The Bond Story Remains the Same
The tale continues to be all about the Federal Reserve and its ongoing quantitative easing program.
Last week was quiet on the news front, as earnings season wound down and no significant economic indicators were released. The Morningstar Corporate Bond Index tightened 3 basis points at the beginning of last week and held on to those gains throughout the week, even though the credit default swap market widened toward the end of the week.
The story continues to be all about the Federal Reserve and its ongoing quantitative easing program. This asset-purchase program continues to distort the market's risk/reward dynamics, as interest rates are driven by monetary policy goals from a buyer who is unconcerned about future mark-to-market losses. It's increasingly disconcerting that more and more clients we have spoken with are of the same general sentiment--this will end badly--but they feel as if they have no choice but to play along for now, or they will undertake too much career risk of lagging the indexes.
Among the themes on conference calls this earnings season, equity analysts have consistently questioned management intentions to issue bonds at these historically low rates to buy back stock, thus effectively increasing debt leverage in the near term. While many firms with large cash positions trapped overseas have issued bonds to lock in these exceptionally low rates, many management teams have affirmed their commitments to their credit ratings and leverage targets. Just last week, Viacom (A-, narrow moat) and Walt Disney (DIS) (A+, wide moat) both publicly stated their assurances to preserve their existing credit ratings. The prior week McDonald's (MCD) (AA-, wide moat) made the same assurances, New York Times (NYT) (BB-, no moat) reiterated its commitment to protect its balance sheet and R.R. Donnelley & Sons (BB, no moat) reaffirmed its leverage target. We suspect that part of the reason that management teams are unwilling to increase leverage in the short term is that they are becoming increasingly nervous about their outlooks for the second half of the year.
Following the ECB, Australia and South Korea Join the Monetary Easing Party
Following the interest rate cuts by the European Central Bank the prior week, the Reserve Bank of Australia cut its interest rate by 25 basis points to a record-low 2.75% last week. The Australian central bank cited its expectations for below-trend growth rates this year and moderating commodity prices in its reasoning to cut its benchmark rate, but we suspect at least some part of the decision is an attempt to devalue the strong Australian dollar. Since November 2010, the Australian central bank has cut its interest rate by 200 basis points. South Korea also cut its benchmark rate last week by 25 basis points to 2.50%, its first interest rate cut since October 2012 and a cumulative decrease of 75 basis points since the Bank of Korea last raised interest rates in June 2011. This action is an attempt to halt the rise of the won versus the yen, as exports account for half of the South Korean economy and have been pressured by the combination of a global economic slowdown and strengthening versus the yen.
New Issue Notes
Price Talk for J.P. Morgan's New 5-Year is Attractive (May 8)
J.P. Morgan Chase (JPM) (A, narrow moat) announced today that it is issuing new 5-year fixed-rate notes. Initial price talk is a spread of +95 basis points for the 5-year notes, which we view as attractive. Of the three large U.S. money-center banks, we view J.P. Morgan Chase as the best managed, having avoided the risk management missteps that critically injured Citigroup (C) (A-, narrow moat) and
Bank of America (BAC) (BBB, narrow moat), in addition to numerous peers around the world. We see no reason this excellent performance won't continue. J.P. Morgan's current 5-year trades with a spread +82, and we view these notes as fairly valued, so we would recommend the new notes all the way down to this +82 spread. For comparison, Citigroup's recently issued 5-year trades with a spread of +95 and we would recommend investors switch to these new Citi notes if the JPM's new deal prices tighter than +80.
For Those Investors Seeking European Exposure, HSBC's Price Talk is Attractive (May 8)
HSBC Holdings (HBC) (rating: A+, narrow moat) announced that it is issuing new dollar-denominated 5-year fixed and floating-rate notes. Initial price talk is a spread of +85 basis points for the fixed-rate notes, which we also view as attractive. HSBC is issuing these notes out of its banking subsidiary HSBC Bank, and although we do not rate this entity, we view it as a similar credit risk to HSBC Holdings. Of the large European banks, HSBC is one of our favorites. It operates in Europe (50% of assets), Hong Kong (15%), other Asia-Pacific (10%), the Middle East (2%), North America (20%), and Latin America (5%). HSBC is among the best-capitalized global banks, especially considering its lower-risk business model. Its Core Tier 1 ratio is over 12% and its Tier 1 ratio is over 13%. We're especially fond of its strong deposit funding base, which is much more stable than the wholesale funding used extensively by most of its peers. For investors looking for higher-quality European exposure, we would recommend these 5-year notes all the way down to a spread of +70. After +70, we would recommend investors switch to our other favorite European bank, Svenska Handelsbanken (SHB A) (A+, narrow moat). Svenska Handelsbanken's recently issued 5-year notes trade with a spread of +70.
Northeast Utilities to Issue $750 Million of 5- and 10-Year Notes at Relatively Rich Whisper Levels (May 8)
Northeast Utilities (NU) (BBB, narrow moat) announced today that it will issue new 5- and 10-year notes, with whisper pricing in the T+80 basis points and T+110 basis points range, respectively. Proceeds from the new issue will likely be used to take out existing $250 million 5.65% senior notes due in June 2013 and an additional $300 million floating-rate senior notes due in September 2013 as management stated on its first-quarter call that is was considering refinancing these notes.
At T+80 (5-year) and T+110 (10-year) levels, we believe the new issue is fairly rich. Specifically, when compared to BBB rated fully regulated utility peer Pepco Holding's 2.7% sr. notes due 2015 trading at T+80 and 7.45% sr. notes due 2032 trading at T+226 (a bond on our best ideas list), we believe Northeast's new 10-yr notes provide less relative value. Despite Pepco's 10-year longer tenor, we think the 10/20 differential should be about 25 basis points and believe Northeast's 10-year fair value to be roughly T+150. Moreover, we note slightly higher rated Scana Corp's 4.125% sr. notes due 2022 trade at T+175 (also on our best ideas list). As such, we would be buyers of Northeast's new issue in the T+90 (5-year) range and T+150 (10-year) range.
While Northeast Utilities' first-quarter earnings were up, benefitting primarily from its NSTAR contributions/ acquisition (April 2012), we believe the firm faces regulatory uncertainty and possible pressure in 2013-14. Specifically, complaints filed in 2011 with FERC related to ROEs earned by New England Transmission Owners entered the hearing phase this past Monday. In April, FERC issued an updated recommendation for a 10.3% ROE (versus current rate base of 11.14%). Additionally, the Connecticut Public Utility Regulatory Authority issued a final decision on its investigation related to CL&P's Tropical Storm Irene and October 2011 snowstorm performance. The decision identified certain penalties that could be imposed, including a reduction in CL&P's allowed ROE in its next 2014 rate case as well as possibly disallowing certain storm restoration costs. As of first quarter 2013, CL&P's deferred storm costs requiring recovery totaled $670 million including October 2012's Hurricane Sandy and February's Zemo blizzard.
Statoil to Issue 5-Year Fixed and Floating Notes, 10-Year and 30-Year Notes; 30-Year Looks Rich (May 8)
Statoil (STO) (A-, narrow moat) announced Wednesday that it plans to issue U.S. dollar 5-year fixed- and floating-rate notes, 10-year notes and 30-year bonds in benchmark size. Initial price talk is +33 basis points for the floating rate note, +50 for the 5-year note, +95 for the 10-year note and +100 for the 30-year bond. We believe fair value on Statoil's new issues are +45 basis points for the 5-year, +90 basis points for the 10-year, and +120 basis points for the 30-year. The use of proceeds is stated as general corporate purposes including debt repayment, working capital or acquisitions. Based on our projections, we expect that the proceeds from this issuance will be used to fill the funding gap between operating cash flow and the company's dividend and capital spending program. Statoil's CFO Torgrim Reitan has said that the company strives for a "predictable, growing dividend."
Within our coverage universe we view Apache (APA) (A-, narrow moat) as comparable to Statoil as Apache has a balanced portfolio of onshore and offshore oil and gas properties throughout the world comprising mature assets and a solid assortment of exploratory and developmental projects. Apache's 1.75% notes due 2017 recently traded at a spread of +38 basis points above the 5-year Treasury, its 2.625% notes due 2023 traded at +104 basis points over the 10-year, and its 4.25% bonds due 2044 traded at +143 basis points above the 30-year. Based on the near-term outlook for Statoil's production levels, operating cash flow, capital spending, and the use of debt to fund dividends, we believe fair value on Statoil's new issuances are +45 basis points for the five year, +90 basis points for the 10 year, and +120 basis points for the 30 year.
The spread curve between Statoil's outstanding 5-year and 10-year notes is the same as initial price talk at +45 basis points, which we view as fair compared to Apache's 5-10s curve. The spread curve between Statoil's outstanding 10-year note and 30-year bond is also the same as initial price talk, but is only +5 basis points. This stands in stark comparison to Apache's 10-30s curve, which is +39 basis points. Statoil faces declining oil production in its key production area in the North Sea on the Norwegian Continental Shelf, which contributes 80% of its production. In an effort to boost production, Statoil is moving away from its areas of expertise. The company has made several international acquisitions and is undertaking more exploratory projects that come with a higher level of risk than the company has historically carried. Therefore the 10-30s curve should begin to resemble that of an exploration and production company. As such, we believe that a +5 basis points 10-30s curve fails to reward 30-year bondholders for the risk inherent in Statoil's long-term growth plans and that the appropriate 10-30s curve is approximately +30 basis points.
We award Statoil a narrow economic moat because of the company's experience operating in the deep-water; deep-water is one of the few remaining opportunities available to international oil companies. Our credit rating is 3.5 notches below the average NRSRO rating due in part to the fact that 80% of Statoil's production is from core fields which have been in production decline since 2001. As a result, Statoil's capital spending program is a strain on the company's ability to generate free cash flow. Statoil has announced large discoveries in its core areas of operation which should help stabilize declining production, although 2013 will be a challenging year as production will be lower than in 2012. The company will rely on international assets to grow production over the next decade. Production should start growing beginning in 2014 with an initial wave of projects, followed by a second wave beginning in 2016 that could accelerate growth to 3%-4% per year. While we maintain a positive long-term view of the company and its balance sheet, we note that the company is taking advantage of the strong credit markets to fund dividend growth at a time when production is declining and Brent crude oil prices are below the level which generates operating cash flow in excess of dividends and capital spending.
Price Talk for Nordea is Attractive, for Those Seeking European Exposure (May 7)
Nordea Bank (NDA SEK) (rating: A, narrow moat) announced today that it is issuing new dollar-denominated 3-year fixed or floating-rate notes and 5-year fixed-rate notes. Initial price talk is a spread of +65 basis points over the Treasury curve for the 3-year notes and a spread of +95 basis points for the 5-year notes, which we view as attractive. For investors looking for higher-quality European exposure, we would recommend these 5-year notes all the way down to a spread of +80. After +80, we would recommend investors switch to Svenska Handelsbanken's recently issued 5-year notes, which trade with a spread of +70. Svenska Handelsbanken is our favorite Nordic bank from a credit perspective and we think it would be worth the 10 basis points for the one-notch better rating on the name.
Morningstar's credit rating of A for Nordea Bank reflects the bank's strong regulatory capital position but is hampered by its balance of nonperforming loans. Based in Sweden, Nordea Bank is a diversified financial-services company with 11 million customers across more than 1,000 branches in nine countries, including Denmark, Norway, Sweden, and Finland, where it has a top-two market position. Approximately 27% of the credit exposure is derived from Denmark, 26% from Sweden, 17% from Norway, 16% from Finland, and the rest from a host of other European countries. Nordea has largely avoided the problems that have plagued the rest of Europe, but the bank has recently seen a significant increase in nonperforming loans rising from Denmark. As with many European banks, Nordea has a lower deposit base and its ratio of customer deposits/customer loans is approximately 60%. While Nordea does fund a large percentage of its balance sheet through the wholesale market, approximately 50% of that funding is derived from covered bonds. Nordea's regulatory capital is sound as its core Tier 1 ratio is over 12% on a Basel II pre-transition basis, but its actual capital levels are much lower and the ratio of tangible equity to tangible assets is approximately 4%.
Sonic Automotive Issuing $300 Million of Senior Subordinated Bonds to Retire Existing Notes (May 6)
Sonic Automotive (SAH) (B+, narrow moat) is tapping the high yield market once again with a new $300 million 10-year non-call 5 offering of senior subordinated notes. Proceeds will be used to call its $210 million 9.0% senior sub notes due 2018 which have a hard call price of 104.5 on March 15, 2014. Sonic will exercise its makewhole option of T+50 to the hard call date. Sonic issued its $200 million of 7.0% senior sub notes with a 10NC5 structure back in July to retire some convertible bonds, so this will further clean up the balance sheet and improve the company's interest expense burden. Those 7.0% notes are indicated at a yield of 4.7% to the first call date in 2017. Auto dealer peer Penske Automotive Group (PAG) (B+, narrow moat) also has a 2022 maturity callable bond trading at 4.7% while Asbury Automotive Group (ABG) (B+, narrow moat) senior sub notes due 2020 are indicated at 4.4% to the 2015 call date. We view all of these as generally fairly valued and continue to maintain a positive fundamental credit view on the industry with ratings upside. We view fair value on the new issue at about 5.0%, slightly inside the Merrill Lynch High Yield Master II index yield of 5.1% given the favorable fundamentals.
We remain very constructive on the auto dealer space given its moatlike characteristics. We continue to think there are more reasons to buy a new vehicle than not to buy one. New vehicle sales continue to grow after bottoming out at 10.4 million units in the U.S. in 2009, used car prices are near record highs, interest rates remain low, and the vehicle fleet is still quite old at nearly 11 years. The follow-on parts and services operations provide steady operating income, leading to narrow moats on our coverage list of dealers. A highly variable operating cost structure allows for further downside protection.
Sonic reported solid first-quarter results including an 8.1% revenue increase. We estimate that rent-adjusted LTM debt/EBITDAR is about 4 times, and this ratio has declined steadily since the peak in 2008. The trend of auto dealers seeing less gross margin but higher volume continued as Sonic saw its gross margin decline 80 basis points year-over-year to 15% while new vehicle retail volume rose 7.4% and used vehicles rose 3.9%. The company's retail new and used volumes were first-quarter records. We are especially encouraged to see monthly used vehicle retail volume per store rise to 88 units per month, and management expects to reach its goal of 100 units in the second half of 2013.
Sonic's new vehicle inventory is healthy at about 56 days' supply, so we would not expect major pricing changes beyond first-quarter levels. The company did not make any acquisitions in the quarter but did repurchase 392,000 shares at an average price of $23.27. The company has $137.2 million remaining on its repurchase authorization, and we expect a mix of buybacks and acquisitions in 2013.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.