Our Outlook for the Credit Markets
The corporate bond market will probably struggle to return much above break-even in 2014.
Fixed-Income Markets Struggled in 2013 as Rising Interest Rates Led to Losses
While rising interest rates have taken their toll on the fixed-income markets this year, we opined last quarter that investors were poised to recapture some losses suffered earlier in the year. Since then, the Morningstar Corporate Bond Index has recaptured 155 basis points of its losses and is down only 1.44% year to date through Dec. 16. Among other fixed-income classes, our US Treasury Index has declined 2.37%, the US Agency Index has decreased 0.80%, and our Mortgage Bond Index has lost 0.59% thus far in 2013. The only indexes that have registered gains this year have been our short-term indexes, as the Federal Reserve has continued to hold short-term interest rates near historic lows.
Losses in our corporate bond index have been driven by an increase in long-term interest rates and only partially offset by a slight tightening in corporate credit spreads. In May, when the 10-year Treasury was below 2%, we said that as we got closer to the Fed beginning to taper its asset purchase program, interest rates would begin to normalize and rise toward historical spreads over inflation and inflation expectations. Since the beginning of the year, the yield of the 10-year Treasury has risen 109 basis points to 2.85%, and we think it has further to rise.
Based on three of the metrics we watch (the spread between current inflation and interest rates, inflation expectations, and the steepness of the Treasury curve) we think the normalized yield on the 10-year Treasury should be closer to around 4%. While the path the Fed takes to reduce and then finally conclude its asset purchase program is highly uncertain, we expect that long-term rates will rise and return to normalized levels by the time the Fed is close to ending its asset purchases.
Returns in 2014 Will Be Constrained by Tight Credit Spreads and Rising Interest Rates
In our base scenario, the corporate bond market will probably struggle to return much above break-even in 2014. With interest rates poised to rise further and credit spreads at their tightest levels since the end of the 2008-09 credit crisis, we expect rising rates to largely offset the yield corporate bonds currently offer. Even with the increase in interest rates this year, the average yield of the Morningstar Corporate Bond Index is 3.15%, not much higher than the lows it hit earlier this year. Based on the current yield and the impact of rolling down the curve, anything greater than a 75-basis-point of increase in interest rates would result in losses again in 2014 (excluding any change in credit spreads).
In our opinion, the most likely upside scenario is that corporate bonds produce low-single-digit returns. In this case, we assume that interest rates remain in a narrow trading range and that corporate credit spreads tighten slightly. In order to generate higher returns than low single digits, one would have to assume that interest rates decline back toward their historic lows and/or credit spreads tighten toward their precredit crisis historic lows. However, such an outcome seems highly unlikely to us unless the U.S. were to lapse into a recession.
In the fall of 2012, we changed our recommendation on corporate bonds to a neutral (or market weight) view from overweight as we thought credit spreads were fairly valued based on our outlook for credit risk. Over the past year, the average credit spread in the Morningstar Corporate Bond Index has traded in a relatively narrow range between +126 and +167 basis points, with an average of +141. In our Market Outlook fourth-quarter 2013, we highlighted our expectation that corporate credit spreads would be pushed toward the bottom of the trading range by the end of the year. As of Dec. 16, the average spread of our index is +126, its lowest level this year, and in fact, the tightest level since before the 2008-09 credit crisis. Although we are back at the tights, it appears that in the short term, the path of least resistance is tighter still. However, from a fundamental viewpoint, we think that the preponderance of credit spread tightening has run its course.
We continue to believe that from a fundamental, long-term perspective, corporate credit spreads are fairly valued in this trading range. Across our coverage universe, our credit analysts generally have a balanced view that corporate credit risk will either remain stable or improve slightly, but that the tightening in credit spreads on those names will likely be offset by an increase in idiosyncratic risk (debt-funded mergers and acquisitions, increased shareholder activism, etc.).
However, this paradigm could rapidly change if interest rates were to spike higher as the Federal Reserve reduces its asset purchase program. In that case, we would expect a repeat of last summer’s chain of events in May and June, when the 10-year Treasury yield rose about 100 basis points. Corporate credit spreads quickly widened out as portfolio managers looked to sell long-term bonds to reduce duration and dodge the brunt of losses from rising yields. Over those two months, the average spread in the Morningstar Corporate Bond index widened 30 basis points, peaking at +167, its widest level for the year.
Looking further back, since the beginning of 2000, the average credit spread within our index is +174, and the median is +156. Currently, credit spreads are 50 basis points wider than the lowest levels reached before the 2008-09 credit crisis. While credit spreads may continue to compress, we don’t anticipate returning to anywhere near those pre-credit-crisis lows. At that time, credit spreads were lower than they should have been because of an overabundance of structured credit vehicles which were created to slice and dice credit risk into numerous tranches, artificially pushing 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 the long term, we expect interest rates to normalize toward historical metrics. Three of the metrics we watch include the spread between current inflation and interest rates, inflation expectations, and the steepness of the Treasury curve. Historically, the yield on 10-year Treasury bond has averaged 200 to 250 basis points over a rolling three-month inflation rate. Even with inflation at the unusually low rate of 1.2%, the yield on the 10-year Treasury could increase to 3.20%-3.70% to reach historical norms.
While we expect interest rates to normalize at higher levels as asset purchases decline, we are not overly concerned that the rise in interest rates will overshoot too much above historical averages. Currently, the spread between the 2-year and 10-year Treasury bond is nearing its widest levels. Since the 2-year bond is highly correlated to short-term interest rates and the Federal Reserve is planning on keeping the Federal Funds rate near zero until sometime late in 2015, the yield of the 2-year Treasury bond should be well anchored. Based on where this spread has historically peaked, the 10-year yield could increase another 50 basis points over the 2-year before beginning to breach its prior ceiling. With the Fed pledging to keep short-term rates near zero until late 2015, we think the 2/10s curve can widen even further and create an even steeper yield curve than we have seen historically.
After peaking in November 2012--a few months after the most recent quantitative easing program had been launched--market implied inflation expectations have been generally declining. With inflation expectations, based on the five-year/five-year forward break-even measure, near the middle of their historical range it should also moderate any rise in rates. However, after the Fed surprised the market with its decision to leave the existing asset purchase program in place in September, the decline in inflation expectations appears to have bottomed out and could begin to rise again.
Financials Outperform in 2013 and May Lead the Way Again in Early 2014
The financial sector handily outperformed industrials and utilities in 2013. Year to date, the option-adjusted spread for the financial sector has tightened 33 basis points compared with the industrials sector, which has tightened only 5 basis points, and the utilities sector, which tightened 13 basis points.
2013 was the first year since the 2008-09 credit crisis in which the financial sector has traded tighter than industrials. Currently, the spread between the sectors is 12 basis points, whereas before the credit crisis, the average spread differential was 40 basis points and had traded as wide as 112 basis points. While we don’t expect the spread differential to return back to the historical wides, we do think that the financial sector will outperform in a low-volatility world where idiosyncratic risk is of greater concern than systemic risk. Within the financial sector, credit quality continues to improve as loan losses abate and capital levels rise. We believe the risk of shareholder friendly actions in the financial sector is lower than the industrial sector as regulators are unlikely to alleviate capital restrictions imposed upon banks any time soon.
The media sector was the worst-performing sector in 2013, widening out 14 basis points. The widening was predominantly because of the buyout of Virgin Media, rumored buyout of Time Warner Cable (rating: BBB-, wide moat), as well as the impact from Viacom (rating: BBB+, narrow moat), which substantially raised its debt leverage target in order to fund share buybacks.
Credit Risk Outlook Appears Benign in Short Term, but Risks Remain
While risks to the corporate bond market appear benign, there are several downside threats lurking. With credit spreads already at lower than average levels and interest rates near historic lows, portfolio managers will need to be especially nimble in 2014 to outperform. In 2014, successful portfolio managers will need to carefully time when to reach for yield to capture additional carry to outperform their index, but will also need to keep one finger above the sell button to reduce risk when events warrant lower credit risk exposure. While volatility is currently very low, when markets correct to the downside, they rarely correct in a gradual fashion but rather in a step function.
As interest rates normalize, we think there is a significant probability that rates may rapidly rise in a replay of last May and June, when the 10-year Treasury rose 100 basis points and credit spreads widened 30 basis points as portfolio managers sold long-term corporate bonds to reduce duration and dodge the brunt of losses from rising yields.
Throughout 2013, we have highlighted that idiosyncratic risk leading to downgrades and issuer-specific credit spread widening was the greatest threat to corporate bond investors. Considering that Robert Johnson, our Director of Economic Analysis, expects gross domestic product growth in 2014 between 2.0 to 2.5%, we don’t foresee a material increase in defaults or cash flow compression resulting from a recession, which could push spreads wider. As such, we expect idiosyncratic credit risk to once again be the greatest determinant of differentiated portfolio returns. However, we don’t believe that idiosyncratic risk will be any greater in 2014 than in 2013. As interest rates rise, debt-funded share buybacks become less attractive. In addition, with the increase in equity valuations, elevated enterprise valuation to EBITDA multiples are limiting the prospects for M&A activity and leverage buyouts. For example, Time Warner Cable, one of the biggest sufferers at the hands of idiosyncratic risk during 2013, may actually survive as an independent firm as its enterprise value has reached a multiple of EBITDA not seen since 2007. The firm’s growth prospects are much smaller today than six years ago. If the rumor-driven froth in TWC’s equity valuation ends up scaring off all would-be suitors, TWC bonds would likely dramatically outperform the broader corporate market. Still, strategic mergers and acquisitions and break-ups/spin-offs will likely comprise most issuer-specific risk in 2014.
Europe: While the economic contraction and systemic banking fears in Europe appear to have been put to rest, if the situation in Italy or Spain deteriorate again, it may lead to another bout of the systemic sovereign/banking crisis we experienced in 2012. In this event, the contagion would probably spread to the financial sector in the U.S. as credit counterparty risk rises. While European Central Bank President Mario Draghi has assuaged the markets for now with his pledge to do whatever it takes to preserve the euro, the Outright Monetary Transactions (OMT) program has not been stress-tested. In addition, German objections to the program could render it ineffective if it were called upon to provide financial assistance to a sovereign borrower that has lost access to the public debt markets. In such a situation, we would expect credit spreads to widen back to the top of the recent trading range, with spreads in the financial sector widening further and faster than the nonfinancial sectors.
The rate of GDP growth in the euro area faltered in the third quarter as real GDP only rose by a meager 0.1%, as compared to the 0.3% growth reported in the second quarter. The second-quarter GDP growth was the first time the euro area had reported positive GDP growth since the third quarter of 2011. Germany’s GDP growth rate fell to 0.3% in the third quarter of 2013 from 0.7% in the prior quarter, and France stumbled to a 0.1% decline for the quarter after having grown 0.5% in the second quarter. Offsetting some of the weakness in the larger economies, several of the southern, peripheral economies showed improvement. Spanish GDP grew by 0.1%--its first positive report since the second quarter of 2011. Italy continued to struggle as its GDP was revised to flat for the third quarter from an earlier estimate of a 0.1% decline, but the rate of decline has now decreased sequentially for the past three quarters.
In order to support economic growth and assuage deflationary fears, the ECB, in a surprise decision, cut its main short-term rate by 25 basis points on Nov. 7. The European Commission cut its forecast for 2014 GDP to 1.1% growth in the eurozone, marking the second forecast reduction the EC has made this year (it cut is forecast in May to 1.2% from 1.4%). The EC also increased its unemployment estimate to 12.2% next year from 12.1%. Because of stagnant economic growth, S&P cut its credit rating for France by one notch to AA. S&P stated that lower economic growth is constraining the country's ability to shore up its credit quality. If the eurozone is unable to sustain positive economic growth, we are concerned that this downgrade may be the beginning of a reassessment of the credit quality of other European countries as well. Peripheral European sovereign bonds have performed extremely well this year. Since the beginning of 2013, the spread between Spanish and German bonds has tightened 169 basis points to a current spread of +226. The spread on Italian bonds over German bonds has also tightened substantially, having declined 97 basis points to +221.
While investors are betting that the economies of those two countries have bottomed, the banking systems of both have remained under pressure as nonperforming loans continue to grow. Intesa Sanpaolo (rating: BB-, no moat) reported that in the third quarter, gross nonperforming loans grew to 15.9% of total loans compared with 12.7% in the year-ago period. UniCredit (rating: BBB-, narrow moat) reported that its nonperforming loans grew to 14% compared with 12% last year. In Spain, doubtful loans have grown every month since the end of 2012, while at the same time, the total amount of loans outstanding has steadily decreased. At the end of August, doubtful loans were 12.1% of total loans outstanding compared with 10.5% last year. While doubtful loans are growing in the country’s banking system, the credit quality of the country continues to deteriorate as well. The Bank of Spain has reported that debt/GDP has continued to climb, reaching 93.4%. The country expects debt to increase next year as well, taking the country’s debt/GDP ratio up to 100%.
China: China served up a double helping of happy headlines in the fourth quarter of 2013—a sequential uptick in GDP growth for the third quarter and a broadly reformist policy road map, adopted at the third plenum. Heading into 2014, sentiment surrounding the world’s second-largest economy has taken on a decidedly more bullish tone. We’d suggest more caution is warranted. A look under the hood of the robust GDP growth figure reveals that infrastructure and real estate supplied much of the horsepower, hardly indicating a transition to the consumer-oriented growth Beijing is hoping to engineer. Meanwhile, total credit expanded at twice the pace of nominal GDP, increasing the fragility of China’s financial system. Swollen debt burdens at state-owned enterprises and local governments will make it difficult to meet some of the policy objectives laid out in the post-plenum decision, slowing the pace of much-needed reforms. If infrastructure growth were to drop precipitously, we would expect global commodity prices to decline substantially and the Chinese banking system to contract considerably. In this scenario, we would expect the Basic Materials sector to suffer the most. While very little of the U.S. economy depends directly on exports to China, credit spreads would probably widen because of the impact from lower global GDP growth.
Strongest Upgrade/Downgrade Ratio Since Third-Quarter 2011
While the pace of our rating changes declined to the slowest rate since the third quarter of 2011, ratings upgrades significantly outpaced downgrades during the fourth quarter. For every downgrade this past quarter, there were 1.5 upgrades. Upgrades were driven by a combination of changes among our assessment of business risk as well as declining debt leverage. For example, our Business Risk score improved for Basf (rating: A, narrow moat) and for E.I. du Pont de Nemours (rating: A-, narrow moat), leading to credit rating upgrades for both issuers. We upgraded Basf’s economic moat to narrow based on the firm’s cost advantages and intangible assets. E.I. du Pont Nemours is planning to spin off its performance chemicals business. We view this transaction as a further step in transitioning DuPont to a more focused specialty chemical company and believe that separating from the performance chemicals business improves overall business risk by lowering the cyclicality of company operations.
Our other upgrades were mainly driven by deleveraging. Since making a large, debt-funded acquisition in 2010, Merck KGaA (rating: A, narrow moat) has steadily reduced its debt such that leverage has declined to 1.2 times from 2 times. Endo Health Solutions (rating: BB, narrow moat) has announced that it is using equity to fund an acquisition, which will help the firm diversify its product portfolio, and since the combined entity will be domiciled in Ireland, the firm will substantially reduce the firm’s ongoing tax rate. We upgraded USG (rating: B+, narrow moat) two notches because of the recent conversion to equity of $325 million of its $400 million 10% convertible bonds outstanding, in conjunction with a sharp improvement in USG's financial metrics subsequent to 2011 and our expectation of continued growth. Lastly, we upgraded Cummins (rating A-, narrow moat) as our financial estimates were revised higher, leading to lower forecast debt leverage.
Our downgrades were driven by idiosyncratic problems. We downgraded Packaging Corporation of America (rating: BBB, no moat) after the firm announced it was making a large debt-funded acquisition that we estimate will increase debt leverage to about 3 times from less than 1 times. While traffic declines in the casual dining sector has been widespread, the volatility of sales trends at Darden's core brands relative to industry peers remains troubling and suggests a continuation of ineffective promotional strategies that plagued results for much of fiscal 2013. As a result, we expect operating margins will range between 7%-8% over the medium term and lease-adjusted leverage will remain above 3 times as compared to the mid-2 times level it has been over the past few years.
We downgraded Teva Pharmaceutical (rating: A-, narrow moat) because of the looming marketing exclusivity loss on its largest drug, Copaxone (which accounts for 20% of its sales and nearly half of the firm's operating profits), in 2014. In addition to our concerns about the firm’s ability to offset the impact from Copaxone, in a surprise move, the CEO resigned because of differences in strategic vision with the board. Finally, we downgraded our credit rating for retail pharmacy Walgreen (rating: BBB-, no moat) to BBB- from BBB to reflect its ongoing investment activities and relatively high lease-adjusted leverage. In early 2013, Walgreen planned an investment in AmerisourceBergen, which came on top of its 2012 investment in Alliance Boots. We believe both of those investments are being made in response to Walgreen's weakening competitive position, and we recently cut our moat rating to none from narrow on the firm. In 2012, Walgreen purchased a 45% stake in Alliance Boots, a European health and beauty retailer and international drug wholesaler. Walgreen retains the option to purchase the remaining 55% of Alliance Boots by 2015. Also, Walgreen plans to take up to a 23% ownership stake in drug distributor AmerisourceBergen by 2017. With those recent and planned investment activities, we estimate Walgreen's lease-adjusted debt/EBITDAR will remain above 3 times through 2017.
Energy Fourth-Quarter Credit Rating Commentary
In the energy sector, during the fourth quarter we launched credit ratings on two companies and placed one company under review because of a large acquisition. In the exploration and production subsector, we initiated Halcon Resources (no moat) with a B- issuer credit rating. Our rating reflects Halcon's lack of an economic moat and its debt-fueled expansion, which resulted in substantial debt levels and very weak credit metrics, partially offset by the firm's rapid growth in production and EBITDA. Halcon remains a speculative credit as the firm seeks to delineate resources on its acquired acreage. In the midstream subsector, we initiated Cheniere Energy Partners (wide moat) with a B+ issuer credit rating. Our rating is supported by the significant funding already secured to finance construction of the Sabine Pass liquefaction facility in Louisiana offset by the significant amount of debt amassed to fund the construction, the risk of construction delays, and the counterparty risk of Cheniere's customers. As operations at Cheniere's liquefied natural gas facility are scheduled to begin in late 2016, Cheniere near-term outlook will be driven by the firm hitting construction milestones. Also in the midstream subsector, we placed our BB- issuer credit rating of Regency Energy Partners (no moat) under review after the company announced a merger agreement pursuant to which Regency will acquire midstream company PVR Partners for approximately $5.6 billion.
Sector Updates and Top Bond Picks
Major chemical conglomerates continue to reallocate their asset portfolios to specialty chemicals and away from commodity chemicals. Recently, Dow Chemical (rating: BBB, no moat) gave more details on plans to carve out a portion of its commodity chemicals business, specifically, assets in the chlorine value chain. Additionally, E.I. du Pont de Nemours has announced that it will separate its performance chemical segment from the rest of the company in a tax-free spin-off to shareholders. We expect large chemical companies to keep trimming commodity products from their portfolios. In general, we think this is a sound strategy assuming the company receives a fair price.
Uncertainty continues to surround the agricultural input markets as Russian Uralkali's late-July decision to leave the cartel-like Belarusian Potash Company and pursue a volume-over-price strategy has continued to roil markets. Producer profits have suffered from a lack of buyer interest in potash, as dealers and large purchasing countries hold out for lower expected prices. Price pressure has also affected nitrogen and phosphate fertilizer markets. In nitrogen, high urea imports from China have pressured prices, and in phosphate, major buyers have taken a step back from purchasing. Over the longer run, we think demand will normalize, probably as soon as next year. That said, there is still a fair amount of uncertainty regarding the path of future potash prices.
Supported by solid Chinese demand growth, prices for iron ore, the mining industry's biggest moneymaker, traded in the $130s for much of the fourth quarter. Through November, Chinese steel production was up 7.8% from last year, underpinned by renewed strong growth in infrastructure and real estate. Benchmark-grade iron ore has averaged $135 per metric ton year to date, slightly higher than our original forecast of $133. Looking ahead to the first quarter, the potential for cold weather, constraints at Chinese mines, and seasonally wet conditions in Brazil and Australia are reasons for tightness. However, with inventories of iron ore at Chinese ports up significantly from this time last year, we see iron ore prices on a downward trajectory as new supply hits the market. We expect prices to average $115 for 2014 before hitting our long-term price expectation of $96 in 2015. For the Big Three producers, BHP, Rio Tinto, and Vale (rating: BBB+, narrow moat), we expect profits to remain robust. We continue to recommend avoiding high-cost producer Cliffs Natural Resources (rating: BB+, no moat) as we see these trends putting continued pressure on its bonds.
Contributed by Dale Burrow
For the coming quarter, we are closely watching acquisition activity, along with our usual issues of debt-funded share repurchases and dividends. We remain concerned that firms will impair their credit qualities in an attempt to grow revenue or return cash to shareholders. Gannett (rating: BB/UR, narrow moat), R.R. Donnelley (rating: BB, no moat), Advance Auto Parts (rating: BBB-, no moat), and Hanesbrands (rating: BBB-, no moat) have all leveraged up over the past quarter to fund acquisitions. VF Corp.'s (rating: A, narrow moat) leverage has recently returned to pre-Timberland acquisition levels, but management has hinted that its leverage may rise again for a debt-funded acquisition. We are also concerned that Costco (rating: AA-, narrow moat) may be considering capital structure changes. We were left dismayed by management's response to a question on getting "more aggressive" on share repurchases given the low leverage level. The firm's response was that the board discusses this quarterly and to "stay tuned" for the next quarterly update. With lease-adjusted leverage around 1.6 times, we believe the firm has roughly $2 billion of additional debt capacity within its current AA- credit rating. This would bring leverage to just over 2 times. Any more debt taken on to reward shareholders in excess of this estimated amount could have a negative impact on our credit rating.
With these worries, we applaud those companies that continually reiterate their commitments to their credit qualities. In a recent earnings call, AutoZone (rating: BBB, narrow moat) specifically highlighted its commitment to a BBB credit rating and intends to hold lease-adjusted leverage in the mid-2 times range toward this goal. Disney (rating: A+, wide moat) plans to accelerate its share-repurchase activity but will not sacrifice its credit rating. Target (rating: A, no moat) has reported sluggish results and pulled back on share repurchases, calling out its commitment to the strong A credit rating as being a driving force behind the level of share repurchases. Ralph Lauren (rating: A, narrow moat) recently highlighted its commitment to the current credit rating and stated that capital spending priorities within the constraints of the rating are investing in the business and returning excess cash to shareholders.
Contributed by Joscelyn MacKay
For the sector, in 2014 we expect sales growth to only marginally exceed nominal GDP growth rates and operating income growth to range in the mid- to high single digits. With organic growth opportunities sluggish and cash balances building, management teams are increasingly feeling the pressure to deploy capital and we expect companies will continue to pursue strategic mergers and acquisitions. However, we expect that most transactions will be centered on smaller, strategic acquisitions rather than large, transformational or private equity sponsored deals. Firms will likely continue putting excess cash to use by building out their distribution platforms at home and abroad, and pursuing smaller, bolt-on transactions.
We expect that heightened competitive pressures will persist throughout the household and personal-care space in 2014. Value-conscious consumers are continually increasing their shopping across multiple competitors in many different channels, no doubt a function of minimal customer switching costs--a phenomenon that is evident around the world. As consumers seek out lower price channels, either through the Internet or from discount stores, traditional retailers are becoming more aggressive on price to fight for market share. As such, the traditional retail channel is pressuring consumer products companies to share in the margin contraction by providing additional marketing support and price cuts, or by investing in new product innovation to drive sales.
In such an environment, we believe it is increasingly important to invest in those firms with demonstrable wide economic moats that have the wherewithal and strong brands to fend off this pressure from the traditional retail channel. One such example is Clorox (rating: A-, wide moat), whose bonds we recommend as an overweight. Partially due to our assessment that the firm has a wide economic moat, we rate Clorox one notch higher than both of the rating agencies. Clorox operates with market-leading brands and a relative cost advantage, which in combination allow the firm to sustain leading market share and generate solid returns and excess cash flow. Clorox's brand strength is undeniable, as nearly 90% of its portfolio holds the number-one or -two spot in the aisle. Further, Clorox ensures that its strong competitive position remains intact by investing significant resources behind its brands and this spending is yielding market share gains.
Currently, Clorox’s 3.05% senior notes due in 2022 yield 3.85%, representing a +117-basis-point spread over the nearest Treasury. While the notes are not cheap enough to warrant a place on our Best Ideas list, we think the bonds are cheap compared with other A- rated bonds within the consumer defensive sector such as Kellogg’s (rating: A-, narrow moat) 3.125% senior notes due in 2022, which trade at +108. Clorox’s notes are also cheap compared with the average A- rated credit spread within the Industrials segment of the Morningstar Corporate Bond Index, which is +104.
Contributed by Dave Sekera, CFA
In our fourth-quarter outlook, we focused on two near-term issues; natural gas price volatility and crude price differentials in the U.S. We continue focus on these key themes and also highlight building concerns in the offshore drilling market.
The outlook for natural gas prices remains promising although the recent run-up in spot prices following an early season blast of cold air across the country leaves little room for further gains. Natural gas storage level of 3,533 billion cubic feet as of Dec. 6 is over 7% below the 2012 level at this time and 3% lower than the five-year average level. Offsetting this positive data point, natural gas production volumes have remained stubbornly high and are on an upward trajectory. While we have a positive view of industrial and power generation demand in the long term, these sources of incremental demand will not grow fast enough to offset production gains in the near term. As a result, unless the country experiences unseasonably cold temperatures, the recent rally in natural gas prices will be short lived. Cimarex Energy (rating: BBB–, narrow moat) and Chesapeake Energy (rating: B+, narrow moat) should benefit from the recent move higher in spot prices.
In the refining sector, credit spreads regained some of their third quarter widening as the price differential between West Texas Intermediate and Brent crudes, which is a key determinant of refining profitability, expanded to more than $13 per barrel. While a $13 differential is roughly in line with our long-term estimate and will lead to sustainable profitability for U.S. refiners, the differential remains volatile. As such, despite tightening in the fourth quarter, we believe that spreads on refiners' debt fail to fully reflect the fundamental improvement in domestic refining. We project that the WTI/Brent differential will begin to stabilize in 2014, leading to further spread tightening in the first quarter.
Offshore drillers reported solid third-quarter earnings which lead to spread tightening across the sector in the fourth quarter. With spreads now roughly 10 to 15 basis points wide of the tight levels reached in early 2013, we recommend investors exercise caution as the long-term outlook for day rates is less certain than it was at the start of the year. We note growing concern in the market about a potential oversupply of deep-water rigs toward the end of 2014, given the large number of newbuild deliveries. We are also tracking an increase in rig mobilizations, which will lower utilization levels and day rates, as rigs move to regions where demand is greatest.
Contributed by David Schivell
Third-quarter 2013 saw continued improvement in credit costs and asset quality across U.S. banks. For instance, according to FDIC data (FDIC Quarterly Banking Profile, Third Quarter 2012), net charge-offs have improved nearly 50% from third-quarter 2012 levels to represent 0.6% of total loans and leases, the lowest level since third-quarter 2007. Similarly, provisions for loan losses were 60.4% lower than the year-earlier period, representing the smallest quarterly loss provision reported by the industry since the third quarter of 1999. Lower provisions have been a significant contributor to earnings year to date in 2013. Similarly, asset quality, as measured by noncurrent assets plus other real estate owned to assets, improved to an annualized rate of 1.75% from a peak of 3.37% reached in 2009. Finally, capital is at modern-era highs of 11.38% for all FDIC-insured institutions from 9.62% in 2008. We expect the combination of modest economic growth in the first quarter of 2014, tight lending standards, and continuing regulatory scrutiny to maintain these trends beneficial to bank profitability. However, the rate of improvement during 2014 is likely to slow, limiting their impact on the bottom line. Finally, we see the risk of shareholder-friendly releveraging in financial issuers as less than in nonfinancial issuers because of capital restrictions imposed on banks by regulators.
In November, Moody’s resolved its negative watch on the eight G-SIFI banks by downgrading the senior holding company ratings of JPMorgan Chase, Bank of New York Mellon, State Street, Goldman Sachs, and Morgan Stanley due to removing all U.S. government support included in the ratings. Moody’s believes that the US bank resolution tools, supported by the Dodd-Frank Act Title II OLA/SPE, have improved. Under this framework, regulators would impose losses on bank holding company creditors to recapitalize and preserve the operations of the bank’s operating subsidiaries. This position emphasized our long-held belief that bank-level (operating company) subordinate debt is structurally senior to holding company senior debt and as a result, should trade at least on top of senior holding company debt. Although this class of debt is difficult to find, we continue to recommend the Regions Bank 7.50% subordinated note due in May 2018, which trade approximately 35 basis points wide of the 2% Regions Financial (rating: BBB, no moat) holding company senior notes due in 2018. We also like the bank-level JPM Chase & Co. 6.00% subordinated note due in July, 2017, which trades approximately 30 basis points wide of JPMorgan (rating: A, narrow moat) 2% due in 2017 indicated at +103 to the nearest Treasury. Similarly, we believe the PNC Bank NA 2.95% subordinated debt due in 2023, which trades approximately 20 basis points wide of the PNC Financial Services Group 3.3% senior holding company debt due in 2023 indicated at +110 to the nearest Treasury, is attractive. Despite the high coupons, we like the Suntrust Bank subordinated 7.25% note due in March 2018, which trades approximately 20 basis points wide of the SunTrust Banks (rating: BBB, no moat), which are indicated at +115 to the nearest Treasury. In time, we believe that regulators could apply the OLA/SPE framework to regional banks, in which case, investors should continue to emphasize bank-level debt over holding company debt.
Contributed by Chris Baker
In early 2014, the Affordable Care Act will usher in major changes to the U.S. health-care system. This reform effort aims to expand coverage to the uninsured (increasing volume) while also bending the health-care cost curve (pressuring prices), creating an overall neutral effect in the long-run for most industry players. However, we see some downside risks at health-care service providers and managed-care organizations. For service providers, being on the front lines of the expected ACA pricing pressure may cause some profitability hiccups, especially in the near term. Since most of the service providers we cover are highly leveraged, we believe bond investors should remain cautious with firms like HCA (rating: B+, no moat) and Kindred Healthcare (rating: B-, no moat) in early 2014. Also, the ACA will negatively affect managed-care profitability primarily through standardization initiatives, minimum medical loss ratios, and less-profitable Medicare Advantage contracts. In an industry where profitability looks set to contract, we believe bond investors should focus on the most profitable and most advantaged managed-care organizations, which are UnitedHealth (rating: A-, narrow moat) and WellPoint (rating: BBB+, narrow moat), as they will likely have more room for error in this changing landscape.
While more immune to the ACA than service providers and managed-care organizations, other health-care niches are dealing with slow growth outlooks because of unrelated fundamental factors, such as a steep patent cliff in pharmaceuticals. During this weak growth period, we believe management teams have incentive to boost growth through debt-funded acquisitions or to appease shareholders through higher dividends and share repurchases. In the large pharmaceutical niche, we recognize AstraZeneca (rating: AA-, wide moat), Eli Lilly (rating: AA, wide moat), and Pfizer (rating: AA, wide moat) as having the weakest fundamental outlooks in the industry and, therefore, the most incentive to pursue such activities, which could cut into their credit profiles going forward. On our Bonds to Avoid list, Mylan MYL (rating: BB+, narrow moat) also has incentive to pursue activities that could hurt its credit metrics, in our opinion.
Contributed by Julie Stralow, CFA
After a solid November, we expect strong December auto sales in the U.S. and expect this momentum to flow into 2014 in part because of cheap credit available to consumers combined with ongoing pent-up demand. Our constructive thesis on the auto sector continues to play out and we have seen more names rise to investment grade from junk. Most recently, Best Idea Delphi (rating: BBB, narrow moat) got raised a notch to BBB- by S&P. This follows TRW Automotive’s (rating: BBB-, no moat) upgrade by S&P in a similar manner in September. We had generally maintained overweight views on TRW ahead of its most recent 10-year offering, which priced aggressively. Additionally, former Best Idea Ford (rating: BBB-, no moat) continues to rally sharply after its September upgrade to investment grade by S&P to levels arguably better than a BBB, and we moved to market weight. We see better value elsewhere and added BorgWarner (rating: A-, narrow moat) and AutoNation (rating: BBB-, narrow moat) to our Best Ideas. We expect generally favorable domestic trends to support AutoNation’s leading dealer network, and global growth and emerging regulatory environment to support BorgWarner. We’ve highlighted bonds maturing in under seven years for these names, which could reduce downside risk either from tight sector spreads backing up or higher overall interest rates.
We continue to expect the homebuilding industry to move higher off the extreme lows realized during the long, drawn-out downturn. Starts remain below 1 million units--far short of the normalized range of 1.5 million--as higher mortgage rates have caused a pause in order growth. We expect more fits and starts in the near term as we approach the important spring selling season with the prospects of tapering and higher rates on the horizon. Indeed, on Toll Brothers’ (rating: BBB-, no moat) recent earnings call management highlighted that the industry has been “flat” since Aug. 1. The success of the spring selling season, which begins the week before the Super Bowl, will provide a better indicator for the health of the new-home market. We expect the recent pause will prove to be just that and not housing recession round two, given recovering household formations, a gradual strengthening of the economy, and historically still-supportive housing affordability. We remain overweight Toll, which leveraged up to make a $1.6 billion cash acquisition of Shapell Industries but is now focused on debt reduction. We continue to view Toll’s land position and focus on the luxury market as favorable relative to the current industry dynamics.
The aerospace and defense subsectors should continue to move in opposite directions as strong commercial order activity supports the former while mandated budget cuts hinder the latter. Costly fuel and the renewed financial strength of underlying airline customers has driven the backlog at Boeing (rating: A, narrow moat) and EADS (rating: A-, narrow moat) to record levels, which will flow through to free cash flow. That said, we view both as fairly valued. Our defense credits face ongoing cuts from sequestration and look likely to post top-line declines in the 5% area in 2014. These companies have done a fantastic job managing margins to minimize the impact. However, increasing share repurchases and dividends are resulting in softer credit metrics. We see the best value in BAE Systems (rating: BBB+, narrow moat), whose 144a yankee bonds provide a nice premium to the peer group. We are also monitoring Textron (TXT) (rating: BBB-, narrow moat), which is a prospective buyer of Beechcraft. Depending on this deal and the financial structure, we believe Textron could represent an interesting investment opportunity that could play out during the quarter.
Contributed by Rick Tauber, CFA, CPA
Technology and Telecommunications
Spreads have generally tightened across both the telecom and technology sectors over the past quarter. Of note, Verizon’s (VZ) (rating: BBB, narrow moat) mammoth debt offering has continued to trade well, with its 5.15% notes due in 2023 tightening another 20 basis points to +146 to the nearest Treasury, or 80 basis points tighter than where they were offered last September. AT&T (T) (rating: A-, narrow moat) has followed Verizon tighter, but not to the same degree, as investors apparently remain concerned with the prospect of a European acquisition. We don’t share this concern. AT&T continues to maintain that its interest in Europe is primarily based on valuations. We believe the fact that AT&T hasn't moved on a transaction in Europe, more than a year after initially indicating its interest, demonstrates that management is taking a disciplined approach to any investment. More broadly, AT&T has consistently reiterated that maintaining an A- rating is a priority for the firm. We believe AT&T bonds are attractive, including its 2.625% notes due in 2022, which trade at +132 basis points to the nearest Treasury.
Hewlett-Packard (HPQ) (rating: BBB+, narrow moat), which is on our Investment Grade Best Ideas list, has tightened more over the past three months than any other technology firm we cover. While the PC and printing segments remain a drag on HP’s results, the rate of decline in these businesses moderated during the firm’s fiscal fourth quarter (ended October). In addition, the enterprise group posted revenue growth for the first time in several quarters, with strength across industry standard servers, networking, and storage. More importantly, HP wrapped up the fiscal year with another quarter of solid cash generation and debt reduction. We expect HP to continue to modestly trim debt over the next year while looking to improve its competitive position in key enterprise segments. The firm has reached its goal of pushing net operating company debt to zero, providing some flexibility to begin seeking strategic acquisitions during 2014. While certainly not as attractive as a quarter ago, we believe the firm’s bonds still have room to tighten another 20 basis points or so.
Time Warner Cable (rating: BBB-, wide moat) has been the biggest exception to the general tightening trend across the tech and telecom group as M&A rumors around the firm have heated up recently. Heavily leveraged Charter Communications (CHTR) (not rated) is apparently readying an offer for TWC, which would almost certainly drag TWC into high-yield territory. TWC bonds now trade as if a move to high yield is a foregone conclusion. The firm’s 4.0% notes due in 2021 yield 5.4%, or a spread of +305 basis points to the nearest Treasury. CCO Holdings, Charter’s primary subsidiary, has 5.25% notes due in 2022 that carry a yield-to-worst of about 6.3%, a spread of about +367 basis points. The CCO notes have nearly a full turn of structurally senior and/or secured debt in front of them, while the TWC notes contain provisions that sharply restrict the amount of secured debt that TWC can issue. While we believe there are legitimate reasons for Charter to pursue TWC, we also believe that current equity valuations make it challenging to put a deal together. As such, the TWC bonds present a compelling risk/reward proposition.
Contributed by Michael Hodel, CFA
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 and the air toxics rule, or MATS (finalized in December 2011). In 2013, the EPA updated stringent emission limits affecting new coal- and oil-fired power plants, effectively killing any economic incentive to build new coal plants in the U.S. While CSAPR was fully vacated in 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 2013 petitioned the Supreme Court to review the D.C. Circuit's decision. In June 2013, the Supreme Court granted the U.S. petition to review the Circuit Court's decision, and in September 2013, the U.S. filed its opening merits brief. 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. We believe these two rules are likely to raise costs for consumers and place increased rate pressure on regulated utilities. Additionally, we believe President Barack Obama will provide continued support for carbon emission and renewable energy regulations as outlined in, “The President’s Climate Action Plan.”
Despite environmental compliance risks, we continue to view fully regulated utilities as a defensive safe haven for investors skittish about ongoing domestic and Eurozone induced market volatility. As economic and geopolitical uncertainties begin to fade in 2014, we expect moderate spread contraction, particularly down the credit quality spectrum. However, given historically tight parent company spreads on higher-quality utilities facing lackluster growth, we continue to urge bond investors to approach investment-grade utilities with caution. We advise utility investors to focus on shorter- to medium-term durations, as any Treasury rate increase in 2014 could quickly erode spread outperformance, given historically tight trading levels. Moreover, we believe investors seeking yield should tread lightly when considering opportunities within diversified utilities. We believe elevated downgrade risks exist, given continued weakness at unregulated genco subsidiaries, and specifically highlight FirstEnergy (FE) (rating BBB-, narrow moat) as a possible source of concern in the new year.
We expect high-quality, fully regulated utility issuers to maintain their elevated pace of debt market issuance into the first-quarter 2014, taking advantage of low rates to refinance or prefinance maintenance, environmental, and rate base growth capital investments. However, the timing of debt-funded environmental capital expenditures will remain highly dependent on the severity of ongoing regulatory rulings, implementation timelines, and energy-efficiency initiatives. Finally, we believe utilities are eager to secure financing ahead of expected Federal Reserve monetary policy changes in 2014.
Unregulated independent power producers continue to face high uncertainty in 2014. Power prices will remain severely strained as long as natural gas prices remain low. Excess natural gas supply and an unseasonably warm 2013-14 winter could push gas prices, currently hovering around the $4.41/mmBtu mark, back down to 2012's historical lows ($1.91/mmBtu). While we maintain our $5.40/mcf midcycle gas price estimate going into 2014, we recognize that independent power producers' margins will continue to experience pressure over the near to medium term. On the other hand, we note moderately declining natural gas storage levels, totaling 3,533 billion cubic feet (as of Dec. 6, 2013), are now 3% below their five-year average of 3,642 billion cubic feet (and down 7% year over year). Moreover, we believe coal prices will generally remain under pressure in 2014 as myriad environmental regulations stymie coal demand.
We continue to expect stand-alone and embedded merchant power producers (within diversified utilities) to experience elevated liquidity constraints, particularly power producers that own uncontrolled coal plants as well as those that have substantial leverage. Specifically, we believe Energy Future Holdings (formerly TXU Corp.) will file for Chapter 11 bankruptcy, likely by the first-quarter 2014 due to an insolvency opinion, creating one of the largest bankruptcies in U.S. history (about $47 billion of debt). We also believe Ameren's (AEE) (rating: BBB-, narrow moat) sale of its merchant Energy Resources Generating Company to Dynegy reflects the changing utility landscape (that is, reduced diversified utility operators) despite our belief that select coal generation should garner much higher asset values in the future (dollar per kW).
While we expect company-level M&A activity to moderate in 2014, we anticipate robust renewables deal activity to fuel the ongoing creation and expansion of industry-wide Yieldco structures. Given high demand-for long-term contracted renewable assets (via PPAs), we highlight independent power producer NRG Energy’s (NRG) (rating: BB-, no moat) fourth-quarter 2013 proposed acquisition of Edison International’s (EIX) (rating: UR+/BBB-, narrow moat) merchant subsidiary, Edison Mission Energy, out of bankruptcy for $2.6 billion (expected first-quarter 2014 close). Moreover, we expect continued renewables deal activity to fuel the growth of TransAlta Renewables and to support the development of NextEra Energy’s (NEE) (rating: BBB+, narrow moat) anticipated Yieldco structure in 2014.
Contributed by Joseph DeSapri
Our Top Bond Picks
We pick bonds on a relative-value basis. Typically, this means comparing a bond's spread with 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
|Data as of Dec. 13, 2013.
Price, yield, and spread are provided by Advantage Data.
SABMiller (rating: A, wide moat)
SABMiller issued several benchmark-size bonds in January 2012 to finance the acquisition of Foster's Group. While leverage did increase appreciably to finance this acquisition, we believe the firm will continue to repay debt and return to pre-acquisition leverage by 2015. We previously opined that the existing trading levels for SABMiller were cheap for the rating and relative to its competitors in the beverage sector, such as Anheuser-Busch Inbev (BUD) (rating: A-, wide moat). Anheuser-Busch's 2.625% senior notes due in 2023 are indicated at +90, whereas SAB's 3.75% senior notes due in 2022 are trading at +115 and SAB's 4.95% senior notes due in 2042 are indicated at +115. As leverage at SAB declines, we think the notes will continue to tighten toward Anheuser-Busch InBev's levels. SAB's 2035s look particularly attractive as they trade significantly wider than the on-the-run bonds.
BorgWarner (rating: A-, narrow moat)
Our credit rating on BorgWarner is one to two notches higher than the rating agencies in part because of our narrow economic moat assessment. The firm has maintained modest gross leverage of about 1 times over the years and has a highly impressive record even through the recent downturns of maintaining positive free cash flow and earnings. We believe the firm is well positioned to take advantage of global auto regulations around fuel economies and emissions, which should result in steady growth over our forecast horizon. We see good value in the notes listed above, which are indicated well wide of supplier Johnson Controls’ (JCI) (rating: BBB+, narrow moat) 3.75% senior notes due in 2021 at +138 over the nearest Treasury, which we view as fair.
Express Scripts (rating: A-, wide moat)
Express Scripts has met its deleveraging goal of 2 times net debt/EBITDA within 18 months of the Medco acquisition, which closed in April 2012. As of September, the firm’s net debt/EBITDA stood at 1.9 times on a trailing 12-month basis by our estimates. While we do not expect Express Scripts to actively deleverage further, especially given its large share-repurchase program, we see upgrade potential in the agencies’ ratings even if the firm sustains its current debt leverage, which would be a spread-tightening catalyst, in our opinion. On a lease-adjusted basis, Express Scripts’ debt leverage just dropped below key peer CVS Caremark’s leverage. However, CVS Caremark’s 2023s have been launched at 125 basis points over Treasuries, creating an attractive relative value opportunity for Express Scripts bond investors in our opinion. We believe Express Scripts notes should trade inside CVS’ notes, and we see significant spread tightening potential (about 30 basis points) in Express Scripts’ notes if they were to trade at our fair value of +115 basis points over the nearest Treasury.
Maxim Integrated Products (rating: A+, wide moat)
We believe Maxim is a stronger company than it may appear at first glance. The firm has a strong position in the high-performance analog semiconductor business. Analog chip design expertise is not easy to come by, so firms that have spent years developing proprietary designs and retaining experienced engineers have an advantage over new entrants. These designs do not rapidly evolve or require cutting-edge production techniques, which enables strong profitability. Maxim has entered more competitive markets in recent years, including the consumer electronics market. The firm has built a strong relationship with Samsung, which has introduced customer concentration risk and more volatile results. However, we believe the underlying high-performance analog business provides a stable base of business that the consumer market sometimes masks. Maxim’s 10-year notes trade at a spread more appropriate for a BBB rated issuer. We believe these notes should trade at least in line with Broadcom (rating: A, narrow moat) and Analog Devices (ADI) (rating: A+, wide moat), whose 10-year notes trade at +121 and +118 basis points to the nearest Treasury, respectively. We’d also note that Texas Instruments (TXN) (rating: A+, narrow moat) 10-year notes trade far tighter at +83 basis points to the nearest Treasury. While Texas Instruments is much larger than Maxim, it also carries more leverage.
AutoNation (rating: BBB-, narrow moat)
AutoNation is the premier auto dealer in our coverage group and the only one rated investment grade. The company’s recent record third-quarter earnings included revenue growth of nearly 14%. Management maintains a disciplined capital-allocation strategy with a priority of investing in the business and then returning cash to shareholders, while also keeping credit metrics solid. The company has maintained rent-adjusted leverage in the low-3 times area, where we expect it to stay. We believe investors are well compensated for the credit risks and highlight other auto comps such as TRW, whose 2021 maturity bonds trade at a spread of about +205 basis points over the nearest Treasury or Ford Motor Credit, whose intermediate-term bonds trade in the +150 area. AutoNation's 2018 bonds are indicated in the +200 area, and we see the 5.50% notes trading toward that level in the next year or so as they approach a five-year maturity.
More Quarter-End Outlook Reports
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