Our Outlook for the Credit Markets

• The basis between U.S. financials and industrials sector credit spreads is holding steady.
• Whether the Fed begins to reduce its asset-purchase program in the near term or medium term, we expect rates will continue to rise back toward the average real return over inflation.
• Credit rating changes are being dominated by idiosyncratic issuer activity.

 

Widening Investment-Grade Credit Spreads and Rising Interest Rates Lead to Losses
While the S&P 500 has risen about 12% this year and is near its record highs, corporate bond investors have grown relatively more cautious. From the beginning of the year through June 17, the average corporate credit spread in the Morningstar Corporate Bond Index has widened 8 basis points to 148. Combined with the 40-basis-point increase in the 10-year Treasury bond yield over the same time period, the Morningstar Corporate Bond Index has registered a 1.58% loss. Investors in European corporate bonds have fared much better as the average spread in the Morningstar Eurobond Corporate Index has tightened 13 basis points to 126 and the yield on 10-year German bonds has only increased by 20 basis points. This has resulted in a 0.99% gain in our Eurobond index.

Within the Morningstar Corporate Bond Index, the industrial sector has suffered the brunt of the losses this year, widening 12 basis points versus only 3 basis points of widening in the financial sector. Within the industrial sector, the most cyclical subsectors including basic materials, energy, and transportation have performed the worst, widening 24, 24, and 16 basis points respectively. The technology subsector has outperformed the most, tightening 7 basis points. Two of the issuers that helped the technology group outperform were Hewlett-Packard HPQ (rating: BBB+, narrow moat) and Symantec SYMC (rating: A+, narrow moat), which tightened 35 and 28 basis points, respectively.

We continue to view the corporate bond market as fully valued at current spread levels. While credit spreads may modestly tighten because of strong demand for corporate bonds during the third quarter, over the longer term, we think the preponderance of credit spread tightening has likely run its course. The tightest spread our corporate bond index has hit since the 2008 credit crisis was registered in April 2010 at 130, just before Greece acknowledged that its public finances were in much worse shape than previously reported, thus triggering the European sovereign debt crisis. The absolute tightest level that credit spreads have reached in our index was 80 in February 2007, the peak of the credit bubble. We don't anticipate returning to anywhere near those pre-credit-crisis levels as an overabundance of structured credit vehicles such as collateralized debt obligations, or CDOs, and structured investment vehicles, or SIVs, were created to slice and dice credit risk into numerous tranches, which artificially pushed credit spreads too low. Once the credit crisis emerged, investors found that many of these vehicles did not perform as advertised. While there have been some reports that a few investors are beginning to re-evaluate investing in CDOs, we doubt that these structures will re-emerge any time soon in any kind of meaningful size. Over a longer-term perspective, since the beginning of 2000 the average credit spread within our index is 176, and the median was 160.

As the Fed continues to purchase mortgage-backed securities and long-term Treasury bonds, investors have increasingly fewer fixed-income assets from which to choose. This has helped the demand for corporate bonds as the supply of available fixed-income securities constricts and the new Fed-provided liquidity looks for a home. Unfortunately, this action has penalized savers as the Fed has artificially held down long-term Treasury rates and spread-based fixed-income securities clear the market at tighter levels than would otherwise occur. Trying to anticipate the timing of the Federal Reserve reducing its asset purchase program has dominated in the current environment, but over the long term, fundamental considerations will eventually hold sway. From a fundamental risk perspective, we generally expect corporate credit risk will hold steady over the next quarter, but we recognize that a number of domestic and global factors that could hurt issuers' credit strength in the second half of 2013.

Robert Johnson, Morningstar's director of economic research, expects real GDP growth in the U.S. to average between 2.00% and 2.25% this year. The risk to his view is that consumer spending, which is one of the main drivers of economic growth, may be pressured as incomes stagnate. Globally, we are concerned that slowing growth in the Chinese economy, along with deepening recessions in Europe and Japan, could pressure cash flow for those issuers with global operations. With these factors in mind, we recommend that investors concentrate their holdings in those firms that we believe have economic moats (long-term, sustainable competitive advantages) and strong balance sheets that can weather any economic storm. We think that the bonds of issuers with the 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 and nonperforming bank loans are increasing;
• exposure to the emerging markets, where economic growth continues to be positive, albeit moderating;
• and companies that have the wherewithal to expand capital expenditures and infrastructure investments to take advantage of competitors that lack the resources to reinvest in their businesses.

Basis Between U.S. Financials and Industrial Sector Credit Spreads Holding Steady
In the second quarter of 2012 we opined that credit spreads for U.S. banks would outperform the broad corporate market. This opinion was based upon our forecast that the credit metrics for U.S. banks would continue to improve over the course of the year. With credit spreads for banks trading wider than equivalently rated industrials, we saw potential for a shift in sentiment toward financials. Our outlook proved correct, as U.S. banks handily outperformed. On March 1, we changed our opinion as we thought unfolding events in Europe may lead to credit spread widening among European bank bonds, which may then lead to widening credit spreads among U.S. banks. As such, we changed to a neutral view on U.S. banks. Since March 1, the basis (or spread between financials and industrials) has held relatively steady.

While we think this basis will remain steady over the near term, we are vigilantly monitoring the increases in nonperforming loans for both Italian and Spanish banks. If their nonperforming loans continue to grow at the current rate, we think it would likely lead the markets to further question the stability of many European banks. As such, if the credit metrics of those Italian and Spanish banks leads us to downgrade our credit ratings, we may consider changing our recommendation on the financial sector to an underweight. Although to a lesser degree, we would expect contagion from credit spread widening among European banks to spread into the trading levels of U.S. banks as well. While the markets currently appear sanguine regarding Europe's banking and sovereign risks, we continue to hold a skeptical view that Europe's structural problems have been resolved.

Interest-Rate Risk and Inflation
Long-term interest rates have begun to rise, and the 10-year Treasury bond has reached its highest level since April 2011. Nevertheless, even after suffering a 40-basis-point increase thus far this year, still near their lowest levels historically. Last quarter, we opined that as long as the Fed continues its $85 billion per month asset purchase program that the yield of the 10-year Treasury would remain in a range of 1.75% to 2.25%. However, we have cautioned investors numerous times that once the Fed announces its intention to begin tapering asset purchases, interest rates will likely rise 100 to 150 basis points in a relatively short period of time.

Historically, the yield on 10-year Treasury bond has averaged 245 basis points over a rolling three-month inflation rate. Even at the currently low rate of inflation of about 1.00%, the yield on the 10-year Treasury could easily increase an additional 100 basis points to 3.25% to 3.50%. Whether the Fed begins to reduce its asset purchase program in the near term or medium term, we expect interest rates will continue to rise (barring a significant exogenous shock to the economy) back toward its average real return over inflation. While we expect interest rates will quickly normalize, we are not overly concerned that the rise in interest rates will overshoot too much from historical averages as inflation and inflation expectations have been declining.

The market implied inflation expectation is quickly sliding as Treasury bonds and TIPS are pricing in a higher probability that the Federal Reserve will begin to taper its asset purchase program in the near term. Our preferred measure of inflation expectations is the five-year, five-year forward inflation break-even rate. This rate rose as high as 3.00% last September after the Federal Open Market Committee announced the beginning of its asset purchase program, but has since decreased to 2.37%. While this is still slightly above the average since 1998 of 2.14%, it is below the 2.45% average since the beginning of 2010 when fixed-income markets began to normalize after the credit crisis.

Credit Rating Changes Dominated by Idiosyncratic Issuer Activity
During the second quarter, ratings downgrades outpaced upgrades mainly due to downgrades in the health-care sector. We downgraded six health-care firms as heightened returns to shareholders and mergers and acquisitions caused most of those changes. Although we maintain a positive outlook for Amgen AMGN (rating: A+, wide moat) going forward, higher ongoing leverage and the continued focus on shareholder returns at the expense of increased credit risk led us downgrade our credit rating by one notch in early April. For AstraZeneca AZN (rating: AA-, wide moat), we downgraded our rating by a notch due to weakening fundamentals and cash flow prospects, as the firm doesn't appear able to internally develop new products to replace products going off patent. Due to these weak fundamentals, we remain on the lookout for negative credit catalysts at AstraZeneca, including potentially large, debt-funded acquisitions. 

For Bristol-Myers Squibb BMY (rating: AA-, wide moat), a review of the pharmaceutical industry revealed that its net leverage had increased to levels that were too high relative to its peers to maintain its previous AA+ rating. We downgraded
Hospira HSP (rating: BBB-, narrow moat) based on worsening cash flow prospects due to quality control problems in its manufacturing operations and a tough intermediate term debt maturity schedule, which could force Hospira to tap its credit facility. We downgraded Merck MRK rating: AA-, wide moat) by a notch after the firm issued debt to fund a large, new share repurchase program. After Thermo Fisher Scientific TMO (rating: BBB, narrow moat) agreed to buy Life Technologies, we downgraded its rating from A+ previously. Thermo intends to boost debt/EBITDA to about 4.5 times after the deal and then only reduce leverage to 2.5 to 3.0 times debt/EBITDA within two years of the transaction.

In the energy sector, our numerous ratings changes in the second quarter were primarily motivated by acquisitions and divestitures. In the midstream sector, we upgraded Plains All American PAA (rating: BBB+, wide moat) based on our improved outlook for the company which is driven by its acquisition of BP's natural gas liquids platform. The acquisition expanded the company's scope and scale as it now has a robust NGL footprint. Conversely, we downgraded Regency Energy Partners RGP (rating: BB-, no moat) due to its acquisition of Southern Union Gas Services. Regency paid a high price for assets that move Regency toward an integrated platform, yet still result in an undifferentiated product offering. In the exploration and production sector, we upgraded Noble Energy NE (rating: BBB-, no moat) as we believe the company's excellent exploration history will enable the company to meet its target of doubling production within the next five years without a material increase in total debt. We lowered our rating on Apache APA (rating: A-, narrow moat) based on our review of the company, which was spurred by $6 billion of acquisition in 2012. Although we maintain a positive outlook for the company in the long term, Apache meaningfully expanded its balance sheet resulting in the near-term deterioration in credit metrics which underlies our ratings downgrade. By spinning off its downstream refining assets, Marathon Oil MRO (rating: BBB, no moat) removed the natural buffer to its E&P business. Without the refining business, our assessment of Marathon's credit risk increased because of the lofty price the company paid for its acquisitions in the Eagle Ford shale and our projection that operating cash flows will not cover capital expenditures. Hence our decision to lower Marathon's issuer credit rating.

We expect global economic growth will continue to be sluggish in 2013, limiting opportunities for organic growth. In order to enhance shareholder value, management teams will likely continue to look for non-organic ways to support their equity prices. We saw a resurgence in strategic acquisitions during 2012 and expect that trend to continue. Depending on how these acquisitions are structured, the credit implications may be either neutral to negative based on the amount of debt and equity used to fund the buyouts. The number of leveraged buyouts in 2013 have thus far been modest as many private equity firms have been more interested in selling many of their portfolio companies in IPOs while the equity market is hot and harvesting gains. However, as domestic banks have rebuilt the capital on their balances sheets we expect their willingness to fund LBOs will increase in the second half of 2013. With capital available from portfolio sales, private equity sponsors have significant amounts of dry-powder and may look to use any pullbacks in the equity market as an opportunity to purchase quality business.

Sector Updates and Top Bond Picks

Basic Materials
We remain skeptical about the sustainability of China's growth trajectory over the next decade. 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 shift of fortune for basic commodity producers under our coverage.

During the past ten years, Metal and mining companies, in particular, have enjoyed a good ride. Now, we think the tide is turning. As Chinese fixed asset investment slows, we expect lofty commod­ity prices to follow suit. Chinese demand for base metals, steel, and metallurgical coal is one of their key global pricing drivers. A pullback in such demand (both in terms of absolute levels and growth rate) would become painfully obvious for metal and mining, steel, and metallurgical coal producers, particularly those at the higher end of the production cost curve.

A prime example, in our view, is Cliffs Natural Resources CLF (rating: BB+, no moat). As a high-cost producer, Cliffs is particularly sensitive to iron ore price fluctuations. With mounting debt from years of acquisitions and heavy capital expenditures on its balance sheet, the company has limited headroom to sustainably absorb the impact of declining iron ore prices. We expect further deterioration in its credit quality in the intermediate to long term.

Although low-cost producers such as Southern Copper SCCO (rating: BBB+, narrow moat) and Vale VALE (rating: BBB+, narrow moat) will feel the impact of China's economic slowdown, both are positioned to generate sufficient cash flows for maintenance and expansionary capital expenditures, and may see some benefits as high-cost marginal players experience financial difficulties.

Thanks to a prolonged spate of wet and cold weather, North American farmers got off to a later-than-normal start to spring planting this year. We see this as a timing issue, and still expect a strong season for crop inputs in North America, as farmers strive to rebuild depleted stocks and benefit from continued high crop prices. Volumes for potash producers have rebounded, with China and India back to the market. Additionally, volumes to North American customers have also seen gains, with farmers set to plant another big crop this season and potash dealers carrying limited inventory into 2013 compared with last year. Despite the higher volumes, potash prices have been pressured, with the major potash marketing organizations--Canpotex and BPC--employing price cuts to entice buyers back to the market. We think prices could firm up later in the year as a result of better demand, but we expect additional long-term pressure on prices as supply growth outpaces demand.

Contributed by Dale Burrow, CFA

Consumer Cyclical
Solid credits in the consumer cyclical space only stay solid credits if management teams are focused on the balance sheet. Furthermore, it is these names that worry us less in the current spread-widening environment. Examples include companies such as McDonald's MCD (rating: AA-, wide moat) and Walt Disney DIS (rating: A+, wide moat) both of which continue to reiterate their commitments to maintaining a solid balance sheet. While McDonald's operating results show a continued challenging macro environment, we are pleased that management reiterated the importance of having a solid balance sheet for its franchisee system. McDonald's has maintained lease-adjusted leverage around 2.25 times, and we expect it to remain at this level.

Despite strong operating performance and robust shareholder returns, Disney's management insists that it would not sacrifice its credit rating to issue debt to return more cash to shareholders. We would argue that with robust and growing free cash flow, Disney is positioned to reward shareholders richly without impairing bondholders. The firm has maintained leverage around the mid-1 times range for the past few years, increasing overall debt levels with EBITDA. We expect the firm to continue channel its cash toward share repurchases.

Still, we harbor concerns over other credits that are in the weak investment grade area returning copious amounts of cash to shareholders. Discovery Communications DISCK DISCA (rating: BBB, narrow moat) has generated solid earnings growth. However, from a credit perspective, we've been concerned with management's willingness to return cash to shareholders to maintain leverage in the 2.5 times to 3.0 times range. We think this level is high for a cyclical company.

Lastly, we are mindful of credits that may be more sensitive to an improvement in the economy, such as Dollar General DG (rating: BBB-, no moat). We believe the slowly rebounding economy has the potential to drive underperformance in the bonds of more defensive names. In our view, a key tenet of Dollar General's story will be the company's ability to retain the consumers gained during the 2008 recession, and whether it can withstand the eventual impact from Wal-Mart Stores' WMT (rating: AA, wide moat) small-store rollout.

Contributed by Joscelyn MacKay

Consumer Defensive
Consumer spending continues to hold up surprisingly well in spite of the payroll tax increase and the impact from the sequestration. 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. With organic growth opportunities sluggish, we expect companies will continue to be on the hunt for mergers and acquisitions. We view the buyout of Heinz as a one-off exception, and expect that most transactions will be centered on smaller, strategic acquisitions rather than large, transformational or private equity sponsored deals.

Most recently, PepsiCo PEP (rating: AA, wide moat) acknowledged that it had discussed various alternatives to enhance shareholder value for activist investor Nelson Peltz's Trian Fund. Considering that Trian owns both Pepsi and Mondelez International MDLZ (rating: BBB, wide moat) and that Mondelez's CEO is a Pepsi alum, rumors surfaced that Pepsi may have evaluated purchasing Mondelez. While a deal certainly looked plausible on paper (see our April 29 analyst note), recent commentary by Pepsi's CEO seemed to quash the rumor. At a recent conference, Pepsi CEO Indra Nooyi empathically denied that her company would need to pursue an acquisition, saying that "we do not need any transformational M&A to accomplish our goals. And we are very happy with the PepsiCo portfolio and that's how it's going to be."

In the tobacco market, electronic cigarettes (eCigs) currently only comprise a minimal portion. However, their popularity as a smoking alternative is growing quickly. We expect the eCig market will top $1 billion in sales this year, and may represent one of the best avenues for the tobacco industry to stem declining volumes in traditional cigarettes.

In 2012, Lorillard LO (rating: BBB, wide moat) acquired the eCig brand, blu, providing the firm with a first-mover advantage over the other large tobacco companies. Lorillard has quickly expanded its retail availability, as it has increased the number of distribution points to 50,000 at the end of 2012 as compared to 10,000 at the time of acquisition. We continue to view firm's bonds as the cheapest in the tobacco sector for the credit risk.

Small, privately held firms control much of the remaining eCig market. However, the other large tobacco firms are developing and testing their own electronic cigarettes. For example, Altria Group MO (rating: BBB, wide moat) is testing its MarkTen eCig brand in Indiana, and Reynolds American RAI (rating: BBB, narrow moat) has launched its VUSE brand in Colorado. While eCigs currently are not burdened by excise taxes or master settlement agreement payments, they are still relatively new, opening the door for potential regulatory risks. In our view, it's possible that lawmakers could use new regulations or taxes to blunt segment growth. If eCigs eventually make up more than 5% of total cigarette market, or if they're proven to be medically harmful, we believe it is highly likely that the federal government and some states will look to levy excise taxes on eCigs. We believe that the wide economic moats that the larger tobacco firms have created over the course of many decades will prove to be valuable assets as tobacco alternatives continue to grow in popularity. Compared with the small, privately held competitors, the large tobacco players have the financial wherewithal and vast distribution systems to more broadly capture the growing market opportunity surrounding electronic cigarettes.

Contributed by Dave Sekera, CFA

Energy
As we look to the third quarter, we see three issues that could impact credit spreads in the energy sector: natural gas price volatility now that storage levels have normalized, additional ultra-deep-water drilling contract announcements, and persistent crude price differentials in the U.S.

An industrywide reduction in natural gas-focused drilling during the last year coupled with a 26% year-over-year increase in heating degree days during the November to March period have reduced natural gas storage levels. As of May 31, the amount of natural gas in storage was 21% lower than last year's level, and below the five-year average. With the Baker Hughes BHI (rating: BBB+, no moat) natural gas drilling rig count remaining unchanged at a low level, the market is at the intersection of average demand and normalizing supply growth. As such, we favor companies with unhedged production that will benefit if a hotter summer drives natural gas prices higher as a result of the limited supply. Although Devon Energy DVN (rating: BBB+, narrow moat) took advantage of the recent increase in natural gas prices to hedge a portion of its production, it still maintains solid exposure to further price rises.
Cimarex Energy XEC (rating: BBB-, narrow moat) and Chesapeake Energy CHK (rating: B+, narrow moat) also maintain substantial exposure to near-term price increases. Spreads on Devon and Cimarex bonds have moved wider with the broader softness in corporate credit, but if a hot summer drives demand higher, we believe these two companies should outperform.

As we anticipated in our second-quarter outlook, several companies, including
Ensco ESV (rating: BBB, no moat), Noble NE (rating: BBB-, no moat) and
Seadrill SDRL (rating: B, no moat), announced new contracts for ultra-deep-water, or UDW, drilling rigs. These contracts and management comments about the strength of demand for UDW rigs confirms the consensus opinion that the sector remains healthy. We recently removed Rowan Companies RDC (rating: BBB-, no moat) from our Bonds to Avoid list after the company announced a long-awaited contract for the second of its four UDW rigs that are currently under construction. Although our major concern about Rowan's ability to contract its rigs has been removed, the company still faces execution risk in terms of delivering its rigs on time and operating them efficiently. In addition, we project that Rowan will need to issue another $600 million of debt in 2014 to fund its fourth rig. With Rowan debt trading at a similar credit spread as larger peers with less risk, we recommend that investors underweight the bonds.

Credit spreads of U.S. refiners have widened with the broader market, but we believe that refiners offer more stability than the market perceives. This is based on our recent research, which supports the sustainability of domestic crude oil discounts. The U.S. oil production surge creates a feedstock cost advantage which moves U.S. refiners down the global cost curve, allowing them to generate more consistent economic returns than in previous cycles. As such, we would view a meaningful increase in credit spreads as an opportunity to take advantage of this paradigm switch.

Contributed by David Schivell, CFA

Financial Services
On April 10, 2013 the Italian government revised its expectations for debt/GDP levels in upcoming years. The government now calls for a debt/GDP ratio of more than 130% for 2013, and 129% for 2014. Both of these numbers are significantly higher than the 126% and 123% for 2013 and 2014, respectively, that were projected late last year. The 2013 projection reflects the Italian economy's continuing deterioration, as the final debt/GDP ratio for 2012 was approximately 127%. Then on April 30, 2013, the Bank of Spain scaled back its 2013 GDP forecast for Spain to a contraction of 1.3% from a contraction of just 0.5%.

For Morningstar, these announcements are no surprise. Our bias toward the Italian and Spanish economies has been bearish for some time. We expect these sluggish economies to continue to struggle for the foreseeable future, driving growth in Spanish and Italian nonperforming loans and inducing continued stress on the balance sheets of Spanish and Italian banks. We think current credit spreads for Spanish and Italian banks don't reflect the potential weaker credit position of these banks. For example, the spread on five-year CDS for UniCredit UCG (rating: BBB-, narrow moat) is currently 330 basis points. While the spread has widened approximately 70 basis points over the past month, it's still a far cry from the over 500 level that was maintained in June and July of last year, the last time European concerns were on the forefront of market participants.

For U.S. large and regional banks, we continue to expect further balance sheet improvement as nonperforming loans continue to drop and capital continues to build. We are maintaining our neutral stance on the sector, however, as overall banks spreads are relatively close to industrial spreads, and we are concerned that this relationship could widen on contagion fears if European banks come under stress. Morningstar's Financial Corporate Bond Index is currently about 6 basis points wide of the Morningstar Industrial Corporate Bond Index, and this difference was closer to 90 basis points just one year ago.

Our outlook for the credit quality of U.S. insurers is good, especially for property and casualty insurers, who will benefit from the improving pricing environment. The possibility of fixed income losses in investment portfolios due to a rapidly rising rate environment does hang over the group. However, barring a violent uptick, we don't foresee any meaningful issues. We do, however, generally view the credit spreads on U.S insurers as too tight for their ratings.

Contributed by Jim Leonard, CFA

Health Care
Reform efforts in the U.S. and ongoing weakness in Europe highlight that developed markets are becoming tougher to navigate for health-care companies. As a result, industry players increasingly aim to grow through acquisitions and/or placate investors with higher dividends and share repurchases. This keeps us cautious about the trajectory of health-care credit ratings going forward. Unless the economy weakens and highlights the health-care industry as a defensive safe haven compared to other industries, we believe spread-tightening may be limited to specific companies rather than the broader industry, which we view as about fairly valued.

In the near future, M&A activities could dominate the new issuance landscape. For example, Thermo Fisher Scientific TMO (rating: BBB, narrow moat) has agreed to buy Life Technologies, which led to Thermo's recent downgrade. Thermo plans to issue $10 billion in new debt to fund the transaction, which will boost debt/EBITDA to about 4.5 times after the deal closes in early 2014, and the firm only plans to reduce leverage to 2.5 to 3.0 times debt/EBITDA within two years of the merger. Also, Valeant Pharmaceuticals International VRX (rating: BB, narrow moat) may continue to fund the Bausch & Lomb deal. After its recent issuance, we could see another $3.5 billion in new debt issuance to fund the remainder of the $6.7 billion in total debt it plans to issue to finance the transaction.

So while our overall view of the industry has a negative bias, we see some positive trends on a company-specific basis. Specifically, our positive outlook on Amgen AMGN (rating: A+, wide moat) relates to its strong pipeline and plan to deleverage to a net cash position by the end of 2013. We recently removed Boston Scientific BSX (rating: BBB-, narrow moat) from our "Bonds to Avoid" list due to in part to potential deleveraging catalysts on the horizon. Diversifying products may emerge from Celgene's CELG (rating: A, narrow moat) pipeline soon, which could lead to spread tightening. Express Scripts ESRX (rating: A-, wide moat) is making big strides on its deleveraging goals after the Medco deal, and we expect deleveraging to below 2 times debt/EBITDA by the end of 2013, which could lead to a rating upgrade. Gilead Sciences' GILD (rating: A, narrow moat) pipeline could produce a huge new blockbuster in hepatitis C by early 2014, which could widen its economic moat and lead to a rating upgrade. Zoetis ZTS (rating: BBB+, wide moat) may enjoy positive credit catalysts in the near future, as it separates more fully from
Pfizer PFE (rating: AA, wide moat).

Contributed by Julie Stralow, CFA

Industrials
Across the industrials sector, trends in credit quality remain stable to slightly positive. We don't expect to see much change over the coming quarter. For the diversified industrial names we follow, organic growth has been tough to come by as persistent weakness in Europe continues to offset steady U.S. and emerging market growth. However, given managements' keen focus on costs, credit profiles haven't suffered. Spreads remain relatively tight across the sector, though Danaher DHR (rating: A, narrow moat) and Dover DOV (rating: A/UR-, narrow moat) look modestly attractive at current levels.

Fundamentals generally look good for the rail sector, given the benefits derived from transporting such a diversified basket of goods. Coal volumes are expected to remain weak, but should be more than offset by continued strength in intermodal, automotive, and lumber shipments, with the latter driven by the recovery in the U.S. housing market. Kansas City Southern KSU (rating: BBB-, narrow moat), our favorite in the sector for much of the past couple years, now looks rich to us after tapping the market for the first time as an investment grade credit at all the rating agencies. Spreads on CSX CSX (rating: BBB+, narrow moat) continue to look attractive relative to similarly rated Eastern peer Norfolk Southern NSC (rating: BBB+, narrow moat).

In the agricultural and construction equipment sector, long-term fundamentals generally remain positive. However, weakness in Europe and slower growth in emerging markets remain 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 AGCO (rating: BBB-, no moat), given its relatively wide spreads for what we view as investment-grade risk.

We expect recent positive fundamental trends in the auto and homebuilding sectors to continue into the third quarter as pent-up demand by consumers gets satisfied. Indicative of strength in the domestic market, we upgraded dealers Sonic Automotive SAH (rating: BB-, narrow moat), Penske Automotive Group PAG (rating: BB-, narrow moat), and Asbury Automotive Group ABG (rating: BB, narrow moat) during the quarter. While we largely see the homebuilding sector as fairly valued, we have maintained overweightings on several auto names including Delphi Automotive DLPH (rating: BBB, narrow moat) and Ford Motor Credit F (rating: BBB-, no moat).

Finally, with sequestration implemented in March the aerospace/defense sector is expected to continue to show top-line pressure. We believe most credits are well-positioned for this given strong cash balances and solid free cash flow, and generally view the sector as fairly valued. However, we remain wary of potential changes in financial policy such as Northrop Grumman's NOC (rating: A-, narrow moat) announcement that it intends to repurchase 25% of its shares during the next three years, followed by a $2.85 billion new bond offering. While we have maintained our rating, it is very weakly positioned. We'll closely monitor the firm's credit metrics. With potentially greater visibility surrounding defense spending, we're concerned that other firms might follow Northrop's lead given greater predictability of future results.

Contributed by Jeff Cannon, CFA and Rick Tauber, CFA, CPA

Technology & Telecommunications
While we continue to believe investors can do well looking at lower-quality technology names like Hewlett-Packard HPQ (rating: BBB+, narrow moat), we're starting to see good value among the strongest credits in the sector. In the past, we've written about the impact that the weak PC market has had on sentiment across the tech sector. That theme has continued into mid-2013. Intel INTC (rating: AA, wide moat) has seen spreads on its 2.70% notes due in 2022 hold consistently wider than 100 basis points over comparably dated Treasuries for the past three months, while spreads on other strongly rated tech firms have held well below this threshold. For example, Google's GOOG (rating: AA, wide moat) 3.625% notes due in 2021 and International Business Machines IBM (rating: AA-, wide moat) 1.875% notes due in 2022 have traded in the range of 70-80 basis points to Treasuries.

Despite weak PC demand, we expect Intel will remain a force within the semiconductor market. While ARM Holdings ARMH (not rated, narrow moat) remains dominant in the mobile process segment, as pretty much all processors used in mobile devices are based on designs from the firm, we think investors should keep an eye out for Intel. The semiconductor behemoth recently scored its first major tablet design win in the 10.1" version of Samsung's Galaxy Tab 3. In addition, Intel will release a refresh of its smartphone and tablet Atom chips, based on the new "Silvermont" architecture, by the end of the year. We think the move could make the firm more competitive in this fast-growing market opportunity.

We also believe that Oracle ORCL (rating: AA, wide moat) debt looks attractive. The firm's 2.5% notes due in 2022 have traded recently around a 96 basis-point spread over Treasuries. As the market focuses on new trends in cloud-based software and "big data" solutions, Oracle's position as an incumbent technology provider is as important as ever. Cloud technologies have been disruptive to some, yet we expect software companies with economic moats built around high customer switching such as Oracle will be able to defend their turf.

Technology companies also continue to look for ways to put cash to use. Collectively, Google, Facebook FB (not rated, wide moat), Yahoo YHOO (not rated, narrow moat) and LinkedIn LNKD (not rated, wide moat) announced 14 acquisitions last quarter, with Yahoo's $1.1 billion offer for blogging site Tumblr and Google's $1.1 billion bid for social mapping provider Waze being the largest. We generally take a favorable credit view of M&A activity in tech, as companies often use acquisitions to bolster their competitive positions. On the less favorable side, several hardware firms have recently announced plans to increase shareholder returns. NetApp NTAP (rating: A+, narrow moat) and EMC EMC (rating: A+, narrow moat) announced their first-ever dividend programs, while Cisco Systems CSCO (rating: AA, wide moat), IBM and HP all increased their payouts. Cisco, EMC and NetApp each carry large excess cash balances, maintain low current payout ratios, and are unlikely to deviate significantly from their existing financial and strategic models for the foreseeable future. As a result, we don't believe these firms have materially altered their credit profiles. On the other hand, we were somewhat disappointed with HP's increase, as we believe that firm still has a ways to go to full repair its balance sheet. Still, we expect HP to make steady progress reducing leverage over the next few quarters.

Contributed by Michael Hodel, CFA

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. While 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, the U.S. Solicitor General, in March, petitioned the Supreme Court to review the D.C. Circuit's decision. The Solicitor General's request specifically addresses whether the court of appeals lacked jurisdiction, whether states are excused from adopting state implementation plans, and whether the EPA interpreted the statutory term "contribute significantly" correctly regarding air pollution contributions from upwind states. 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 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 allowed returns on equity declining (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 further increases in Treasury rates in 2013 could quickly erode spread outperformance given historically tight trading levels within the Utilities sector. Moreover, we believe investors seeking yield should tread lightly when considering opportunities at diversified parent companies. 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 $3.80/mmBtu mark, back down close to 2012's historic lows ($1.91/mmBtu). Furthermore, we revised our mid-cycle power prices downward in December 2012 to reflect a $5.40/mcf mid-cycle gas price (versus $6.50/mcf), negatively affecting independent power producers' projected margins. Although, we note declining natural gas storage levels totaling 2,347 billion cubic feet (as of June 7) are now 2% below their five-year average storage level of 2,405 billion cubic feet (and down 20% 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 EIX (rating: BBB-, narrow moat) merchant generation company, Edison Mission Energy, was the first casualty following Dynegy Holding's 2011 bankruptcy (2012 fourth-quarter emergence). We also believe Ameren's AEE (rating: BBB-, narrow moat) March 14 announced merchant generation sale of Ameren Energy Resources Generating Company 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 (dollar per kW).

On the other hand, the industry's broad desire to accumulate regulated assets fueled M&A activity in 2012. While we expect this pace to moderate in 2013, we highlight MidAmerican's (Berkshire Hathaway) $5.6 billion cash acquisition of Las Vegas-based NV Energy in May for a 23% premium. Moreover, NV Energy's high concentration of renewables (solar and wind) and increased cash flow were the primary drivers of value. Representative deals that closed in 2012 include all-stock mergers between Northeast Utilities NU (rating: BBB, narrow moat) and Nstar;
Exelon EXC (rating: BBB+, wide moat) and Constellation Energy; and Duke Energy DUK (rating: BBB+, narrow moat ) and Progress Energy. Additionally, independent power producer NRG Energy NRG (rating: BB-, no moat) 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 high operating leverage upside), NRG announced that it would reduce leverage by $1 billion, principally at GenOn.

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 AEP (rating: BBB+, narrow moat) 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 for institutions.

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
Intel	INTC	AA	2022	2.70%	$96.05	3.19%	107
St. Jude Medical	STJ	AA-	2023	3.25%	$97.25	3.58%	140
Celgene	CELG	A	2022	3.25%	$98.63	3.42%	135
Washington Post	WPO	BBB+	2019	7.25%	$118.53	3.57%	235
W.R. Berkley	WRB	BBB+	2022	4.63%	$106.65	3.73%	177
Data as of 6-17-13. Price, yield, and spread are provided by Advantage Data.

Intel INTC (rating: AA)
Intel has fallen out of favor with investors over the past six months as the personal computer market has struggled. While the PC market certainly has an effect on the firm, we believe that demand for processing power, in a broader sense, in more relevant to Intel's future. The firm's massive scale advantages provide it with the ability to produce more powerful chips at lower cost than its competitors, which has enabled it to remain dominant in the PC and server processor markets. We expect that it will begin to press this advantage in the market for smartphone and tablet process over the next year or so as it develops new products that consume less power and begins to shift the Atom product line to its latest manufacturing facilities. While chips based on the ARM architecture combined with large-scale foundries such as Taiwan Semiconductor could disrupt Intel's market position over time, we haven't seen any evidence of this occurring.

Intel has added a chunk of leverage to its balance sheet during the past couple years as uses of cash have ramped up. In particular, the firm spent $8 billion in 2011 to acquire McAfee, and it has increased its dividend payout to about $4.5 billion annually. However, gross debt remains modest at $13.2 billion, or about 0.6 times EBITDA. Intel also continues to carry a hefty cash balance of about $17 billion, and it generates very strong cash flow--about $10 billion during the past year.

The combination of strong competitive advantages and a solid financial position create what we believe is one of the strongest credits in the tech industry. Yet, spreads on Intel's debt are currently well wide of other tech giants. For example, Google's 3.625% notes due in 2021 currently trade at about +83 basis points over Treasuries. Intel also looks attractive relative to the broader credit market, with spreads on its recently issued 10-year notes sitting about 10 basis points wide of the A+ bucket within the Morningstar Industrials Index.

St Jude Medical STJ (rating: AA-)
St. Jude Medical is one of our bond picks as an absolute and relative valuation play. The firm's 2023 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. The market appears to be anchoring on the agencies' A/Baa1 ratings, which may display a size bias. Given St. Jude's enviable position in the cardiac device industry, we think the firm has dug a wide moat, which overrides its modest top line in our rating methodology. Also, we believe St. Jude represents an attractive relative value compared with Medtronic, a key competitor that we rate only one notch higher at AA. However, St. Jude's 2023s are currently indicated at spreads about 35 basis points wider than Medtronic's 2023s, and we think investors should take advantage of this relative spread differential. Investors may want to consider St. Jude's new 30-year issue, too, as we believe it also represents an attractive value.

Celgene CELG (rating: A)
Although Celgene received FDA approval of Pomalyst, a potential multiple myeloma blockbuster, in early February, its notes continue to offer relatively attractive compensation compared with notes from similarly rated drugmakers, including
AbbVie ABBV (rating: A, narrow moat), Gilead Sciences GILD (rating: A, narrow moat), and Teva Pharmaceutical Industries TEVA (rating: A, narrow moat). Also, we see potential catalysts on Celgene's horizon. Specifically, we still look forward to seeing whether Celgene can succeed with apremilast (Phase III in psoriasis indications) and Abraxane in other cancer indications. These drugs could start boosting sales at Celgene in the next year or so, which would be positive for Celgene bondholders. Celgene needs to expand its product portfolio behind multiple myeloma drug Revlimid, which represents about two thirds of sales. Important for long-term investors, we remain confident in Revlimid's prospects even beyond its 2019 composition patent expiration primarily because of its controlled distribution, which may make it difficult for generic firms to even access Revlimid to determine bioequivalence. With big ongoing cash flow from Revlimid and a net cash position, we remain confident in debt repayment even in our worst-case scenario for pipeline candidates. However, spread tightening may only happen if Celgene finds a new growth driver.

Washington Post WPO (rating: BBB+)
Washington Post's bonds trade much too wide for the rating, particularly given the fact that the firm's balance sheet has more cash than debt. Washington Post's education division, Kaplan, has realized steep earnings declines, primarily the result of weakness in the postsecondary education market. Accordingly, we project that the enrollment dip and slower recovery in the out years will push lease-adjusted leverage to roughly 2 times from 1.5. Still, the firm has a comfortable Cash Flow Cushion of roughly 2 times our base-case expense and obligation forecast, thanks to meaningful cash flow generation from the cable and television broadcasting divisions. We believe the market has unfairly punished Washington Post on the aforementioned drop in earnings.

W.R. Berkley WRB (rating: BBB+)
As a company, W.R. Berkley often seeks risks that many of its competitors avoid. Rather than writing more commodified insurance contracts, the company focuses on specialty lines where it believes it is being better rewarded for the risks it takes. The company has developed a culture that allows underwriters to focus on the underlying profitability of the business they write, rather than chasing annual budget or premium targets. This allows Berkley to select risks that will compensate it over the long term while shunning less profitable business. This strategy has allowed it to maintain very high underwriting margins, evidenced by its low combined ratios over a cycle. Most property-casualty insurers do not benefit from favorable competitive positions and therefore do not possess a moat. W.R. Berkley's focus, however, on specialty insurance, which is subject to less competition than traditional insurance, allows the company to earn a narrow economic moat.

Although W.R. Berkley is smaller company with less liquid bonds than some of the other well-known property-casualty insurers, we still think these bonds are too wide in comparison with similar-rated insurers. For example, the credit spread on
Allstate ALL (rating: BBB, narrow moat) trades approximately 70 basis points tighter for a one-notch lower rating.

More Quarter-End Outlook Reports

• Stock Market
• Economy
• Muni Market
• Basic Materials
• Consumer Cyclical
• Consumer Defensive
• Energy
• Financial Services
• Health Care
• Industrials
• Tech & Communication Services
• Utilities