Markets Shrug Off Government Dysfunction

The corporate credit market shrugged off the political rhetoric emanating from Washington last week. Corporate credit spreads traded in a narrow range last week, in a relatively directionless market. Spreads had tried to weaken at the beginning of the week, but as soon as they started to move wider, traders snapped up those offerings and pushed credit spreads right back down again. 

The buy-the-dip mentality is alive and well as portfolio managers are for the most part ignoring the political antics, trying their best to pretend it's not happening. For all of the headlines proclaiming the potential for a default on government bonds after the Treasury reaches the debt ceiling, investors are not placing any probability on a payment default actually occurring. After having been to the brink several times over the past few years only to be saved by a last-minute resolution, investors have been conditioned like Pavlov's dogs to expect an 11th-hour agreement.

Regarding the economic impact of the government shutdown, Robert Johnson, Morningstar's director of economic analysis, wrote, "If they come to a settlement on the debt ceiling and budget issues in the next week or two (and include retroactive pay for government employees), the economy will do just fine." However, he cautions, "A month long shutdown would likely cut GDP growth by at least 0.5% in a world of 2% growth." Considering the political impact and repercussions of the government shutdown that have already occurred, it appears that the congressional and executive branches will not be able to reach an agreement on a continuing resolution to fund operations in the near term. As such, it appears the most likely course of action will be to resolve both the budget and debt ceiling issues at the same time over the next two weeks.

While the rhetoric in Washington is getting red-hot, volatility in the markets continues to be very low. Since we changed our opinion on corporate bonds a little over a year ago to market weight from overweight, corporate credit spreads have traded in a relatively narrow range. Over the past 12 months, the average spread of the Morningstar Corporate Bond Index has ranged from +129 to +167 and is currently near the middle of that range. The standard deviation thus far this year is a modest 8 basis points versus about 30 basis points in 2012. Credit spreads backed up this summer as investors sold long-term bonds in order to dodge the impact of rising interest rates, but once the rate of increase in interest rates began to slow, corporate credit spreads quickly regained about half of their widening. While credit spreads have only traded within a 38-basis-point range this year, the average annual trading range is 137 basis points over the past 13 years. Even excluding the 2008-09 credit crisis, the average annual trading range is 80 basis points, which is still more than double what we've experienced this year. The average annual standard deviation for the credit spread in our corporate bond index is 39 basis points, or 22 basis points excluding the credit crisis years.

  - source: Morningstar Analysts

We continue to believe that from a fundamental long-term perspective, corporate credit spreads are currently fairly valued in this trading range. Across our coverage universe, our credit analysts generally hold a balanced view that corporate credit risk will either remain stable or improve slightly, but that the tightening in credit spreads generally will probably be offset by an increase in idiosyncratic risk (debt fund mergers and acquisitions, increased shareholder activism, and so on). However, over the near term, with the Federal Reserve's quantitative easing program providing a steady flow of liquidity into the markets, we expect corporate credit spreads are likely to be pushed toward the bottom of the current trading range.

The new issue market was relatively quiet last week, as only a few issuers braved fighting the negative headlines to bring deals to the market. The transactions that came to market were originally talked at somewhat attractive concessions to existing trading levels, but these whispered concessions mostly disappeared when the deals were priced and the bonds performed reasonably well in the secondary market. The week's crop of successful offerings may give other issuers and underwriters the comfort to bring more new issues to market this week. The new issue window is open, and those companies seeking financing may be better off coming to market before the debt ceiling debate becomes any more convoluted.

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

New Issue Notes

Honda Finance's Multitranche Offering Looks Cheap on Initial Price Talk (Oct. 3)
American Honda Finance, the North American finance subsidiary of  Honda Motor (HMC) (rating: A, no moat), is in the market with 3-year and 5-year fixed-rate bonds and a 3-year floater. We view the finance sub as being of comparable credit quality to the parent given the existing support agreement and the inextricable linkage in the businesses. Initial price talk on the 5-year is a spread in the high 90s with the 3-year 20 basis points tighter. We view fair value at a spread of +80 on the 5-year and 20 basis points tighter on the 3-year. Other finance subs issuing 5-year bonds in the late 2012 or 2013 period include  Daimler's (DAI) (rating: BBB+, no moat) recent 5-year indicated at +104 versus the nearest Treasury,  Volkswagen's (VOW) (rating: A-, no moat) bond due November 2017 indicated at +84 versus the nearest Treasury, and  Toyota's (TM) (rating: A, no moat) 5-year issued in January indicated at +53 to the nearest. We view the Toyotas as rich and the other two as fair. Honda's 5-year bond issued in February is indicated at 82 over the nearest Treasury. Based on these comparable issues, we believe the new Honda offering looks attractive.

A weaker yen against the dollar and recovering U.S. demand for light vehicles make the future bright for Honda. The company's products and strong financial position should keep it on solid ground. Honda's brand and reputation for quality drive demand for its vehicles, but the company's longtime niche in fuel-efficient cars has positioned Honda well to take advantage of consumers seeking more fuel-efficient vehicles. Unlike the Detroit Three, which just recently began focusing more on fuel-efficient cars, Honda's product line is not reactionary and instead comes from management anticipating consumer demand for such cars over SUVs and pickups. We expect this trend to continue as gas prices appear likely to remain at elevated levels for the foreseeable future. In 2012, cars made up about 57% of Honda's U.S. sales mix compared with 40% for  General Motors (GM) (NR, no moat) and 34% for  Ford (F) (rating: BBB-, no moat). This mix gives Honda an advantage as the critical U.S. market is undergoing a structural shift away from gas-guzzling pickups and sport-utility vehicles and toward Honda's vehicle-making expertise. The Detroit Three, however, have dramatically improved their compact, subcompact, and midsize models.

Despite a strong product lineup, Honda still operates in an industry with formidable threats. If steel prices increase again, it will hurt profits for Honda and all other automakers. Honda can mitigate this problem by using more common-size vehicle platforms to reduce costs, but even that will probably only partially offset raw material price increases. The weak dollar relative to the yen also hurts profits, but this trend abated in 2013 as the dollar strengthened considerably against the yen. Still, expanding production outside the triad of Japan, North America, and Europe is critical for Honda and all other automakers as OEMs should produce where they sell to mitigate exchange risk. With emerging markets still growing and Honda's gas-friendly U.S. lineup expanding, the company's prospects look bright in this improving U.S. sales environment.

Magellan Midstream to Issue 30-Year Debt; Initial Price Talk Is Fair (Oct. 3)
 Magellan Midstream Partners (MMP) (rating: BBB+, wide moat) announced it is issuing $300 million of 30-year notes; the issue size will not grow. Magellan intends to use the proceeds to repay borrowings outstanding under its revolving credit facility and for general partnership purposes, which may include capital expenditures. As of Oct. 1, Magellan had $90 million outstanding under its $800 million senior unsecured revolving credit facility.

Initial price talk for the new 30-year issue is +160 basis points. We view this level as fair compared with existing levels, comparable companies' bonds, and our fair value. Before today's announcement, Magellan's existing 4.20% senior notes due 2042 were quoted at spread of 137 basis points over the nearest Treasury. The firm's 4.25% senior notes due 2021 were indicated at about +135 basis points, which we view as slightly cheap for an 8-year note.

For comparison,  Plains All American Pipeline's (PAA) (rating: BBB+, wide moat) 4.30% senior notes due 2043 trade at a spread of 137 basis points above the nearest Treasury. Plains' 3.85% senior notes due 2023 are trading on top of our fair value of 135 basis points above the nearest Treasury. At these levels, Plains' 10s-30s curve is essentially flat, whereas we think the curve should be roughly 20 basis points.

Magellan does not intend to issue equity this year, funding its capital budget with cash on hand and debt. We estimate this will increase Magellan's total debt by $700 million to $3.1 billion by year-end 2013. Based on our estimate of 2013 EBITDA, we project year-end leverage to be 3.7 times. This compares to LTM leverage of 3.1 times for Magellan and 2.9 times for Plains. In light of Magellan's capital needs in 2013 and our projection for declining credit metrics in the near term, we view Magellan's curve as too flat. Despite our positive view of Magellan's growth prospects, we believe the curve should also trade closer to 20 basis points, which is more representative of the increased risk inherent in the longer-dated bonds. As such, we peg fair value on Magellan's new 30-year notes at +155 basis points.

Monsanto Plans New Debt to Fund Climate Corporation Acquisition (Oct. 2)
 Monsanto (rating: A+, wide moat) released fourth-quarter and fiscal 2013 results Wednesday morning. Quarterly results were more or less in line with our expectations, with the fourth quarter being a seasonally weak period for Monsanto. In 2013, corn margins were dented by higher production costs and soybean margins took a hit from lost royalties in South America. We expect improvement on both fronts in fiscal 2014. In corn, costs should normalize and the annual introduction of new hybrids will probably lead to price increases. For soybeans, Monsanto's agreement with DuPont will increase royalty payments for Roundup Ready 2 Yield, and the launch of Intacta in Brazil will mark a return of the soybean royalty stream in South America. Sales for the full year were up about 10%, as was EBITDA, which came in at just over $4 billion.

Management also announced it has entered into a definitive agreement to acquire The Climate Corporation for all-cash price of $930 million. The Climate Corporation is a technology company that will develop predictive tools to help Monsanto's customers fine-tune planting and operating decisions. The acquisition fits nicely with Monsanto's current Integrated Farming Systems platform, which aims to bring seed science, field science, data analysis, and precision equipment together to maximize yields. Monsanto's first offering in the IFS platform, FieldScripts, is in the trial phase with an aim to increase corn yield per field by varying hybrid choice and planting rates within the field.

The acquisition is expected to be funded through a combination of cash and debt. With a cash balance of more than $3.5 billion and leverage at only 0.5 times annual EBITDA, Monsanto has the capacity to fund this acquisition without putting undue pressure on its balance sheet metrics. Although no details were provided regarding the amount of debt to be issued, we do not see this transaction negatively affecting our A+ rating; we believe Monsanto could fully fund the transaction with debt and still maintain total debt/EBITDA below 1.0 times.

Monsanto's outstanding 2.2% senior notes due 2022 currently trade around 90 basis points over the nearest Treasury, which we view as slightly cheap. For comparison,  Praxair's (PX) (rating: A, wide moat) similar-maturity notes are indicated at the same level, and we remain market weight the name. Both trade tight to the broader Morningstar Industrials Index, where the A+ level is at a spread of +95 basis points.

TransCanada to Issue 10- and 30-Year Debt; Initial Price Talk Looks Attractive (Oct. 2)
 TransCanada (TRP) (rating: BBB+, narrow moat) announced it is issuing 10- and 30-year notes out of its wholly owned subsidiary, TransCanada PipeLines, which we do not separately rate. While we award TransCanada a narrow economic moat, we view TransCanada PipeLines as a wide-moat business based on its stable cash flows and the regulated nature of its pipelines. As a result of our wide moat view, we have a similar opinion as the rating agencies that TransCanada PipeLines' credit rating is higher than that of its parent corporation. TransCanada Pipelines intends to use the proceeds for general corporate purposes and to reduce short-term borrowings, which were incurred to fund the company's capital spending program. As of June 30, TransCanada Pipelines had almost CAD 1.5 billion of long-term debt classified as current.

Initial price talk on the new notes is +140 and +155 basis points for the 10-year and 30-year, respectively. We view these levels as attractive to both existing levels and comparable companies' bonds. Before today's announcement, TransCanada PipeLines' existing 2.50% notes due 2022 were quoted at spread of +110 basis points, while its 6.10% bonds due 2040 traded at a spread of +139 basis points, both over the nearest Treasury. For comparison,  Kinder Morgan Energy Partners' (rating: BBB+, wide moat) recently issued 4.15% notes due 2024 trade at a spread of +170 basis points, and its 5% bonds due 2043 trade at a spread of +193 basis points. We view both Kinder Morgan issues as roughly 10-15 basis points cheap to fair value, partially due to a recently published third-party research report, which offered a negative opinion about the company. We believe the subsequent move wider in spreads is unwarranted, and we rate Kinder Morgan overweight. Kinder Morgan is a master limited partnership, not a wholly owned subsidiary, such that a higher percentage of its free cash flow is distributed to unitholders in the partnership. Given the difference in cash flow distribution between TransCanada Pipelines and Kinder Morgan, and our assumed ratings differential, we peg fair value on TransCanada Pipelines' new notes at +125 and +150 basis points, respectively.

Click here to see more new bond issuance for the week ended Oct. 4, 2013.