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Credit Insights

Corporate Bonds Largely Unchanged Following Fed Statement

New Best Idea highlighted, but otherwise, value hard to find.

While the corporate bond market awaited the Federal Reserve's statement following the September Federal Open Market Committee meeting with bated breath, the market reaction following its release was largely a nonevent. The Fed retained its "considerable time" language as to how long it will keep the federal funds rate at near zero, made a few minor changes to its economic projections, and released a separate statement regarding how the FOMC intends to normalize monetary policy. The market yawned at the news and credit spreads were largely unchanged last week. The 10-year Treasury ended the week at 2.59%, 2 basis points below where it ended the prior week. In the investment-grade sector, the average spread of the Morningstar Corporate Bond Index closed the week where it began at +110 bps. In the high-yield sector, the spread of the Bank of American Merrill Lynch High Yield Master II Index tightened 6 basis points to +397.

In the high-yield sector, junk bond mutual funds and exchange-traded funds suffered another outflow last week, totaling $1.2 billion. While this outflow was not enough to meaningfully affect credit spreads, if this trend continues, it could lead to weakness in the high-yield market as portfolio managers sell bonds to fund redemptions. In July and early August, credit spreads had widened 95 basis points from a low of +335 bps near the end of June to a high of +425 bps in early August.

New Best Idea Highlighted, but Otherwise, Value Hard to Find
We added Owens & Minor (OMI) (rating: BBB+, no moat) to our investment-grade Best Ideas list. The firm's new 7-year and 10-year notes are trading at +160 and +185, which we view as cheap based on our view of the company's credit risk. For example, our fair value estimate on the 10-year notes is +130 basis points, some 55 basis points tighter than where the bond currently trades. Our issuer rating is one notch higher than S&P's and three notches higher than Moody's, which rates the firm below investment grade at Ba1. Our BBB+ credit rating reflects the firm's solid cash flow prospects and manageable leverage. Owens & Minor operates in the mature, slow-growing medical and surgical supply market, where it distributes health-care products such as disposable gloves, syringes, sterile procedure trays, and surgical gowns. When accounting for its new debt issuance, we estimate its lease-adjusted debt/EBITDAR stands around 3 times. While elevated from its normal debt leverage in the low 2s, the firm has the opportunity to deleverage, primarily through profit growth.

Dollar-denominated new issue volume was light last week as most issuers did not want to tap the capital markets while investors waited for the statement from the September FOMC meeting. Value was similarly hard to find as only a few new issues appeared attractive to us. PNC Bank (PNC) (rating: A-, narrow moat) issued 3-year and 5-year senior bank-level notes at spreads of +45 and +63 basis points over Treasuries, respectively. While the 3-year priced at our fair value estimate, we think there is additional upside in the 5-year notes, where we think fair value is +55 basis points. PNC has emerged from the financial crisis as a larger and better-capitalized company with improving asset quality and profitability. Nonperforming loans ended the second quarter at 1.4% of total loans and trailing one-year net charge-offs finished at 0.4% of loans, down 33 basis points from the prior year. Profits are ahead of most peers with return on equity of 10.4% and return on assets of 1.3%. In addition to solid performance, PNC has doubled its size, expanded its territory, and remained focused on improving profitability through stronger expense controls.

Humana (HUM) (rating: BBB, no moat) issued 5-year, 10-year, and 30-year bonds to redeem existing debt and fund its share-repurchase program. The notes were priced at spreads of +85, +127, and +162. The 5-year and 10-year priced on top of our fair value estimate, but the 30-year bonds look attractive. Our fair value estimate on the 30-year bond is +150, which is 25 basis points higher than the 10-year fair value. Humana recently increased its share-buyback plan to $2 billion from $782 million; however, in our opinion, the increase in leverage to fund shareholder-friendly activities probably will not be enough to significantly damage its credit profile. We continue to think Humana will maintain a conservative balance sheet relative to its managed-care peers, which helps compensate for its lack of an economic moat.

We recommended investors shy away from Alcoa's (rating: BB+, no moat) new 5.125% senior notes due 2024, as we don't believe investors are being adequately compensated for the credit risk, and as such, we rate the firm's bonds as an underweight. Proceeds from the debt along with a convertible preferred stock issue and cash will be used to fund an acquisition. The company's recent financial performance has improved, allowing Alcoa to achieve a modest reduction in net leverage, moving it closer to its target range of 30%-35% debt/capital (35.4% at June 30); however, the new acquisition debt will push this level closer to 39% and net debt/adjusted EBITDA to 3.3 times. Though we expect the company to lower debt over our explicit forecast period, we do not believe Alcoa will return to its target range for an extended period.

Morningstar's Upgrades Outpace Downgrades Thus Far in 3Q
Since the end of June, we have upgraded our issuer credit ratings for eight companies and downgraded our ratings on six. This is the first time since the fourth quarter of 2013 that our upgrades outpaced our downgrades. However, we see more risk for downgrades than upgrades in the fourth quarter. Currently, we have our issuer credit ratings for eight companies under review for downgrade, three companies under review for upgrade, and three companies under review where the rating trajectory is uncertain.

The industrial sector led our upgrades this past quarter as we upgraded our moat assessments in the railroad subsector. We upgraded Union Pacific (UNP) (rating: A, wide moat), Canadian National Railway (CNR) (rating: A, wide moat), and Kansas City Southern (rating: BBB, wide moat) by one notch and upgraded Canadian Pacific Railway (CP) (rating: A-, wide moat) by three notches. The combination of improved Business Risk scores, aided by the group's shift to wide economic moat ratings from narrow, and significant deleveraging in recent quarters, thanks to solid earnings growth and modest debt reduction, resulted in a meaningful improvement in credit metrics. For greater detail regarding the rail sector, please see Basili Alukos' Sept. 2 publication, "Switching North American Class I Rails to Credit Upgrade Track." In the industrial sector, we also upgraded Emerson Electric (EMR) (rating: A+, wide moat) by one notch as we upgraded our assessment of the firm's economic moat to wide from narrow.

Other upgrades include increasing Mylan's (MYL) (rating: BBB-, narrow) rating to investment grade from high yield based on its plan to acquire Abbott's branded generics assets in an all-stock transaction, which we expect will reduce the firm's debt leverage to 2.3 times from 3.4 times. In the financial sector, we upgraded American International Group (AIG) (rating: BBB+, no moat) on the company's improved balance sheet risk, lower leverage, refocused insurance operations, enhanced regulation, and repayment of government support. Finally, we upgraded Royal Caribbean Cruises (RCL) (rating: BB, narrow moat) on the company's slowly improving leverage, which we believe will continue to decline over the next few years.

Idiosyncratic risk in health care led our downgrades, as we cut our ratings by one notch on Medtronic (MDT) (rating: AA-, wide moat), Shire (rating: A-, narrow moat), and AbbVie (ABBV) (rating: A-, narrow moat). Medtronic's downgrade was prompted by its plan to merge with Covidien (rating: AA-, wide moat), which will increase debt leverage of the combined entity to 2.3 times from 2.0 times. While we think the combined entity will be able to quickly deleverage back to historical norms around 2.0 times, much of the firm's cash reserves will decline, which negatively influences our credit rating. We expect net debt/EBITDA will stand around 2 times after the merger closes, up from a net cash position at the end of April. While we suspect Medtronic will rebuild its cash reserves and financial flexibility, it will take several years to return to its recent strength. We downgraded both Shire and AbbVie due to AbbVie's leverage-increasing planned takeover of Shire. We believe AbbVie's gross debt/EBITDA leverage on a pro forma basis could rise to about 3.5 times from 2.1 times.

The remaining downgrades were rounded out by one-notch downgrades on Monsanto (rating: A, wide moat), 3M (MMM) (rating: AA-, wide moat), and Norwegian Cruise Line (NCLH) (rating: BB-, narrow moat). Monsanto announced a recapitalization program that will increase its leverage from a net cash position to a net debt/EBITDA of 1.5 times by the end of fiscal 2015. The increase in debt will be used to fund management's $11 billion share-repurchase program over the next two years. Similarly, 3M is undertaking aggressive actions to return cash to shareholders to the detriment of bondholders, in our view. 3M intends to repurchase $17 billion-$22 billion in shares (20%-25% of its market capitalization) through 2017, in addition to its recent 35% dividend hike to a $2.3 billion payout for 2014. Collectively, these actions will cause the firm to add $2 billion-$4 billion in additional debt and result in total debt/EBITDA leverage increasing to 1.2 times during our forecast period, up from 0.8 times as of March 31. Norwegian Cruise Line announced its intention to acquire Prestige Cruises, which we estimate will increase debt leverage to the mid-5 times range from 4.6 times.

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