In our third-quarter corporate credit outlook published Sept. 25, we outlined why we thought corporate credit investors were poised to begin recapturing their losses suffered this summer. Since then, the Morningstar Corporate Bond Index has risen 1.12% and is now down only 1.49% year to date. We continue to think the corporate bond market will recover in the short term. Interest rates are likely to continue to decline due to the Federal Reserve's ongoing asset-purchase program, and the demand for corporate bonds will push corporate credit spreads tighter. Fund flows into bond funds have returned, and as the Fed's asset purchases remove Treasury and mortgage-backed bonds from circulation, demand for corporate bonds has improved. Last week, this increased demand helped to reduce the average credit spread in the Morningstar Corporate Bond Index by 5 basis points to 138 over Treasuries.
We continue to believe that from a long-term fundamental perspective, corporate credit spreads are fairly valued in the current trading range. However, over the near term, because of the Fed's quantitative easing program providing a steady flow of liquidity into the markets, we expect corporate credit spreads will probably be pushed to the bottom of this year's trading range. The tightest credit spread in our index reached +129 on May 15. Across Morningstar's coverage universe, our credit analysts generally hold a balanced view that corporate credit risk will either remain stable or improve slightly, but that tightening credit spreads will generally be offset by an increase in idiosyncratic risk (debt-funded M&A, increased shareholder activism, and so on).
The new issue market was relatively quiet last week, as only a few issuers braved the headlines to bring deals to the market. The transactions that came to market were originally talked at somewhat attractive concessions to existing trading levels. Due to strong demand, these whispered concessions mostly disappeared when the deals were priced and the bonds performed well in the secondary market. Fund inflows are pressuring portfolio managers to put cash to work, but there has not been enough new issuance to satisfy demand. We think last week's successful offerings, tightening credit spreads, and lower interest rates will prompt other issuers and underwriters to bring more new issues to market this week.
With new issue market volume moribund over the past few weeks, investors have only had the secondary market in which to invest cash. Bonds from well-regarded issuers that were offered for sale in the secondary market immediately found buyers. While most bonds quickly traded, there is still a batch of bonds on offer that haven't traded. These bonds have largely been picked over, and there is a reason those bonds haven't traded (typically due to either weak credit quality or other catalyst-driven concerns). While it's tempting to reach for additional spread in this environment, we caution investors to remain judicious. Several of those issues we have seen offered that haven't been bought quickly are on our Bonds to Avoid list.
Earnings Season Gets Under Way; Too Early to Discern Investment Themes
With the government back to work (at least until January) and the debt ceiling suspended (until February), the political rhetoric emanating from Washington will subside (until December) and allow investors to concentrate on third-quarter earnings and fourth-quarter guidance. It's too early in the earnings season to discern any recurring themes in third-quarter results or fourth-quarter guidance. In fact, earnings, guidance, and capital-allocation decisions have thus far varied greatly.
The oil-services sector has performed well, as Schlumberger (SLB) (rating: A+, wide moat) and Baker Hughes (BHI) (rating: BBB+, no moat) both reported strong revenue growth and said they expect exploration and production spending to increase in 2014. Medical device maker St. Jude Medical (STJ) (rating: AA-, wide moat) maintained positive operating trends in the third quarter as sales grew 3% and adjusted earnings rose about 8%. The firm's notes remain on our Best Ideas list, as St. Jude's 2023 notes are indicated around 118 basis points over the nearest Treasury while Medtronic's 2023s are indicated around 89 basis points over the nearest Treasury. While we recognize Medtronic's better credit profile with a one-notch differential in our ratings, we do not believe that difference is enough to warrant nearly 30 basis points worth of spread differential in those notes.
Thus far this quarter, on the downside we moved our assessment of Textron (TXT) (rating: BBB-, narrow moat) to market weight from overweight as the firm reported weak results. This is primarily driven by low deliveries of Cessna aircraft, as well as its lowered earnings forecast for the year. Yum Brands' (YUM) (rating: BBB+, narrow moat) third-quarter update revealed that the recovery in its China division has stalled, and we are concerned from a credit perspective that lease-adjusted leverage rose to just over 3 times from 2.7 times. While we continue to project that earnings will improve and believe leverage will return to 2.7 by year-end, we will closely monitor the firm's performance for any further deterioration of credit metrics.
One of the most common themes over the past two years has been the willingness for issuers to increase debt leverage to fund large share buybacks, and we continue to see examples of this. For example, comments from Quest Diagnostics (DGX) (rating: BBB+, narrow moat) and LabCorp (LH) (rating: BBB+, narrow moat) on their earnings calls led us to place both companies on our Potential Supply list as they may issue new bonds to fund share-repurchase programs. However, we are starting to see a divergence from the debt-funded share-buyback theme as some companies are beginning to shore up their balance sheets in anticipation of a possible economic slowdown.
Intel's (INTC) (rating: AA, wide moat) third-quarter results were roughly in line with our expectations. However, from a capital-allocation perspective, Intel's actions have been friendly to bondholders. The firm continues to hold share repurchases at a very low level versus the recent past, allowing cash to build, and acquisition spending has also been modest this year. We previously recommended Intel's bonds on our Best Ideas list, and we continue to recommend investors overweight the bonds. Intel's 2.70% notes due in 2022 have traded recently at +104 basis points to the nearest Treasury, which we view as roughly 20 basis points too wide. We have long preferred Intel's bonds to those of International Business Machines (IBM) (rating AA-, wide moat), which reported disappointing third-quarter earnings as the firm continues to struggle to reinvigorate growth in key product categories.
QE for as Far as the Eye Can See?
Quantitative easing may be with us a lot longer than most investors had thought. In September, we discussed why March 2014 might be the first realistic opportunity for the Federal Reserve to begin tapering its asset-purchase program. Depending on how much the economy was affected during the fourth quarter by the government shutdown and whether we go through another shutdown come January, we can envision a scenario in which the Fed could hold off on tapering until the June meeting.
There is no chance that the Fed will begin to taper after its October meeting. The shutdown has disrupted the collection and dissemination of too many economic indicators, and there is too much confusion as to the short-term impact the government shutdown will have on the economy. Robert Johnson, Morningstar's director of economic analysis, estimates that fourth-quarter GDP could be one fourth to one half a percentage point lower than it otherwise would have been.
As part of the agreement to suspend the debt ceiling and fund government expenditures, Congress agreed to formulate a commission to negotiate a budget plan for the next 10 years by Dec. 13. The Federal Open Market Committee's December meeting is scheduled for Dec. 17-18, a few days after the deadline for this budget proposal. If this commission is unable to agree to a budget proposal by its deadline, it could lead to heightened concern that Congress may once again force a government shutdown in January. The Fed may not want to begin reducing liquidity or risk rising interest rates as another shutdown would impair first-quarter economic and job growth.
The January 2014 FOMC meeting is scheduled for Jan. 28-29, after the expiration of the Jan. 15 deadline that government expenditures are funded through. If the government goes through another shutdown, then once again it may preclude the Fed from beginning to taper. This decision to hold off would be based on the duration of the shutdown, the effect it may have on economic and job growth, and whether it appears another debt ceiling battle is looming, as the debt ceiling suspension expires Feb. 7.
The March FOMC meeting (the first meeting that the next chairperson is scheduled to take over) is March 18-19. If we have suffered another shutdown and debt ceiling battle that negatively affects first-quarter economic and job growth, the Fed may decide to hold its asset-purchase program steady.
The FOMC's April meeting does not include an update of the summary of economic projections and press conference by the chairman, and the Fed may not wish to make such a major change in policy without providing the data and forecasts behind such as decision and without having the ability to explain its decision in a press conference. Thus, in this scenario, the June meeting would the first realistic opportunity the Fed would have to begin reducing its purchase program.
Click to see our summary of recent movements among credit risk indicators.
New Issue Notes
CSX's New 10-Year Bonds Look Fair Based on Initial Price Talk (Oct. 17)
CSX (CSX) (rating: BBB+, wide moat) is in the market with a $500 million 10-year senior note offering. The firm has a $200 million bond due in February that it may be refinancing, and CSX paid down $779 million in debt year to date through the third quarter. Initial price talk around +120 looks fair. In comparison, Eastern railroad peer Norfolk Southern's (NSC) (rating: BBB+, wide moat) 10-year bond issued in February is currently indicated at about +119 to the nearest Treasury, which we also view as fair. Western railroad competitor Union Pacific's (UNP) (rating: A-, wide moat) 10-year bonds issued in January are indicated at about +103 to the nearest Treasury, which also looks fair. UNP posted very strong earnings today.
Yesterday, CSX reported solid third-quarter earnings and indicated that annual net income is likely to modestly exceed the prior-year level despite ongoing coal weakness. The rail increased its top line 4%, but about half of this growth was from liquidated damages in coal contracts. Weak coal demand is no surprise for investors following railroads; 7% lower quarterly volume and 2% lower price pushed coal hauling revenue down 9%. Year-to-date coal volume also is down 9%, and both international oversupply and high Southern domestic stockpiles persist.
More encouragingly, the rail increased carloads 5%-6% in its two noncoal segments--merchandise and intermodal--leading to growth of 2.7% in consolidated units and 3.1% in gross ton miles. We think there's room for a bit more optimism near term too. Within merchandise, agricultural volume improved just 1% year over year, and we expect sharper gains during the fourth quarter when the firm laps volume weakened by the 2012 drought. We also continue to expect intermodal to be the principal secular volume driver because the rails are taking share from trucking and can do so even in a weak economy. The 5.6% intermodal unit growth in the period pushed year-to-date volume to 3.5% above 2012 year-to-date levels and slightly above our projected 3.0% growth for this year and coming years.
Operations performed well, by reducing road crew starts by 2.9% and operations head count by 4%, even while hauling the aforementioned 3.1% greater ton miles. We attribute the 100-basis-point unfavorable quarterly operating ratio of 71.5% to a mix richer in intermodal and leaner in high-margin coal. Same-railroad core pricing improved 1% all in, but 3% excluding coal. The 70.2% nine month operating ratio was flat to 70.1% in 2012, and just a notch better than the 71.0% we model for the full year. The balance sheet remains in good shape for our BBB+ rating, with TD/EBITDA for the latest 12-month period at 2.0 times, as the firm reduced total debt by about $300 million during the quarter. During the quarter, the company generated free cash flow (after capital expenditures of $602 million) of $318 million, which was used for dividends ($152 million) and share repurchases ($129 million). Leverage is likely to remain around 2 times as management continues to steer free cash flow toward shareholders.
Packaging Corporation of America Issues Senior Notes to Fund Boise Acquisition (Oct. 15)
Packaging Corporation of America (PKG) (rating: BBB, no moat) today announced details regarding its issuance of new debt to fund the acquisition of Boise and refinance its outstanding term loans. The $2.0 billion financing includes a combination of 5- and 7-year term loans (totaling $1.5 billion) and $500 million in new 10-year senior notes. This is consistent with expectations for funding the acquisition, and as outlined in our recent credit report raises the company's total debt to $2.6 billion and PKG's pro forma total debt/EBITDA to 3.0 times.
Initial price talk for the new senior notes of +212.5 to +225 appears attractive when compared with PKG's current outstanding 3.9% senior notes due 2022 trading around 197 basis points over the nearest Treasury and the Morningstar Industrial Index's BBB tranche at 187 over Treasuries. The price talk is also attractive compared with similar-rated International Paper (IP) (rating: BBB, no moat), whose 4.75% notes due 2022 currently trade about 153 basis points over the nearest Treasury, which we view as rich. We think fair value for the new issue is around +185-190 basis points.
We note that PKG is implementing a debt structure heavily balanced to bank debt. This is not surprising, given management's prior statements that it plans to use free cash flow to reduce outstanding debt by as much as $1 billion during the next three to four years. This structure offers the flexibility to execute this plan. Our forecasts indicate this is achievable and will reduce the company's total leverage to below 2 times during the next five years.
Click here to see more new bond issuance for the week ended Oct. 18, 2013.