Credit Markets Stand Back and Watch Equity Markets Vacillate
Commentary on earnings calls suggests that economic activity in Europe continues to slow and the pace of consumer spending in the U.S. has decelerated in April.
For the most part, the credit markets stood by and watched the equity markets swing back and forth. The average spread in the Morningstar Corporate Bond Index ended the week unchanged at +138 and is essentially flat for the year. Year to date, our corporate-bond index has returned 1.27%, putting it on pace to meet our estimated low- to mid-single-digit return for the year.
New Issue Market Standstill as Investors Pore Over Earnings
The new issue market was virtually nonexistent last week as most investors spent their time digging into earnings reports. From the syndicate desks we have talked to, this week should also be quiet, as the number of companies reporting earnings will peak this week. Thus far, about one third of the companies in the S&P 500 have reported earnings. As we've seen for the past several quarters, top-line growth has been stagnant, but most companies seem to have been able to meet their earnings targets through tightened cost controls. Commentary on earnings calls suggests that economic activity in Europe continued to slow and the pace of consumer spending in the United States decelerated in April. Trading volume felt quiet all week but slowed significantly on Friday as many large asset managers stayed at home and the rest of Wall Street's attention was tuned into the Boston bombing manhunt.
Economic Data Sluggish, but Not Recessionary
Economic data released last week was discouraging as far as looking for indications of rising economic growth, but neither did it augur a recessionary slowdown--just more of the same amount of economic activity plodding along. Activity also continued to slow globally, as China reported that its first-quarter GDP grew at 7.7% year over year. While that growth rate would be the envy of any developed market, it was a reduction from the 7.9% recorded in the fourth quarter and much lower than the 8.0% consensus expectation. Subsequent to this report, most economists reduced their estimate for China's 2013 GDP by 0.4 percentage point to an average 7.8%.
Economic data and anecdotal evidence from earnings calls this quarter suggest that the recession in the eurozone may be worsening. GDP estimates for the eurozone are for a 2% decline and some prognosticators are beginning to call for a potentially deep recession in France. Highlighting the length and severity of the downturn, Fitch downgraded its credit rating on the United Kingdom to AA+ from AAA on Friday, citing slowing prospects for economic growth. We expect many more sovereign downgrades to come before the European economy bottoms out. As a result of weakening activity in Europe and slower growth in the emerging markets, the International Monetary Fund reduced its forecast for global growth to 3.3% from its 3.5% forecast made in January.
Federal Reserve Poised to Keep the Pedal to the Metal
Several members of the Federal Reserve gave speeches last week that indicate the Fed will keep the pedal to the metal for the time being. While Federal Reserve vice chair Janet Yellen (who is a voting member on the Federal Open Market Committee) acknowledged that "Low interest rates may induce investors to take on too much leverage and reach too aggressively for yield," she currently does not see "pervasive evidence of rapid credit growth, a marked buildup in leverage, or significant asset bubbles." Minneapolis Federal Reserve Bank president Narayana Kocherlakota also said he also does not see any asset bubbles, and in a question-and-answer session after his speech, he reportedly said the Fed wants investors to take on more risk. Based on comments such as these, lackluster job growth in the U.S., and worsening conditions in Europe, we think the Fed will not reduce its asset-purchase program anytime in the near future.
Reimbursement Rate Pressure May Be Increasing in U.S. Managed-Care Sector
We have long argued that the managed-care industry already trades at credit spreads that do not adequately compensate investors for the credit risk. We have begun to reassess our estimates for U.S. reimbursement rates and believe that increasing pressure from the sequestration and new reform efforts may cut into managed-care organizations' growth and profitability more than expected in 2013-14. For example, based on what we saw from UnitedHealth Group (UNH) (A-) last week, those trends spooked MCO equity investors and may point to some weakness in the economic moats of MCOs. The MCO sector trades too rich for our blood, so continuation of these trends may provide a negative catalyst for the bonds.
New Issue Notes
We Expect Pricing to Be Driven Down From Initial Talk on AutoZone's New Bond Deal (April 18)
AutoZone (AZO) (BBB, narrow moat), the category leader in the auto parts retail sector, is coming to market with $500 million in 10-year notes. Price talk in the mid-160 basis points over Treasuries range is wide of existing notes, and we believe the spread will tighten toward the existing notes. AutoZone's 2023 notes (issued last November) were recently indicated at a midpoint of 148 basis points over Treasuries, well inside Morningstar's BBB 10-year Industrials index of 174 basis points over Treasuries. Accordingly, we have an underweight stance on the name. Issuers in the auto parts retail sector generally trades tight to their ratings, as the main players have continued to thrive amid uncertain economic conditions. The weak economy has boosted the auto parts retailers as there have been fewer new car purchases and consumers are keeping their vehicles on the road longer. Still, we think this level is too rich and have an underweight stance on the retail sector as a whole. Other BBB retailers, Macy's (M) (BBB, no moat) and auto parts retailer peer O'Reilly Automotive (ORLY) (BBB, no moat) have 2023 and 2022 notes, respectively, that also trade inside the index at 138 and 161 basis points over Treasuries, respectively, which we also view as overvalued.
We expect the funds from the debt issuance will be used to pay for share repurchases. From a credit perspective, AutoZone's strong margins and healthy free cash flow generation are slightly offset by the firm's penchant for share repurchases. With high-single-digit revenue growth and modest margin expansion through the downturn, AutoZone's capital structure has been relatively stable despite taking on roughly $1 billion in debt to help fund $3.7 billion in share repurchases during the past two years. Lease-adjusted leverage is in the mid-2-times range and the firm's cash flow cushion is well over 1 times. AutoZone's current $3.6 billion debt load is manageable, in our view. Even though we project a slowdown in top-line growth and margin gains during the next five years, the firm generates strong and stable cash flows, and we project free cash flow to average 10% of revenue over this period, which should allow AutoZone to comfortably service its debt obligations. As current debt matures, we expect AutoZone will continue to maintain leverage and issue debt in order to fund share repurchases. During the next five years, we project AutoZone will repurchase about $3.8 million in shares, or 84% of free cash flow.
Bank of Nova Scotia's New 5-Year Needs New Issue Concession to Be Attractive (April 18)
Bank of Nova Scotia (BNS) (A+, narrow moat) announced today that it is issuing new 5-year, dollar-denominated benchmark notes. No whispers on price guidance yet, but Scotiabank's current 5-year trades at a spread of approximately +65 basis points over the Treasury curve, which we view as fairly valued for this Canadian bank. As a comparison, Royal Bank of Canada (RY) (AA-, narrow moat), which we rate one notch higher, trades at a spread of about 55 basis points over the 5-year point of the curve. So, for investors looking for Canadian bank names, we think the new Scotiabank bonds would look attractive with 5-10 basis points of new issue concession. However, comparable U.S. banks, such as Wells Fargo (WFC) (A+, narrow moat) trade with a spread of 75 basis points over the 5-year point of the curve. For those investors who do not need the diversity of a Canadian bank name, if the new Scotiabank bonds are priced tighter than 75 basis points above the Treasury curve, we recommend the Wells Fargo 5-year notes instead.
As with other major Canadian banks, we are positive on Bank of Nova Scotia from a credit perspective as a result of Canada's highly regulated banking oligopoly. Scotiabank's regulatory capital, however, is below average when compared with other Canadian banks as its Basel III common equity Tier 1 ratio is 8.2%. Our rating for Scotiabank, much like the other Canadian banks, is one to three notches lower than the rating agencies' as we take a more critical view on the overall credit status of financial companies and the overleveraged status of the Canadian consumer.
In the Overpriced Insurance Sector, Price Talk on Hartford Is Reasonable (April 15)
Hartford Financial Services Group (HIG) (BBB-, no moat) announced Monday that it is issuing $300 million of new benchmark 30-year notes. Initial price talk is a spread of 170-175 basis points above the Treasury curve. Overall, we view this pricing as fairly valued as it is about 15-20 basis points wide of Hartford's existing 30-year, which we view as rich. We still view the entire sector as somewhat rich, but for those investors looking to add exposure, we recommend smaller niche players like W.R. Berkley (WRB) (BBB+, narrow moat). Many of these smaller players, however, do not issue 30-year debt. Therefore, if an investor needs 30-year paper in the sector, these fairly valued new notes from Hartford are reasonable, with the caveat that we would not recommend the notes inside the price talk of 170 basis points above the Treasury curve.
Morningstar's credit rating of BBB- for Hartford Financial Services reflects the company's improving balance sheet, hampered by its exposure to capital markets. Before the financial crisis, the company generated outsize profits through growth in variable annuities and international markets. These products, however, wreaked havoc on the company's earnings and balance sheet as the financial crisis caused a drop in asset prices across the globe. Since the crisis, almost the entire management team has turned over and Hartford has pulled out of its international operations and has placed its variable-annuity business into runoff. Under pressure from an activist shareholder, management has executed a number of sales with the goal of freeing up capital and shedding noncore businesses. But given that discontinued products represented such a large portion of profitability in the past, it is difficult to get an exact picture of what the earnings power of the company will look like going forward. Although Hartford's existing underwriting is a mix of life insurance and property-casualty, its balance sheet more closely resembles one of a life insurance company with higher leverage levels.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.