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Credit Insights

Benign News Flow Holds Corporate Credit Spreads Steady

So long as the Fed continues its asset-purchase program at the current run rate, we don't expect interest rates to rise meaningfully and think they will remain range-bound.

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The average corporate credit spread in the Morningstar Corporate Bond Index held steady, ending the week at +136. While a few earnings reports prompted some changes in our recommendations, earnings and news flow was mostly benign from a credit viewpoint. The release of the Federal Open Market Committee's minutes after the October meeting was a nonevent. The minutes included a few minor changes, but none that appeared to indicate any changes in the Fed's outlook. Economic data released this week continued to suggest softening economic growth, but Robert Johnson, Morningstar's director of economic analysis, sees GDP growth remaining around 2%.

The current credit spread in our index is only 7 basis points higher than the tightest spread of 2013, reached in May at +129 basis points. The tightest our index has traded at since the 2008-09 credit crisis was +128, in April 2010. In "Our Outlook for the Credit Markets," published in September with the index trading around +147 basis points, we opined that corporate credit spreads would be pushed back to the bottom of the year's trading range, +129-165 basis points, in the near term. We also expected that corporate bond investors were poised to recapture a significant amount of the losses experienced earlier this year. The Morningstar Corporate Bond Index rose 1.54% in October and is now only down 1.07% for the year. While corporate credit spreads in the United States haven't quite reached their tightest level of the year, spreads in Europe have. In fact, European corporate credit spreads are trading at their tightest levels since May 2010.


  - source: Morningstar Analysts

The yield on the 10-year Treasury bond rose 12 basis points last week to 2.62%; however, we don't expect rates will rise dramatically from here. The increase last week was probably a small bounce following the rapid 50-basis-point decrease from the recent peak in early September. So long as the Fed continues its asset-purchase program at the current run rate, we don't expect interest rates to rise meaningfully and think they will remain range-bound. However, once the markets again begin to believe that the Fed is nearing a decision to taper its purchases, we expect 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 sprang to life. Among the firms that we rate, almost $22 billion of new bonds were issued. Issuance was dominated by the consumer sector, as  Altria Group (MO) (rating: BBB, wide moat),  Coca-Cola (KO) (rating: AA-, wide moat),  Colgate-Palmolive (CL) (rating AA, wide moat), and  Procter & Gamble (PG) (rating: AA, wide moat) accounted for about half of the issuance. In our Potential New Issue Supply report published Sept. 9, we had identified Altria, Coke, and P&G as likely candidates to come to market in the near term. Our next Potential New Issue Supply report should be out later this week. With earnings season finishing up, we expect tight credit spreads and low interest rates will prompt other issuers and underwriters to bring substantially more new issues to market this week.

Notable Earnings Announcements and Recommendation Changes
Two companies on our Best Ideas list posted solid quarterly results last week.  Zimmer Holdings's (ZMH) (rating: AA, wide moat) organic growth continued to pick up, as the firm reported 6.7% growth in the third quarter compared with 5.5% in the second quarter and 1.0% in the first quarter.  Celgene's (CELG) (rating: A, narrow moat) core business remained strong in the third quarter as total revenue increased 18% in the quarter and we continue to wait for new products and pipeline candidates to diversify its product portfolio significantly. Also in the health-care sector, we maintained our overweight recommendation on  Gilead Sciences (GILD) (rating: A, narrow moat) based on building pipeline momentum. Gilead reported solid third-quarter results last week and a Food and Drug Administration panel endorsed the firm's key hepatitis C product candidate, which we expect will be approved for marketing in late 2013. Because of the large market potential of that product, which is outside Gilead's core HIV niche, we plan to increase our moat rating to wide from narrow if this drug is approved, which could also be a catalyst for upgrading Gilead's credit rating by a notch. Given that potential upgrade based on increasing product diversification and projected free cash flow growth, we think the credit spread of Gilead's bonds will tighten further.

In the industrials sector, we upgraded our recommendation on  Masco (MAS) (rating: BB, no moat) to market weight after the firm posted its third straight quarter of accelerating sales and EBITDA growth. For the third quarter, sales and EBITDA improved 12.4% and 38.0%, respectively, as all five operating segments posted solidly improved sales. Adjusted operating margins expanded 260 basis points to 10.3%, the eighth straight quarter of margin improvement. Masco also paid down a $200 million debt maturity with free cash flow. With that, last-12-months debt/EBITDA declined to 4.5 times, a sharp reduction from 6.0 times at year-end.

Among other changes in our recommendations last week, we reduced our recommendation on  TRW Automotive Holdings (TRW) (rating: BBB-; no moat) to market weight from overweight, as we do not see any additional catalysts for spread tightening given the recent S&P upgrade to investment grade, the likelihood of net leverage continuing to trend higher, and the potential for new issuance. While TRW posted strong third-quarter results, it also sharply increased its share-repurchase goals. TRW has bonds maturing in December and March, and we would not be surprised to see it refinance part of these maturities. We also cut our bond recommendation for  Teva Pharmaceutical Industries (TEVA) (rating: A/UR-, narrow moat) to market weight from overweight. We placed Teva's credit rating under review after the CEO resigned amid conflicts with the board. With the looming loss of its largest drug, Copaxone, in 2014, Teva had already faced significant transitional concerns. Now, the firm faces turmoil in its management ranks, which we believe may raise uncertainty around its stewardship and ongoing cash flows. Given these problems, the Business Risk pillar of our credit rating may weaken significantly, driving a potential downgrade in our credit rating.

Spanish Bonds Rally to Lowest Yield and Spread Since May 2010
Spanish sovereign bonds continued to rally, sending the yield on 10-year notes to 3.97% and the resulting spread to just 227 basis points over comparable German bonds (and only 134 basis points higher than U.S. Treasuries). Both the yield and spread are the lowest levels at which Spanish 10-year bonds have traded since May 2010. Spain's real GDP rose 0.1% in the third quarter from the second quarter, the first time Spain has registered positive quarter-on-quarter GDP growth since the first quarter of 2011.


Positive GDP growth helped to push the unemployment rate down 0.3%, yet the country's unemployment continued to hover at a staggering 26% in the third quarter. While rising GDP and declining unemployment are certainly good news for the beleaguered country, we hesitate to sound the all-clear signal for Spain's financial prognosis just yet. Even with the slight uptick in the third quarter, year-over-year GDP growth is still negative 1.2%, and nonperforming loans rose to new highs in August: According to the Bank of Spain, NPLs increased to 12.1% of outstanding loans compared with 12.0% in July and 10.5% a year ago. In addition, total loans outstanding decreased at a 12.3% annual pace in August, indicating that financing for small business continues to contract. While nonperforming loans and unemployment are often lagging indicators of economic growth, we'd still prefer to see these metrics decline before we become comfortable with the country's financial position.

Among other European sovereign bonds, the yield on Italian 10-year bonds decreased to 4.08%, resulting in a 238 basis point spread over German Bonds (and only 145 basis points below U.S. Treasuries). These levels are not all that far from the lowest yield and tightest credit spread that Italian bonds have reached since the European banking and sovereign debt crisis began in May 2010. The lowest yield on Italian bonds was 3.82% in May 2013, and the tightest spread was +230 in August 2013. Even Greek bonds have rallied strongly over the past few months as the world is awash with liquidity. The yield on Greek 10-year bonds decreased to 7.99%, representing a 630-basis-point spread over German bonds. The yield on Greek bonds was 11.70% just three months ago and more than 18% a year ago. However, we continue to believe Europe could face another bout of diminished confidence in its financial system, despite what the markets are currently saying.

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

New Issue Notes

Diamond Offshore to Issue 10-Year and 30-Year Debt; Initial Price Talk Looks Fair (Oct. 31)
 Diamond Offshore Drilling (DO) (rating: BBB+, no moat) announced Thursday that it plans to issue a total of $1 billion of new debt split between 10- and 30-year notes. The total issue amount will not grow. Use of proceeds is to refinance two $250 million bonds that mature in September 2014 and July 2015, and general corporate purposes, including funding construction rigs. Initial price talk on the new notes is +105-110 and +125 basis points respectively. We place fair value on the new 10-year notes at +110 basis points and at +125-130 basis points for the 30-year notes.

Diamond recently reported third-quarter results which were negatively affected by customer nonpayments. Diamond wrote off $23 million in bad debt expense related to Brazilian operator OGX, which just filed for bankruptcy protection, and it is attempting to collect a combined $70 million in revenue from OGX and Niko Resources. In addition, as of Oct. 23, Diamond's backlog stood at $7.4 billion, down from $8.4 billion at the end of the second quarter, partially due to more than $500 million of lost business from these two companies. While we expect more bad-debt write-offs in the fourth quarter, we believe 2014 will deliver improved results as several new-build rigs enter service. Thus we do not anticipate changing our issuer credit rating as a result of the OGX bankruptcy or the issues with Niko.

As of the third quarter, pro forma for the net addition of $500 million of debt from this offering, total leverage is 1.6 times compared with 1.1 times in the second quarter, while debt/capitalization increases to 30% from 24% last quarter. Including the new debt, we now estimate the ratio of EBITDA less capital expenditures/cash interest to be 3.5 times compared with 6.0 times in the second quarter. Diamond's large cash position helps offset these weaker credit metrics, as net leverage remains very low at 0.2 times on a pro forma basis. Based on our projections, we estimate year-end 2014 leverage to be around 1.5 times while net leverage increases to roughly 1.0 times.

Before the new issue announcement, Diamond's 5.875% notes due 2019 were quoted at 87 basis points above the nearest Treasury while its 5.70% notes due 2039 traded at +116 basis points, although the 2039 notes are constrained by a high dollar price. We view these levels as rich and had an underweight recommendation on Diamond due to expectations for increasing leverage and the issues with OGX and Niko. We believe  Baker Hughes (BHI) (rating: BBB+, no moat) is a fair comparable for Diamond. Baker Hughes has similar credit metrics to Diamond's pro forma metrics, but a better near-term fundamental outlook. Baker Hughes 3.20% notes due 2021 trade at a spread of +87 basis points over the nearest Treasury, while its 5.125% notes due 2040 trade at +101 basis points. We also have an underweight recommendation on Baker Hughes, placing fair value on its 3.20% notes at +105 basis points. Adjusting for the near-term issues facing Diamond, we peg fair value on the new 10-year notes at +110 basis points. Based on the 10s-30s curve for Baker Hughes, as well as the 10s-30s curve for lower-rated drillers, we believe Diamond's 10s-30s curve should be 15-20 basis points, which puts fair value for the new 30-year at +125-130 basis points.

More High-Rated Consumer Product Issuers Come to Market; P&G Issuing 3- and 5-Year Bonds (Oct. 30)
Procter & Gamble is reportedly in the market this morning offering new 3-year fixed-and/or floating-rate notes and 5-year bonds. Considering the firm has significant near-term debt maturities in January and February 2014, we had placed P&G on our Potential New Issue Supply report we published Sept. 9. Whisper price talk is +30 basis points on the 3-year tranche and in the low +50s for the 5-year tranche. Considering that Coca-Cola issued new 5-year notes at +42 yesterday and Colgate issued 5-year notes at +35 on Monday, we expect the official guidance to be tightened and that fair value on the new 5-year notes is 37 over Treasuries. Fair value on the 3-year fixed rate notes is 15-20 basis points tighter than the 5-years. In August, P&G issued 10-year notes at +60, which are currently trading at +57. We think the appropriate 5/10 curve for P&G is around 20 basis points.

Progress continues to be slow and steady at P&G, but we still regard the company as a wide-moat giant that enjoys the benefits of scale and unprecedented brand reach. While it's early in the firm's fiscal year, results are generally trending in line with the company's full-year expectations (for 3%-4% top-line growth and 5%-7% underlying earnings growth, which strike us as reasonable). Over our five-year forecast period, we project debt leverage will average 1.5 times and interest coverage will average in the mid-20s. Our forecast is based on our assumption that the top line will grow an average of 3.7% per year and the operating margin will expand by an average 200 basis points. We expect the firm's dividend payout ratio will average 55% and that the firm will utilize excess cash flow to repurchase about 2% of its outstanding shares each year.

Another high-rated comparable is Wal-Mart's WMT (rating: AA, wide moat) 1.95% senior notes due 2018, which are currently indicated at 50 basis points over the nearest Treasury. For the credit risk, we view these notes as slightly cheap. Within consumer products, for investors with a higher risk appetite, we think  Clorox (CLX) (rating: A-, narrow moat) is an attractive value for the credit risk. For example, Clorox's 2022 notes are indicated at about 114 over the nearest Treasury, roughly in line with the A- component of Morningstar's Corporate Bond Index. Given the defensive nature, we think Clorox should trade inside the index and rate the firm's notes as overweight.

LabCorp Issuing New Debt as Expected; Initial Price Talk Modestly Attractive (Oct. 29)
Diagnostic laboratory operator  LabCorp (LH) (rating: BBB+, narrow moat) is in the debt market issuing $700 million in new 5- and 10-year notes. Proceeds will be used to repay outstanding borrowings on its credit facility ($372 million) and for general corporate purposes, which we believe will include either share repurchases or potential acquisitions. At the end of September, the firm remained about half a turn below its net debt/EBITDA leverage target of 2.5 times. Given that target and management's recent statements regarding the potential for debt-funded share repurchases ($1.3 billion authorized) and acquisitions, this new debt issuance fits within our expectations.

Initial price talk looks modestly wider than we would expect for this firm at 140-145 basis points over Treasuries for the 5-year and 180-185 over Treasuries for the 10-year notes. We believe fair value is closer to where LabCorp's existing issues are indicated. Its 2017s are indicated around 120 basis points over the nearest Treasury while its 2022s are indicated around 165 basis points over the nearest Treasury. That would also be in line with issues from its key peer,  Quest Diagnostics (DGX) (rating: BBB+, narrow moat). For example, Quest's 2021s also are indicated around 165 basis points over the nearest Treasury. We currently maintain market weight bond recommendations on LabCorp and Quest. 

Coke's Whisper Talk Too Cheap; Expect Official Guidance to Tighten Meaningfully (Oct. 29)
Coca-Cola announced a bond offering consisting of 3-year fixed / floating, 5-, 7-, and 10-year notes, in benchmark size. Proceeds are expected to be used to repay $3.15 billion of short-term debt including the company's 0.75% notes due 2013, floating-rate notes due 2014, and 3.625% notes due 2014, as well as for general corporate purposes. Whisper talk on the new fixed rate notes is +35, +50, +70, and +80. Earlier this year, Coca-Cola issued 5-year and 10-year bonds that are currently trading at +36 and +48 to the nearest Treasury, respectively. The whisper talk is cheap compared with where the firm's existing bonds trade and where an AA issuer in the consumer product sector should be able to price a new bond deal; however, we expect that once official guidance is released, the spreads will tighten up meaningfully. Most recently, in the consumer product sector, Colgate, which we rate the same as Coke, priced a 5-year bond yesterday at +35. We rate Coke's bonds a market weight and think fair value for the firm's new issues is +22, +37, +47 and +57 for the 3-, 5-, 7-, and 10-year bonds, respectively.

While  PepsiCo (PEP) (rating: AA-, wide moat) is the closest comparable to Coke based on the rating and business similarities, Pepsi bonds trade significantly wider than Coke's bonds. Pepsi has been targeted by shareholder activists, which are attempting to pressure management into making changes to the company's business profile to try to enhance shareholder value. For example, rumors have circulated that Pepsi may acquire  Mondelez International (MDLZ) (rating: BBB, wide moat). If Pepsi were to make a debt-funded purchase of Mondelez, we would probably downgrade PepsiCo at least several notches; however, we do not believe PepsiCo will purchase Mondelez. There was also speculation that PepsiCo may split into two businesses. This also appears unlikely, as Pepsi's CEO has remained steadfast that the combined firm benefits from the "Power of One," having stated that the combined operation derives almost $1 billion per year of synergies. Pepsi's 2.75% senior notes due 2023 are currently trading at +102 to the nearest Treasury. While this spread is very attractive compared with the company's credit rating, we recommend only a market weight position on the Pepsi's notes until the overhang from this potential shareholder activism is lifted.

In the beverage sector, we continue to recommend overweighting  SABMiller (SBMRY) (rating: A, wide moat). We rate SABMiller two notches higher than the rating agencies and believe the firm's bonds will continue to tighten toward the levels of  Anheuser-Busch Inbev (BUD) (rating: A-, wide moat). SABMiller's 3.75% senior notes due 2022 are indicated at 119 over the nearest Treasury; whereas BUD's 2.625% senior notes due 2023 are trading at +85. SABMiller also has outstanding some off-the run bonds that it assumed when it bought Foster's, which are indicated at even wider levels. For example, the 5.875% senior notes due 2035 are marked by our pricing service at +153.

Calpine to Issue $490 Million of NC5 Senior Secured Notes Due 2024; We Expect Fair Value Around 6.0% (Oct. 29)
 Calpine (CPN) (rating: BB, no moat) announced today that it will sell $490 million of senior secured notes due 2024 in a private placement. It will use the proceeds to redeem 10% of the original aggregate principal amount of each series of its existing notes (other than its 7.25% senior secured notes due 2017). The notes will be guaranteed by each of Calpine's current and future subsidiaries that is a guarantor under Calpine's first-lien credit facilities. Calpine's existing senior secured bonds due 2023 currently yield 5.80% (509 basis points over the nearest Treasury) and trade to their next call date of 2017. This compares favorably with the Bank of America Merrill Lynch US High Yield Master II, which yields 5.71%. When compared with slightly lower-rated  NRG Energy's (NRG) (rating: BB-, no moat) senior unsecured notes due 2023, which yield 6.57% (561 basis points over the nearest Treasury) and trade to their next call date of 2017, we would expect fair value for Calpine's new issue to yield around 6.0% (or approximately 350 basis points over the 10-year Treasury).

We believe Calpine will ultimately benefit from the last week's vote by the Public Utility Commission of Texas supporting the development of a capacity market in Texas, which would allow incumbent power producers to receive payments for making their plant capacity available. However, a final decision will not be made until January, following publication of a power market study analyzing state resource adequacy. We anticipate implementation of a capacity market by 2016. We estimate a $100/MW-day change in midcycle capacity prices represents $257 million of incremental EBITDA.

Calpine reported a 15% decline in second-quarter adjusted EBITDA of $343 million versus $403 million as well as weaker adjusted free cash flow of $38 million versus $87 million year over year. Weak second-quarter adjusted EBITDA was due primarily to weak commodity mark to market results, particularly in Calpine's Texas (down 20%), North (down 10%), and Southeast (down 60%) markets. Weak performance was due to reduced generation output resulting from lower spark spreads, higher natural gas prices, and power plant sales (Riverside and Broad River). However, given portfolio and capacity payment timing shifts, we expect Calpine to report better operating performance in the third quarter (reporting Nov. 7), despite higher wind generation levels well as cooler weather in Calpine's operating territory.

USG in Market With New 8NC3 Senior Guaranteed Notes; Existing Notes Look Attractive (Oct. 28)
 USG (USG) (rating: B-, narrow moat) wasted no time after its strong third-quarter earnings results to tap the high-yield market to help fund its $500 million Boral joint venture. The company is offering $350 million of 8-year noncall 3 senior notes that will be guaranteed by the majority of its domestic subsidiaries. We believe these notes will be pari passu with the company's most recent issue, its 7.875% senior notes due 2020, as well as the 8.375% senior notes due 2018. These two bonds, plus the $59 million of 9.75% senior guaranteed notes due 2014, constitute $659 million of USG's $2.3 billion in debt. These bonds are all structurally senior in the capital structure to $1 billion of senior nonguaranteed notes due in 2016-18, as well as the $400 million 10% convertible notes that are callable in December. Through the third quarter, LTM total debt/EBITDA was 6.4 times, though the existing senior guaranteed notes leverage is 2.6 times (including industrial revenue bonds and other debt). Layering in the new bonds, leverage through the guaranteed notes would be 3.6 times, not including any EBITDA contribution from the Boral investment. The Boral deal is expected to close in January, although we note that these bonds will remain outstanding even if the deal doesn't close. We continue to have a constructive outlook on USG with upside ratings potential and also view the Boral investment as a positive strategic move.

Given our constructive view on the company and the new notes' positioning in the capital structure, we view fair value on the new notes at about 5.75%. This implies a spread of about 350 basis points over the nearest Treasury. USG's 7.875% notes currently offer a yield to the 2016 first call date of 5.00% and a spread to worst of +460, which we view as attractive. In the building products space, Masco's 2022 maturity senior notes are indicated at 5.15% and a spread of +291, which we view as rich. We note that Masco's gross leverage exceeds 5 times. We believe USG's new bonds should trade at tighter spreads than the overall high-yield market, which currently offers an OAS of +442 per the Merrill Lynch High Yield Master II Index, but somewhat wider than the BB index, which is currently at +315.

Colgate's 5-Year Notes Will Price at Fair Value; Wal-Mart Cheaper for Same Rating (Oct. 28)
Colgate-Palmolive is in the market today to issue $300 million of 5-year notes. The firm's existing 0.90% senior notes due 2018, issued in May, are currently trading around 30 basis points over the nearest Treasury. The firm's 2.10% senior notes due 2023, also issued in May, were last indicated at 63 basis points over the nearest Treasury. Early whisper talk on the new notes is +40; however, we expect the new issue will price at the current market level, which we view as fairly valued. We think Colgate's existing bonds are fairly valued as they currently trade tighter than equivalent-rated bonds, which is appropriate for a defensive consumer product issuer. Colgate is one of our highest-rated consumer product companies, with a wide economic moat (our AA rating is one notch higher than the rating agencies), and strong investor demand for high-rated bonds should push pricing to existing market levels. We currently rate the firm's bonds market weight.

For the same rating, we prefer  Wal-Mart Stores' (WMT) (rating: AA, wide moat) 1.95% senior notes due 2018, currently indicated at 50 basis points over the nearest Treasury, which we view as slightly cheap. For investors with a higher risk appetite, we think Clorox is a better value for the credit risk. For example, Clorox's 2022 notes are indicated at about 122 over the nearest Treasury, roughly 10 basis points wide of the A- component of Morningstar's Corporate Bond Index. Given the defensive nature, we think Clorox should trade inside the index and rate the firm's notes as an overweight.

For the third quarter, Colgate reported a 6% increase in sales driven by higher volume (5%) but more subdued price increases (1%). Growth was predominantly weighted toward emerging and developing markets (up 9.5%) as opposed to developed markets, which remained sluggish (up just 2%). The firm's relentless cost focus offset higher commodity costs, as the adjusted gross margin popped 40 basis points to 59.0% and the adjusted operating margin held flat at 23.9% (reflecting increased advertising investments, up 6%). We project debt leverage will average 1 times over our forecast period and interest coverage will average 36 times. We forecast Colgate's dividend payout ratio will average slightly over 50%, and we estimate the firm will repurchase 2% of shares annually.

Altria in Market to Fund Tender Offer; New Issue Guidance Leaves Some Upside (Oct. 28)
Altria is issuing debt consisting of 10-year and 30-year notes, in benchmark size. The proceeds will be used to fund the tender offer for the company's outstanding high coupon bonds. Altria was last in the market in April 2013 and issued 2.95% senior notes due 2023 (which were indicated at 125 over the nearest Treasury before this debt offering) and 4.50% senior notes due 2043 (which were indicated at 155 over the nearest Treasury). Subsequent to the announcement of today's offering, both bonds are currently being quoted 20 basis points wider in the secondary market. Guidance on the new issue is +155-160 for the 10-year and +175-180 for the 30-year. We think fair value on the new 10-year is +145, which would place the spread in line with the BBB+ component of our corporate bond index and closer to the historical spread differential of where Altria bonds have traded versus our index. Historically, due to their wide economic moats and the defensive nature of the category, tobacco companies have traded tighter than their ratings would otherwise suggest. We think fair value for the 30-year bonds is +165, 20 basis points wider than the 10-year bonds.

The closest pricing comparison to Altria is  Reynolds American (RAI) (rating: BBB, narrow moat). While we rate both firms the same, Altria's bonds should trade tighter than Reynolds as we believe Altria's Business Risk is lower due to the firm's wide economic moat as opposed to Reynolds' narrow economic moat. Reynolds' recently issued 4.85% senior notes due 2023 are trading at 152 over the nearest Treasury. Another tobacco peer is  Lorillard (LO) (rating: BBB, wide moat), whose 3.75% senior notes due 2023 are trading at 208 over the nearest Treasury. However, Lorillard's notes trades significantly wider than the other tobacco names as its revenue is highly dependent on the menthol category. The Food and Drug Administration has been examining the menthol category to determine if additional restrictions or an outright ban on menthol products should be instituted. We think an outright ban is highly unlikely and expect the FDA will impose greater restrictions on the marketing and perhaps the availability of menthol cigarettes, which is incorporated in our forecast. Nevertheless, any restrictions imposed on the menthol category are likely to hurt Lorillard more than its more diversified peers. Once the FDA releases its conclusions, and assuming our opinion is correct, we expect credit spreads for Lorillard's bonds to tighten significantly and trade at about a 25-basis-point discount to Altria. We view Lorillard's notes as an overweight. Another comparison to Altria is  British American Tobacco (BATS) (rating: BBB+, wide moat), which we rate one notch lower than the rating agencies, but one notch higher than Altria. British American's 3.25% senior notes due 2022 are indicated at 111 over the nearest Treasury, which we view as fairly valued. Finally, Philip Morris PM (rating: A-, wide moat), which is our highest rated tobacco company, has 2.625% senior notes due 2023 that are trading at 103 basis points over the nearest Treasury, which we view as fairly valued to slightly cheap.

Altria recently reported good third-quarter results, with its Marlboro brand increasing volume and holding share and its Copenhagen brand continuing to do very well. As the dominant player in the U.S. market with more than 50% share, Altria can generate the greatest economies of scale in the industry. Its iconic Marlboro brand has an exceptionally loyal following, with 90% of Marlboro smokers purchasing the brand 100% of the time. Over the long term, we forecast that cigarette volume will decline at a 3%-4% rate annually, but that decline will be more than offset by annual price increases. While the proposed tender offer may slightly increase the firm's debt leverage, we intend to hold our rating steady as the lower interest expense and longer debt profile of the new notes should improve our Cash Flow Cushion score.

Click here to see more new bond issuance for the week ended Nov. 1, 2013.

David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.