Corporate Bond Market Continues to Recapture Losses
The demand for corporate bonds should push corporate credit spreads tighter, says Morningstar's Dave Sekera.
The Morningstar Corporate Bond Index rose 0.50% last week based on a combination of tightening corporate credit spreads and declining interest rates. The average spread in the Morningstar Corporate Bond Index tightened 2 basis points to +136 and the yield on the 10-year Treasury bond declined 11 basis points to 2.50%. In our third-quarter corporate credit outlook published in September, we outlined why we thought corporate credit investors were poised to begin recapturing their losses suffered this summer, and we continue to think the corporate bond market will recover more in the short term. At its lowest point, the Morningstar Corporate Bond Index had declined 4.62% this year through Sept. 5, but has recaptured a substantial amount of that loss since then and is now only down 1.00%.
Interest rates are likely to continue to decline as a result of the Federal Reserve's ongoing asset-purchase program, while the demand for corporate bonds should push corporate credit spreads tighter. With fund flows into bond funds returning to positive territory and the Fed's quantitative easing increasingly removing Treasuries and mortgage-backed bonds from circulation, demand for corporate bonds will continue to improve. We expect corporate credit spreads will be pushed to the bottom of this year's trading range, which was +129 on May 15. The Fed's asset-purchase program will probably push the 10-year Treasury into a 2.25%-2.50% trading range until the market begins to believe, once again, that we are coming close to when the Fed will begin to taper. At that time, interest rates will quickly rise, as they did last summer, toward levels that are closer to historically normalized levels based on current inflation and inflation expectations.
Last week, the new issue market began to emerge from its hibernation of the past month. Issuance was led by the financial sector, as six banks brought new deals ranging from 3-year floating-rate notes to 30-year fixed-rate subordinated offerings. For example, Wells Fargo (WFC) (rating: A+, narrow moat) issued 5-year senior notes at 85 over Treasuries and 30-year subordinated notes at +170. While we thought both bonds offered attractive investment opportunities, we thought the 5-year tranche was a better value. Bristol-Myers Squibb (BMY) (rating: AA-, wide moat) also tapped the market, pricing $1.5 billion of notes consisting of 5-, 10-, and 30-year maturities. We rate Bristol-Myers one to two notches higher than the rating agencies, fueling our opinion that the original whisper talk on the bonds was about 15 basis points cheap. However, because of strong market demand, the official price guidance was tightened and the notes were eventually priced at +55, +87, and +92, respectively--nearly on top of our fair value estimates. At the current credit spread levels, we rate Bristol-Myers bonds market weight as the market is valuing the bonds more in line with our view of the credit risk than the rating agencies'. As we wind our way through the middle of earnings season this week, we expect tightening credit spreads and declining interest rates will prompt other issuers and underwriters to bring substantially more new issues to market.
Financial Sector Fully Valued; Media, Energy, and Basic Materials Still Have Upside
The average spread of the Morningstar Corporate Bond Index is currently 7 basis points wider than the tightest level of the year, reached May 15. With the Fed likely to continue its quantitative easing program as far as the eye can see, we think credit spreads will tighten back toward those low May levels as the Fed's newly created money searches for a home. In the financial sector, spreads have already reverted to their tights for the year. Issuers in the financial sector have not experienced the same negative issuer-specific catalysts, such as debt-funded acquisitions or large debt-funded share-buyback programs, which have led to credit spread widening among some industrial issuers. In fact, the credit profile of the banking subsector has generally continued to improve as loss provisions subside and credit metrics improve as the banks prepare for the higher capitalization requirements dictated by banking regulators.
The industrial sector is currently 12 basis points wider than the overall index as compared with last May. In the industrial sector, there are several subsectors that are comparatively wider, which may offer additional upside to investors. For example, media is 31 basis points wider than it was last May, energy is 16 basis points wider, and basic materials is 13 basis points wider.
There are a few other subsectors that are comparatively wider, but do not offer the same upside potential, in our view. The average spreads of the transportation and telecom subsectors are currently 22 and 19 basis points wider than on May 15; however, these sectors have more limited upside than these spreads may indicate. The average rating for both sectors has declined from A- to BBB+ levels because of downgrades in the sectors and the inclusion of lower-rated issuers. In telecom, notably, Verizon's (VZ) (rating: BBB, narrow moat) spreads have widened following the firm's decision to acquire the remainder of Verizon Wireless and its subsequent record-breaking $49 billion debt offering. Both rating agencies downgraded Verizon by one notch as a result of the increase in debt leverage. In addition, AT&T (T) (rating: A-, narrow moat) credit spreads widened out in sympathy with Verizon, which we believe has created an opportunity in its bonds.
New Issue Notes
Initial Price Talk Attractive on Bristol-Myers' New Offering (Oct. 24)
Bristol-Myers Squibb (rating: AA-, wide moat) is in the market offering about $1.5 billion in new 5-, 10-, and 30-year notes. The proceeds are earmarked for general corporate purposes, including the repayment of $470 million of its commercial paper borrowings. Also, Bristol has noted business development as its top priority for capital allocation activities, and it remains committed to its dividend. Initial price talk of 70, 100, and 105 basis points over Treasuries on the new bonds due in 2019, 2023, and 2044, respectively, look wider than we believe is fair. We view fair value around 55, 85, and 90 basis points over Treasuries, respectively.
Our view of fair value uses Bristol's own existing notes and similar-rated peers as a guide. For example, Bristol's current on-the-run issues are indicated at much slimmer spreads than initial price talk on the new issues, with indicated spreads of 45, 80, and 80 basis points over the nearest Treasury for Bristol's 2017s, 2022s, and 2042s, respectively. We also considered where other AA- rated pharmaceutical firms' issues are indicated, including Allergan (rating: AA-, wide moat), AstraZeneca (AZN) (rating: AA-, wide moat), Merck (MRK) (rating: AA-, wide moat), Roche (RHHBY) (rating: AA-, wide moat), and Sanofi (SNY) (rating: AA-, wide moat). On average, 5-year, 10-year, and 30-year spreads are around 55, 85, and 90 basis points over the nearest Treasuries, respectively, from these AA- rated issuers.
Overall, we think Bristol should be able to easily meet scheduled interest and principal payments during the foreseeable future, which contributes to its AA- rating. Although we see limited growth opportunities in the next few years due to recent and expected patent expirations, including Abilify (14% of sales) in 2015, other drugs and pipeline candidates should pick up the slack, keeping Bristol on solid financial footing. On top of its positive business characteristics, Bristol-Myers operates with light debt leverage (2.1 times gross debt/EBITDA and 0.3 times net debt/EBITDA on a trailing twelve month basis). At the end of September, the firm held $6.3 billion in cash and marketable securities compared with $7.2 billion in debt outstanding. This new debt issuance combined with the repayment of its commercial paper borrowings will increase gross debt/EBITDA by less than half a turn to about 2.4 times, and we do not believe these actions significantly change Bristol's credit profile.
Yum Coming to Debt Market to Fund Tender Offer of Outstanding Debt; Talk Fair (Oct. 22)
Yum (YUM) (rating: BBB+, narrow moat) is coming to market today with $600 million in 10- and 30-year notes. The firm also announced a tender offer for up to $525 million of its existing notes. Earlier this month when Yum reported third-quarter earnings, we noted that we were concerned from a credit perspective that lease-adjusted leverage rose to just over 3 times from 2.7 and that Yum remains committed to shareholder-friendly activities despite its softness in earnings. The firm reiterated its commitment to repurchasing $700 million in shares for this year, but we acknowledge that this is much lower than the nearly $1 billion repurchased last year. Also, last month, the firm announced a 10% increase to its dividend to roughly $685 million annually, up from $620 million. Still, we continue to project that earnings will improve and believe leverage will return to 2.7 by year-end. We are monitoring the situation for any further deterioration of credit metrics.
Initial price talk of +160 and +190 areas for the 10- and 30-year tranches, respectively, appears fair given the commitment to shareholder-friendly activities despite its softness in earnings and potential for deterioration in credit metrics. Price talk is also reasonable relative to similarly-rated consumer cyclical credits. Macy's (M) (rating: BBB, no moat), AutoZone (AZO) (rating: BBB, narrow moat), and O'Reilly (ORLY) (rating: BBB, no moat), all have 2023 notes that trade at 159, 148 and 156 basis points over the nearest Treasury, respectively. However, given our cautious outlook on the credit, we would need at least 20 basis points of spread widening for us to overweight Yum's bonds at this time.
Alliant Techsystems Offering $300 Million Senior Notes to Fund Bushnell Acquisition (Oct. 22)
Alliant Techsystems (rating: BB+, narrow moat) is offering $300 million of 8-year noncall 3 senior unsecured notes as a complement to its recent bank loan financings to fund its $1 billion purchase of Bushnell Group. ATK had previously established a $1 billion term loan A maturing in January 2018 and a $250 million term loan B maturing in January 2020 to take out its existing $320 million term loan B's as well as to provide cash to fund Bushnell. ATK also established a $600 million revolver, also due in 2018. The new bonds will be wedged between that $1.3 billion of senior secured bank debt and two senior subordinated notes totaling $550 million. ATK's $200 million 3.00% senior subordinated converts are callable and putable in August next year and are currently in the money with a strike price of about $77 versus the stock at $104. The full principal amount will be redeemed for cash with any additional value potentially settled in stock. ATK also has $350 million of 6.875% senior subordinated notes due 2020, which are first callable in September 2015. As a result, ATK has numerous triggers to pull to reduce debt over the next few years.
Pro forma total debt/EBITDA is 2.7 times, per our estimation, and management has indicated its intent to reduce leverage over time, as it has several times in the past. We estimate senior secured leverage of 1.6 times and total senior leverage of 2.0 times. We have maintained our BB+ issuer rating considering the favorable strategic implications from the Bushnell and Caliber acquisitions as well as our expectation for leverage to be reduced to more appropriate levels over time. Given this as well as the positioning of the bonds in the capital structure, we view fair value on the notes at about 5.00%. This represents a spread of about +275 basis points to the nearest Treasury. ATK's 6.875% senior subordinated notes are indicated at 5.18% to the 2015 call date. We view this as attractive yield-to-call paper, despite their subordination in the capital structure, considering the Merrill Lynch BB Index at 4.56%. Other peer comparables include Bombardier BBD (rating: BB+, narrow moat), whose 2022 maturity bonds yield 5.50% and provide a spread of +325 basis points to the nearest Treasury, which we view as attractive and support our overweight recommendation. Spirit AeroSystems' (SPR) (rating: BB, no moat) 2020 maturity notes, also subordinated to secured bank debt, offer a yield to the 2018 par call of 5.48% and a spread of +415, which we view as fair.
As we highlighted in early September, ATK announced that it will acquire Bushnell for about $1 billion--representing 10 times EBITDA--to expand once again in the sporting goods and accessories business. This follows the acquisition of Caliber on June 24 for $315 million in cash. The company's business mix continues to shift and, on a pro forma basis, the sporting group will represent 45% of total sales. The firm's legacy aerospace and defense units will constitute the remainder. Additionally, commercial and international sales will be about 50% of the total and thus reduce overall exposure to weak domestic defense spending. We view these transactions as strategically favorable and thus maintained our credit rating despite the higher leverage. Notably, we meaningfully increased our equity fair value estimate to reflect the improved cash flow prospects and valuation of the firm.
Union Pacific's 30-Year Bonds Look Fair After Solid 3Q Results
Union Pacific (UNP) (rating: A-, wide moat) is in the market with its second 30-year bond offering this year. The firm is offering $500 million senior notes with initial price talk of 115-120 basis points over Treasuries. UP has $691 million due in the next 12 months including a $311 million bond due in February. UP's $325 million 30-year notes issued in March are currently indicated at +109 to the nearest Treasury. Peer Canadian National's (CNI) (rating: A-, wide moat) 2042 notes are indicated at +101 to the nearest Treasury. Moving down slightly in credit quality, Norfolk Southern's (NSC) (rating: BBB+, wide moat) 30-year bond issued in August is indicated at +128. We view each of the above issues as roughly fairly valued, and thus would view fair value of the new UP bonds on top of the existings.
UP posted a best-ever 64.8% operating ratio for its third quarter, thereby pulling down the year-to-date OR by 150 basis points from the prior-year period to 66.5%. UP's OR was nearly 90% a decade ago and 76% just four years ago--the pace of railroad margin improvement has been astonishing, not only at UP, but also among the other historical margin laggards Kansas City Southern and Canadian Pacific. However, while each rail faces unique challenges, UP set new levels of profitability amid the adversity of weak coal and agriculture volumes (down 9% and 8% year to date).
UP increased revenue 4.6% year over year during the third quarter via 3.5% core price improvement and modest 1.1% volume and mix benefits. Gross ton miles per employee declined 2%, but salary and benefit expenses increased 1% despite flat carloads and 2% fewer revenue ton miles than in the prior-year period. While these numbers sound bad, we think this reflects staffing to offset attrition and complete capital projects; the rail improved productivity in other metrics. Pricing does work a wonder on margins, and UP expanded average revenue per car by 8.8% in autos, 9.5% in coal, and 5.3% overall. All in, we summarize the quarter as demonstrating solid execution and pricing power despite weak demand in important coal and agricultural commodities.
The balance sheet remains in good shape for our A- rating, with TD/EBITDA for the latest 12-month period at 1.1 times, as the firm reduced total debt by about $350 million during the quarter. UP generated free cash flow (after capital expenditures of $905 million) of $758 million, a nice improvement from the prior-year period of $530 million. However, this was more than consumed by dividends ($322 million) and share repurchases ($599 million).
Initial Price Talk on Well's 5- and 30-Year Notes Attractive, but We'd Prefer the 5-Year (Oct. 21)
Wells Fargo (rating: A+, narrow moat) is issuing two benchmark notes—5-year senior notes and 30-year subordinated notes. Both bonds are being issued at the holdco level. Initial price talk is +90-95 and +175 for the 5-year and 30-year bonds, respectively. We believe the whisper talk is cheap relative to comparable bonds and taking into account the firm's sound financial position. For instance, the Wells Fargo 3.50% senior bonds due 2022 are indicated at a spread of 96 over the nearest Treasury, putting the current price talk roughly on top of the 10-year notes. We peg fair value for the 5-year notes closer to +85. Accounting for both the subordination and longer maturity, we think fair value for the 30-year notes is closer to +170. Trading levels for Citigroup's (C) (rating: A-, narrow moat) 2.50% notes due 2018 and J.P. Morgan's (JPM) (rating: A, narrow moat) 1.625% notes due 2018 are indicated at 105 and 95 over Treasuries, respectively. Wells Fargo and several other banks, including Citigroup, are in the market this morning issuing notes to take advantage of the recent contraction in bank spreads.
We think the 30-year notes are modestly attractive despite their subordination. We assign Wells Fargo the highest credit rating among the large U.S. money-center banks. Our rating reflects Well's stellar banking operations and superior net interest margin. Further, we think Wells Fargo has a clear funding cost advantage as low-cost deposits fund its entire loan book and approximately 80% of its earning assets. The company also maintains sound capital levels as its Tier 1 common equity ratio of 10.6% on a Basel I basis and 9.5% on a Basel III basis. Therefore, we think that nearly 80 basis points of additional spread over the Wells Fargo 10-year bond is sufficient compensation for the junior position and 20 additional years of maturity.
Price Talk on Toyota Credit's New 5-Year Notes Looks Fair (Oct. 21)
Toyota Motor's (TM) (rating: A, no moat) finance subsidiary Toyota Motor Credit Corp. is in the market offering 5-year medium term notes. We view the credit of TMCC as similar to the parent due to a support agreement between Toyota and its finance subsidiaries as well as the inextricable linkage between the businesses. We view fair value on the new notes at 65 basis points over Treasuries, slightly inside initial price talk in the low 70s. Looking across auto finance subs, Honda's (HMC) (rating: A, no moat) subsidiary American Honda Finance issued 5-year notes earlier this month that are now indicated at 67 basis points above Treasuries, which we view as rich. Other auto finance subsidiary comparables include Daimler's (DDAIF) (rating: BBB+, no moat) recent 5-year indicated at +103 versus the nearest Treasury and Volkswagen's (VLKAY) (rating: A-, no moat) bond due November 2017 indicated at +77 versus the nearest Treasury. We view both of these as roughly fair.
We believe Toyota is at the front end of a multiyear period of solid sales and EBITDA growth that will put its financial position more in line with historical levels, positioning it well in the rating category. Toyota remains the dominant automaker in Japan and has strong leadership positions in hybrids and in the luxury market with Lexus. We believe the sharp recovery in fiscal 2013 will be followed by stable growth and margin expansion in fiscal 2014 and beyond based on improving auto markets, along with full production capability. We expect this to keep gross leverage below 0.5 times, with overall liquidity remaining very strong.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.