarter, much worse than forecast, sending the stocks of Microsoft (MSFT) (AAA), Intel (INTC) (AA), and Hewlett-Packard (HPQ) (BBB+) down. While the stock prices for each of these companies were down anywhere from 2% to 6% on the announcement, this pullback only brought Microsoft and Intel down to the same price that these stocks closed on Monday, and HP's stock price is still higher than it was a month ago. The corporate bond market equally shrugged off the news; the companies' credit spreads barely budged as trades cleared closer to the ask side, but failed to move the bid/ask spread wider.
Alcoa (BB+) led off earnings season with mixed results, as the top line missed but earnings per share posted a slight beat to consensus expectations. Alcoa's EBITDA of $690 million has shown little change in the past year, with productivity improvements offsetting an aluminum price that continues to hover around $1,900 per ton, a level that is below the cash cost of production for about half of global aluminum smelters. In this current "reach for yield" environment, these mixed results were enough to encourage investors looking for spread and Alcoa's bonds tightened over the course of the week.
The markets softened Friday, as even this bull market couldn't ignore the weak retail sales number. Two weeks ago, Robert Johnson, Morningstar's director of economic analysis, had written that retail sales were projected to rise 0.4%. With more negative economic news and poor individual store reports last Thursday, those estimates dropped to a decline of 0.1%. The actual retail sales number reported Friday morning was an even worse decline of 0.4%. Excluding gasoline and autos, sales were still down 0.1%. The year-over-year number (unaveraged, all in) looked slightly better with 3.7% growth, which was just below the averages of the past several months. However, there is no denying that based on a three-month moving average basis, year over year, excluding autos and gasoline, the trend is clearly down. We continue to view the corporate bond market as fairly valued at current levels, but will be analyzing earnings and guidance closely this week and next for clues as to the direction of credit risk through the rest of this year.
J.P. Morgan's and Wells Fargo's First-Quarter Earnings Solid From a Credit Perspective
J.P. Morgan Chase (JPM) (A) and Wells Fargo (WFC) (A+) reported first-quarter earnings results. For both, the results were rather blase from an equity perspective, but solid from a credit perspective. Revenue for both firms was lower for the quarter from the prior-year period, mainly due to lower net interest margins and weaker loan demand growth. However, quarterly net income was higher year over year, as both firms lowered expenses. For Wells, the expense reduction was mainly due to a lack of unusual items, and we doubt that the firm has much room to reduce expenses further. With a lackluster U.S. economy, we don't foresee much room for dramatic growth in these headline numbers.
Dimming Economic Outlook in Italy Supports Our View
On April 10, the Italian government revised its expectations for debt/GDP levels in upcoming years. The technocratic government, led by Mario Monti, now calls for a debt/GDP ratio of more than 130% and 129% for 2013 and 2014, respectively. Both of these numbers are significantly higher than the 126% and 123% for 2013 and 2014, respectively, projected late last year. The 2013 projection demonstrates the continued deterioration of the Italian economy, as the final debt/GDP ratio for 2012 was approximately 127%. Interestingly, the annual budget deficit for 2013 was projected to be 2.9%, within the European Union's 3% limit. The key issue is that with no real economic growth, the annual budget deficits add directly to the growth in the debt/GDP ratio.
The announcement by the government is no surprise to us, as we have had a more bearish view on the Italian economy for some time. This stance can best be seen in our ratings of the Italian banks, Intesa Sanpaolo (ISP) (BB-) and UniCredit (UCG) (BBB-), which are two to three notches below those of the rating agencies. Also, last month we pointed out that nonperforming loans in Italy are still increasing, with no sign of a slowdown in the rate increase. We continue to expect that with the continued problems throughout Europe, and with Italy's austerity program still in place, the Italian economy will remain troubled. Italian real GDP has been negative for the past six quarters, and while we could see one positive outlier quarter in the next couple of years, we expect that on a year-over-year basis there will be effectively no real growth in Italy. With this in mind, we find it hard to imagine that the current debt/GDP projection of 129% for 2014 can be met, and we expect this projection to increase in the next year. With no government consensus achieved in the last election and with the extreme distress in the Italian economy, our outlook on the credit of Italian banks remains poor.
Contributed by Jim Leonard, CFA
New Issue Notes
Fidelity National Issues 5- and 10-year Notes at Attractive Levels After Upgrades (April 10)
Fidelity National Information Services (FIS) (BBB, narrow moat) announced Wednesday that it is issuing new benchmark 5- and 10-year notes. Initial price talk is a spread in the area of 170 basis points above the Treasury curve for the 5-year and 200 basis points for the 10-year. Given that Morningstar's bond index for BBB industrials has a spread above Treasuries of approximately 180 basis points for 10-year debt, we would recommend these new 10-year notes all the way down to a spread of 180 basis points. Even though we are recommending these bonds, this pricing does appear aggressive to us based on where existing debt trades. Fidelity's 5% notes due 2022 are callable and recently traded with an approximate option-adjusted spread of 250 basis points over Treasuries, which we view as attractive
On March 14, we upgraded Fidelity National to BBB from BB+ based on our updated assessment of the company's new targeted debt/EBITDA range. This credit rating reflects the company's lower leverage and considerable free cash flow generation. FIS has come a long way in just a few years, and after several post-spin-off mergers, the company now ranks with Fiserv as one of the leading bank technology providers. While FIS serves the banking industry, which recently experienced near-depression-like economics, its business model was able to minimize the effects of the financial crisis. Eighty-five percent of FIS' services generate recurring revenue, and most of the company's services are not discretionary. As a result, the financial crisis hardly dented the company's top line, although organic growth has been hard to come by over the past couple of years. It should be noted that on March 21, Moody's upgraded Fidelity National to Baa3 from Ba1.
EADS Makes Debut in U.S. Market With 10-Year Offering (April 9)
Airbus parent European Aeronautic Defence and Space (EAD) (A-, narrow moat) is in the market with a 10-year bond offering via its subsidiary, EADS Finance. This 144a issue will be the company's first U.S. dollar issue. EADS compares most closely with Boeing (BA) (A-, narrow moat), with a blend of both commercial aerospace and defense. Airbus represents about two thirds of EADS' revenue, with defense and other commercial operations representing the remaining one third. With the strong upcycle in the commercial aerospace market continuing, we forecast annual sales growth of more than 5% over the next four years with steady growth in EBITDA. Free cash flow will be constrained by sizable capital spending related to product launches including the A350 wide-body commercial aircraft. Still, EADS maintains a strong balance sheet with cash at year-end of EUR 17 billion versus total debt of EUR 4.8 billion and debt/EBITDA of slightly over 1 times. EADS does have a EUR 3.75 billion share-repurchase program in progress, which will reduce government ownership positions and increase the percentage of free float in its shares. Germany and France will each own 12% of the company, with Spain owning 4%. Moody's rates EADS A2, which includes a one-notch uplift for implied government support. S&P rates the credit A-. We do not provide any uplift for implied government support to our rating.
We view fair value on the new 10-year EADS bonds at about 110 basis points over Treasuries. This compares with Boeing's 7-year bond, which was recently indicated at a spread of about +80, which we view as fair given the positive fundamental trends. Other defense comps include Raytheon (A-, narrow moat), Northrop (NOC) (A-, narrow moat), and Lockheed (LMT) (A-, wide moat). Raytheon's 10-year bond issued in December trades at a spread of about +96, which we view as moderately rich. Northrop's and Lockheed's 2021 maturity bonds are indicated at about +117, which we view as slightly cheap.
Dollar General Coming to Market to Pay Down Secured Debt, Price Talk Looks Very Rich (April 8)
Dollar General (DG) (BBB-, no moat) is coming to market with $1.3 billion in 5- and 10-year notes to refinance existing secured indebtedness. Two weeks ago, the firm announced its intention to replace its secured debt (term loan and credit facility) with unsecured debt (revolver, notes). Initial price talk of 112.5 and 162.5 basis points over Treasuries for the 5- and 10-year tranches, respectively, is too rich in our view. It places the firm closer to a BBB retailer, as opposed to a BBB-, where we believe it belongs. We think fair value for the 5- and 10- year notes is around 150 and 200 basis points over Treasuries, respectively.
Similar-rated comparables Family Dollar and Gap (GPS) (both BBB-, no moat), have 2021 notes that were recently indicated around 250 basis points over Treasuries. Staples (BBB-, no moat) has 2018 and 2023 notes that are trading around 175 and 235 basis points over Treasuries, respectively. Macy's (M) (BBB, no moat) and AutoZone (AZO) (BBB, narrow moat) have 2023 notes that were recently indicated around 145 basis points over Treasuries. O'Reilly (ORLY) (BBB, no moat) has 2022 notes that are trading around 155 basis points over Treasuries. It should also be noted that price talk is very tight relative to the firm's current note issue. Dollar General 2017 bonds were recently indicated at 190 basis points over Treasuries, which we think is too wide, but probably reflects the structural subordination from the secured debt.
While we would place Dollar General as the best among the BBB- credits, given its more favorable industry dynamics relative to Gap and Staples and more conservative approach to the balance sheet and shareholder returns compared with dollar store peer Family Dollar, we still argue that it merits pricing closer to a BBB- than a BBB. Dollar General's leverage is around 3 times (management's target), and it is our opinion that the management structure will keep leverage elevated to return cash to shareholders. Buck Holdings, controlled by KKR, continues to own a significant percentage of outstanding common stock. We believe this could lead to favoring shareholders, perhaps to the detriment of bondholders.
FedEx Expected to Issue $750 Million of 10- and 30-Year Notes; Initial Price Talk Sounds Fair (April 8)
We're hearing that FedEx (FDX) (BBB+, narrow moat) intends to tap the bond market for $750 million, split between 10- and 30-year maturities, and that the deal size is unlikely to grow. Initial price talk is +115-120 for the 10-year and around +130 for the 30-year, which generally sounds fair if it holds. However, with existing bonds trading 10-15 basis points tighter than the talk on the new bonds, we wouldn't be surprised to see final pricing tighten. The FedEx 2.625% notes due 2022 recently traded around a spread of 104 basis points over Treasuries, which looks a little rich to us. For comps, we tend to look to the rails, given their similar credit ratings and difficult to replicate networks. Norfolk Southern (NSC) (BBB+, narrow moat) has a 2022 bond that recently traded around a spread of 97 basis points over Treasuries, which we view as rich. CSX (CSX) (BBB+, narrow moat) has a 2021 bond that was recently quoted around a spread of 115 basis points over Treasuries, which looks fair to us. We would place fair value for a new FedEx 10-year around 115 basis points over Treasuries and 15 basis points wider for the 30-year.
Last month, FedEx reported fiscal third-quarter results, with margins trending weaker, but the balance sheet remains strong. Ground performed well, but international express dragged down profitability as customers downshifted to lower-yield products. The problem boils down to yields constrained by excess market airfreight capacity and too much low-yield volume on FedEx aircraft. The company is already addressing international trade shifts (recognized by its first stage of realignment charges [$46 million]--mostly voluntary buyouts for U.S. officers), and ground's growth and margins remain strong.
Despite the dip in profitability, the balance sheet remains in good shape, appropriate for our BBB+ rating. Last October, we upgraded our rating one notch, reflecting an improved Cash Flow Cushion score along with our expectation of healthy free cash flow generation and modest deleveraging. Total debt/EBITDA for the latest 12 months ended February was 0.4 times, generally in line with the prior fiscal year-end; however, when taking into account sizable lease commitments, adjusted TD/EBITDA and rents is 2.7 times, constraining our rating. During the quarter, cash flow from operations totaled a healthy $1.3 billion, with $542 million used to fund capital expenditures. The remainder was used to bolster the company's cash position, which now totals $3.4 billion versus $2.2 billion of debt. No shares were repurchased during the quarter. We expect the company to be modestly free cash flow positive in fiscal 2013, with free cash flow approaching $1 billion annually during the next few years.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.