(By Dave Sekera, CFA)
Credit Sector Roundup
In our last quarterly update, we predicted some banks would begin to return capital to shareholders in the new year, and only a few minutes after the Federal Reserve announced the completion of its Comprehensive Capital Analysis and Review (CCAR), a few of the strongest banks we cover--including J.P. Morgan Chase (JPM, rating: A+), Wells Fargo (WFC, rating: A+), US Bancorp (USB, rating: A+), and State Street (STT, rating: A-)--raised their dividend payouts and announced share repurchases.
While we expect continued earnings improvement at these banks as the economy improves, we think even more capital will be paid out to shareholders as payout ratios and absolute levels of net income increase, limiting the benefits to bondholders. The same holds true for some relatively weaker credits, like KeyCorp (KEY, rating: BBB) and SunTrust (STI, rating: BBB), both of which are paying back TARP preferred stock with newly raised common equity in the wake of the CCAR. KeyCorp also raised its dividend, though it is only paying out approximately 15% of our projected earnings for the year, leaving plenty of room to build capital as the bank works through a large portfolio of problem loans.
While we don't see blinding bargains in the bonds of these banks, a few issues stand out. As of this writing, Wells Fargo's five-year bonds are trading 142 basis points above comparable government issues, and roughly 50 basis points over the average A+ rated bond in our coverage universe--an attractive price for this high-quality name. Additionally, SunTrust's 10-year bonds are trading 200 basis points over similar government bonds and 40 basis points over the average BBB rated issuer we cover. In the unlikely event SunTrust's credit quality were to take another serious turn for the worse, we think the bank's operations are appealing enough to attract quality bidders at the right stock price, providing further support for the company's bonds.
The global economic recovery has been very kind to those portions of the basic materials sector with direct exposure to emerging-markets economic growth. No corner of the basic materials sector has benefited more than mining, where surging commodity prices have dramatically improved credit metrics. As we've previously discussed, spreads have tightened dramatically over the past several quarters, making it increasingly difficult to find value.
In contrast to high-flying mining, steel has been a clear laggard throughout the upturn. Indeed, for most U.S. steel companies, profitability and financial health remain weak compared with pre-crisis levels. In the second quarter, we expect to see signs of improvement driven by stronger steel prices and improved utilization rates, which could lead to some spread tightening in steel industry bonds. Heading into the back half of the year, however, there's risk of slippage, as some of the order book improvement we expect for the second quarter seems to be a function of customer restocking activity and pre-buying behavior.
Despite continued uncertainty, we see good value among steel bonds, at least in contrast to mining bonds. Here, our favorite pick remains Steel Dynamics (STLD, rating: BB), one of the few domestic steelmakers that remained profitable each quarter in 2010. In the investment-grade space, we think ArcelorMittal (MT, rating: BBB-), Gerdau (GGB, rating: BBB-), and Posco (PKX, rating: BBB+) offer decent value.
From where we stand, the consumer cyclical names on our coverage list have shaken off the dust of the credit crisis. While shareholder-friendly activities began to emerge well over a year ago, the late-cycle recovery firms are now jumping on the bandwagon. Because office products distributors are tied to unemployment, they tend to lag an economic recovery. As such, it was no surprise that Staples (SPLS, BBB+) shied away from share repurchases and dividend hikes in 2010 as it waited out the end of the credit crisis. But the firm's recent dividend increase signals to us that it is comfortable with its trajectory in the slowly improving economy. We believe we will continue to see management teams favoring shareholders over bondholders throughout the year.
Concerns on commodity cost inflation will likely push spreads wider for some retailers and restaurants, but we believe the larger, more established names on our list that possess economic moats are better positioned to offset higher commodity costs in 2011. This could create a bond buying opportunity for companies such as Nike (NKE, rating: AA-) and Darden (DRI, rating: BBB+). While the bonds are currently fairly valued, we're comfortable with these firms' ability to weather the rise in commodity costs and would likely recommend the bonds if spreads eked out a bit. We're more concerned on Hanesbrands' (HBI, rating: BB) ability to defray rising costs and would not recommend this firm's bonds.
Strong retail sales comparables from the year-ago period could hamper some retailers bonds in the second quarter. We expect March's numbers to appear soft on a year-over-year basis. On average, same-store sales increased 12.1% for Morningstar's retail coverage universe last March, one of the best months in several decades. Macy's (M, rating: BB+) will probably be the exception, as we expect the firm's bonds to continue to tighten as its credit metrics improve.
While an unexpected global shock, such as the recent disaster in Japan, may send investors scrambling for high-quality paper, we maintain that a desire for higher yields, coupled with increased comfort on the stability of the economy will increase demand for weaker credits and tighten spreads. As such, our top picks include Macy's, RR Donnelley (RRD, rating: BBB-), and Gannett (GCI, rating: BB). On the higher end of the credit spectrum, we recommend Home Depot's (HD, rating: A) bonds as they offer attractive relative value versus home superstore peer Lowe's (LOW, rating: A+).
Over the near to medium term, we expect performance in the consumer defensive sector will depend on both avoiding those issuers that suffer self-inflicted credit deterioration for the benefit of shareholders as well as by accepting greater amounts of credit risk. Credit spreads in the sector are significantly tighter than Morningstar's comparably rated indexes, and bonds will neither gain appreciably in a spread tightening environment nor will they generate enough yield to benefit from a "muddle along" environment where spreads remain unchanged.
Tough year-over-year comparisons, inflation, and struggling low-end consumers will prove to be formidable headwinds for issuers in this sector throughout the year. The preponderance of credit improvement has been captured, and bondholders will need to invest carefully in this sector to sidestep potential credit deterioration. Pricing power will likely be constrained, as firms will find it difficult to raise prices without negatively impacting volumes and profitability. As we also expect heightened shareholder activism and LBO activity in this sector, we recommend investors conduct covenant reviews to identify bonds that have greater downside protection and steer away from those bonds that do not.
Considering that most consumer defensive names are trading significantly tighter than the equivalent index for comparably rated companies, we expect outperformance in this sector will be driven by investors who are able to accept heightened risk. For example, we have highlighted Lorillard (LO, rating: BBB) in the past, which we believe has attractive probability weighted upside characteristics. The FDA has been investigating the impact of menthol cigarettes on public health, and the potential outcome of this investigation could range anywhere from an outright ban of menthol products to a tightening of marketing restrictions to no changes in the product category. Recently, some of the findings and recommendations from the FDA's scientific panel have been released, concluding that menthol cigarettes have a negative impact on public health, but falling short of recommending a ban on the use of menthol. We believe the FDA will implement additional marketing restrictions but will not ban menthol products. The bonds trade at a wide credit spread to compensate investors for the heightened credit risk as Lorillard derives substantially all of its cash flow from menthol products. Once the FDA releases its findings and assuming our opinion is correct, we expect credit spreads for Lorillard's bonds to tighten significantly.
For investors willing to accept heightened credit risk of below-investment-grade (or junk) bonds, we have highlighted Supervalu (SVU, rating: BB). The firm's margins have been adversely impacted by the recession and food inflation leading to poor credit metrics. However, we believe the wide credit spreads of the firm's bonds compensate investors for the greater credit risk. We forecast that the firm's initiatives to bolster operations through improving supply-chain efficiency and increasing private-label penetration will pay off over time and lead to lower credit risk.
We continue to expect near-term credit deterioration for some E&P companies focused primarily on gas-directed drilling, as persistently low gas prices will continue to weigh on cash flows. Looking beyond 2011, we think natural gas pricing fundamentals should improve, leading to a wave of long-awaited credit enhancement in 2012 and beyond, which makes 2011 an interesting year to consider gas-weighted E&P debt securities.
From a fundamental standpoint, we believe that the combination of low gas prices, high service costs, less drill-to-hold acreage pressure, and weak internal cash flow generation at E&P companies will sap the desire and ability to perpetuate the presently high active gas rig count. Although this still argues for a weak gas price for the remainder of 2011, it should set up better fundamentals for gas-levered companies in 2012 and beyond.
Given all of the pain being experienced by gas-oriented E&P companies, it is somewhat unusual to note that U.S. focused oil and gas services companies have continued to experience a period of very strong pricing power. Service company consolidation and high oil and natural gas liquids prices combined with a desire to drill-to-hold gas prospective acreage (even despite low gas prices) have contributed to strong services demand from U.S. E&P companies and pricing power for the services companies. Many E&P companies have thus felt the squeeze from both ends--lower gas selling prices and higher services costs--and earnings power has suffered. We think these dynamics are unsustainable longer term. Much like we expect higher gas prices in a few years, we question the ability for services companies to maintain present pricing power well beyond early 2012.
Alternatively, assuming a lack of levering M&A transactions, oil weighted firms appear set for credit improvement in the remainder of 2011, as cash flows benefit from the higher oil prices we have been experiencing. Near-term oil price fundamentals continue to contrast sharply with gas fundamentals, and we think the market is largely factoring in better times ahead for those exposed to oil. Barring a collapse in demand due to economic weakness, marketplace fundamentals and uncertainty in the Middle East appear to support continued elevated crude oil prices.
Rising commodity prices likely won't have a direct effect on credit quality in the health-care industry. However, if commodity prices remain high on a sustainable basis, we'd worry about the impact a slowing economy would have on these firms.
Most health-care firms display some level of recession-resistance, but firms dependent on elective procedures can experience slower-than-normal growth during times of economic uncertainty. In the most recent recession, we saw potential patients who were either unemployed or worried about their jobs delay surgical procedures, including orthopedic and cardiac procedures that are the bread and butter of firms such as Medtronic (MDT, rating: AA), Stryker (SYK, rating: AA), and Zimmer (ZMH, rating: AA), as well as aesthetic procedures that affect firms such as Allergan (AGN, rating: AA-).
With employment trends beginning to improve, we'd previously theorized that a rebound was due in the growth of these firms, but if that growth doesn't materialize, continued procedure delays could keep growth rates low in elective niches, negatively affecting share prices. Since cash flows would likely remain solid at these well-capitalized firms, we could see management teams attempt to boost shareholder returns through higher dividends, share repurchases, and acquisitions, which often are unfriendly activities for debtholders. Depending on the size of those activities, we could see credit quality at affected firms modestly decline, causing some spread widening in elective niches.
Positively for the long-term outlook of device firms, the climate for regulatory change in a key approval process may favor industry players if the economy weakens. With politicians and regulators appearing to recognize the need for ongoing innovation for the health of this largely U.S.-based industry, we suspect final rulings on that approval process may be less onerous than once feared, especially if economic uncertainty rises. We'll likely hear more about potential regulatory approval process changes this summer.
Over the last quarter, earnings trends remained generally positive across most of the industrial names we cover, driven largely by improving demand as the global economic recovery continues to take hold. Recent economic data support a continuation of this trend, which should lead to gradually improving credit fundamentals over the next quarter. Given this outlook, we think credit spreads should continue to grind tighter for the sector as a whole. However, all is not rosy, as rising input costs remain a major drag on earnings growth and the longer-term impact of the natural disaster in Japan is not yet known.
Not much has changed in our outlooks for the diversified industrial and transportation (ex-airlines) sectors. We remain positive over the near term for the reasons mentioned above. However, spreads in these two sectors remain relatively tight, presenting few compelling opportunities, in our view.
We are also positive on the fundamental outlook for autos, as new-vehicle demand continues to accelerate. We like the bonds of TRW (TRW, rating: BBB-), as the company continues to generate free cash flow and strengthen its balance sheet. We also like the bonds of Honda (HMC, rating: A+) given recent spread widening, which we think is overdone, in the wake of the Japanese tsunami.
We are more constructive on the longer-term prospects for the housing and building materials sectors. However, we expect the near term to remain volatile as recent housing data remain mixed. We continue to like the bonds of Lennar (LEN, rating: BB) and Owens-Corning (OC, rating: BBB) in this space.
We are less constructive on the airline industry given the recent runup in oil prices coupled with the heightened uncertainty surrounding the geopolitical events unfolding in the Middle East. We would be very selective in this sector, favoring secured debt and EETCs (enhanced equipment trust certificates). Although we are generally comfortable with the aerospace sector, we are somewhat concerned that the negative trends in the airline industry could spill over into this space. Finally, we remain cautious on the high-grade defense sector as ongoing uncertainty around defense spending is compounded by tight trading levels.
Technology & Telecom
Despite the potential for Japan-related supply-chain disruption over the near term, particularly within semiconductor equipment, the technology and telecom sectors remain a bastion of healthy credits. Given the large number of firms in the sectors that produce steady cash flow, carry loads of cash, or both, tech and telecom will likely continue to be viewed as a relatively safe haven, holding already-tight spreads down.
We expect large, high-quality firms across both sectors will generate significant free cash flow throughout 2011, adding additional financial strength. Firms in both sectors have continued to hoard cash and repay debt, limiting the need for new debt offerings. Of the roughly 80 companies we've rated across the sectors, debt issuance year to date has totaled only $17 billion. The majority of debt offerings within the group have come from firms with large overseas cash positions looking to raise cheap U.S. funds. Microsoft (MSFT, rating: AAA) and Cisco (CSCO, rating: AA), which raised $2.25 billion and $4 billion, respectively, are the two biggest examples. Juniper Networks (JNPR, rating: A) also added debt to its balance sheet for the first time in several years, raising $1 billion in March. The Cisco notes look particularly attractive to us, as the markets, both equity and credit, have beaten the firm up on issues that we believe are short term in nature.
Although we think credit quality will improve on average across tech and telecom, we expect the abundance of cash in the sectors will fuel additional acquisitions. AT&T's (T, rating: A-) $39 billion bid for T-Mobile provided a late-quarter reminder that well-positioned, financially strong companies are unlikely to reverse course on strategic acquisitions, regardless of broader economic or geopolitical concerns. Should this deal pass regulators' scrutiny, AT&T's credit metrics will take a hit in the short run, but we believe the benefits that the firm would gain offset this negative. On the flip side, Deutsche Telekom (DTEGY, rating: BBB-) will use the cash raised to reduce leverage.
2011 will also provide investors an opportunity to evaluate the track record of cash-rich, acquisitive technology giants. Dell (DELL, rating: A+), for example, has a propensity to overpay for deals in an attempt to diversify beyond PCs. While we've been skeptical of rich valuations in certain deals, Dell's surprisingly strong fourth-quarter gross margin suggests that the company is indeed beginning to benefit from the billions of dollars it has spent recently.
In the second quarter of 2011, we expect to see very limited M&A activity among utilities given our view that the majority of transactions have already been announced. We also anticipate seeing healthy bond issuance given the recent rally in Treasuries, tempered only slightly by the recent spread widening that has occurred in the sector following the Japanese disaster.
There were two dominant themes in utility credit in the fourth quarter of 2010 that we anticipated slowing down in the first quarter of 2011: M&A activity and robust bond issuance. While the pace of M&A deal activity did indeed slow down in 1Q in terms of the number of deals announced, we were nonetheless surprised to see the capstone deal in the space announced in early January: Duke Energy's (DUK; rating: BBB+) $25.7 billion all-stock deal for Progress Energy (PGN; rating: BBB+)), which upon closing in late 2011 or early 2012 will create the largest regulated utility in the United States.
From a bond issuance standpoint, we saw a more subdued first quarter due to the backup in interest rates and the previous pull forward of demand from record low interest rates in the second and third quarters of 2010. After over $15 billion of utility bond issuance priced in the fourth quarter, we estimate that approximately $12 billion of utility bonds were issued in the first quarter of 2011, or about 20% less volume, albeit still a healthy amount.
From an operating perspective, we continue to expect several earnings headwinds over the coming quarters from a return to normalized weather and a subdued demand outlook as we expect residential and commercial demand to continue to lag the industrial recovery. Increasing maintenance and capital expenditures to upgrade and replace infrastructure to meet tougher environmental regulations, energy efficiency standards, and renewable energy requirements also could be headwinds that utilities will face over the intermediate term.
Despite the headwinds mentioned above, we think this is a good time for investors to add domestic utility exposure to their portfolios, particularly on the regulated side, as we believe the widening in the domestic utility sector as a result of the Tokyo Electric Power Company tragedy is overblown, and we do not see a material change in the credit quality of most U.S. regulated utilities.
Our Top Bond Picks
We pick bonds on a relative value basis. Typically, this means comparing a bond's spread against spreads on bonds that involve comparable credit risk and duration.
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 a sustainable competitive advantage), and our year-by-year forecast of the firm's cash flows in comparison to the yield pickup along the curve.
| Top Bond Picks|
|Maturity||Coupon||Price||Yield (%)||Spread to U.S. Treas|
|Data as of 03-22-11. |
Symantec (SYMC; rating: A+)
Symantec has a solid balance sheet and track record of consistent cash flow generation. The firm carries $2.5 billion in cash against a $2.6 billion debt load currently. Despite heavy share repurchases and acquisition activity over the years, Symantec has typically carried more cash than debt, though a recent acquisition has pushed debt up a bit. Free cash flow has been positive every year for more than a decade, typically running at about 20% of sales. The firm's 2020 notes offer an attractive spread relative to our A+ rating and trade more in line with the BBB rating the major agencies have placed on it. The bond is also attractive relative to other wide-moat software firms with similar ratings. Adobe's 2020 notes, for example, offer a spread of +122. Finally, Symantec is required to repurchase these notes at 101% of par on a change of control that causes a ratings downgrade, a nice premium versus the current price. While we don't believe the firm is a strong takeover candidate in its current form, Intel recently agreed to acquire McAfee, its closest peer.
Home Depot (HD; rating:A)
Comparable store sales turned positive in 2010, and Home Depot posted a 4.8% comp (vs. a 1.1% comp for Lowe's) in the last quarter of 2010. Additionally, the firm's stable margins provide for copious free cash flows. Given Home Depot's wide moat and solid credit metrics, we would encourage investors to reach further out the maturity schedule for the issuer, as they offer roughly 50 basis points of pickup from the firm's 5-year and 10-year notes. Lowes' 5.8% notes due 2040 trade at 97 basis points, and we find the differential between Lowe's and Home Depot's bonds to be much too large. While we would expect Home Depot to trade slightly wider than Lowe's due to its marginally weaker credit metrics and lower credit rating (A versus Lowe's A+), we think there is room for Home Depot's bonds to tighten.
Exelon (EXC; rating: BBB+)
With 11 nuclear plants generating 80% of the fleet's output, Exelon (ticker: EXC, rating: BBB+) is the largest nuclear operator in the United States. Given the recent events at Tokyo Electric Power Company ("Tepco"), Exelon Generation Company ("Genco") notes traded off as much as 40 basis points. While the company would face some credit risk if operating costs rose or regulators required new capital investments at existing reactors, Exelon faces virtually no operating license renewal risk and has no near-term plans to build new reactors. In addition, management said that it may delay or cancel its plans to spend $1.5 billion on nuclear uprates through 2013, which would result in a significant boost to near-term cash flows and would be credit enhancing. Further, to the extent that Japan's demand for conventional energy sources such as coal and natural gas grow and raise power prices, we think Exelon stands to be a net beneficiary. For investors willing to live with political uncertainty resulting from the Tepco disaster, we believe Exelon Genco bonds offer significant excess spread relative to our BBB+ rating.
Bombardier (BBD.B; rating: BBB)
Our BBB rating reflects Bombardier's strong positions in the aerospace and transportation industries, which warrant a narrow economic moat. In addition, the firm's refinancing activities this year position most of its debt maturities outside our forecast horizon, improving the Cash Flow Cushion score. We are comfortable buying any of Bombardier's debt, which trades well wide of the BBB benchmark and less than 50 bps tighter than lower-rated subordinated debt at issuers such as Alliant Techsystems (ATK; rating BB+) and Spirit AeroSystems (SPR; rating: BBB-). We are comfortable owning the longer-dated 2034 bonds ($250mm) owing to the firm's moat, although the 7.5% of 2018 ($650mm) represent the next major maturity and are also attractive. Management has targeted investment-grade ratings at the NRSROs and appears intent on managing to those metrics. We believe spreads can tighten materially over time as the aerospace cycle recovers and the substantial backlog in transportation equipment converts to cash flow.
Cloud Peak (CLD; rating: BB+)
Cloud Peak's debt load consists entirely of two senior unsecured issues: $300 million in 8.25% notes due 2017 and $300 million of 8.5% notes due 2019. While we think both issues, which typically trade at YTWs around 450-500 bps wide of Treasuries, offer compelling value, the 2017s tend to be more liquid. On an absolute basis, the notes trade wide of the BB bucket in Merrill Lynch's High Yield Index, which, as of March 18, featured an average spread of T+376 bps. The notes are also compelling from a relative value perspective. For instance, they trade around 150 bps wide of peer Arch Coal's 7.25% notes of 2020 (T+329 bps to Oct 18 call @100).
Daniel Rohr, Joscelyn Mackay, Julie Stralow, Michael Hodel, Patrick Goff, Rick Tauber, Jeff Cannon, Min Tang-Varner and James Sinegal also contributed to this report.