Fed shocks the market; long-term rates headed lower in the near term. Fights over debt ceiling and continuing spending resolutions to fund federal expenditures are heating up. Emerging markets' central banks are raising short-term rates to defend plunging currencies. Downgrades outpace upgrades as acquisitions and share buybacks raise debt leverage.
Fed Shocks Market by Holding Asset-Purchase Program Steady, Sends Bond Prices Higher
Rising interest rates have taken their toll on the corporate bond market this year, but with the Federal Reserve refusing to dial back on its highly accommodative monetary policy, as the market largely expected, investors are poised to recapture some of these losses. Year to date through Sept. 20, the Morningstar Corporate Bond Index has declined 2.99%. A modest amount of the loss has been due to a very slight increase in credit spreads, but the preponderance of the decline stems from the rise in interest rates.
In May, when the 10-year Treasury was below 2%, we opined that as soon the Fed intimated that it would begin tapering its asset-purchase program, interest rates would quickly rise by 100-150 basis points. Based on new language in the Federal Open Market Committee's May statement, Chairman Ben Bernanke's responses to questioning from the Joint Economic Committee, and improving economic metrics, the yield on the 10-year Treasury increased to almost 3%, as the market anticipated that the Fed would begin to taper in September.
However, the Fed has shocked the market, holding its asset-purchase program steady until it receives enough additional economic data to indicate that the economy is on a sustainable footing. This action (or inaction) led to an immediate rally in bond prices, pushing yields back down. The FOMC has only two more meetings before a new chairman takes over in January. The October meeting does not have a press conference scheduled, and the committee would probably not want to make such a major policy change with only the brief FOMC statement to explain its actions. There is a press conference and updated economic projections release scheduled after the December meeting, but that is probably too close to when a new chairman would take over in January 2014. The FOMC would be hesitant to make a major change in policy before a new chairman has the chance to analyze and influence policy. So unless there is a drastic upswing in the economy, job growth, or inflation, the FOMC may not decide to begin to taper asset purchases until the March 2014 meeting.
In the short term, as the market prices in the probability that the Fed may hold its extraordinarily easy monetary policy steady for the next few months, it appears that long-term interest rates are headed lower. With the Fed continuing to purchase mortgage-backed securities and long-term Treasury bonds, investors have increasingly fewer fixed-income assets from which to choose. This decrease in supply is becoming even more pronounced as the U.S. government's deficit is shrinking and requiring less new debt issuance. This has positively affected the demand for corporate bonds as the supply of available fixed-income securities constricts and the new Fed-provided liquidity looks for a home.
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 +130 and +167 basis points, with an average of +143. As of Sept. 20, the average spread of our index was +144. We continue to believe that from a fundamental, long-term perspective, corporate credit spreads are currently 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 fund M&A, increased shareholder activism, and so on). However, over the near term, we expect corporate credit spreads will probably be pushed toward the bottom of the trading range over the past year.
In April 2010, just before Greece admitted that its public finances were in much worse shape than previously reported (thus triggering the European sovereign debt crisis), and again in mid-May of this year, just as interest rates were about to start to meaningfully rise, our corporate bond index tightened to around +130. This represents the lowest level our corporate bond index has hit since the 2008 credit crisis. The absolute tightest level that credit spreads have reached in our index was +80 in February 2007, the peak of the credit bubble. We don't anticipate returning to anywhere near those pre-credit-crisis levels as an overabundance of structured credit vehicles were created to slice and dice credit risk into numerous tranches, which artificially pushed 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 collateralized debt obligations, we doubt that these structures will re-emerge anytime soon in any kind of meaningful size. Over a longer-term perspective, since the beginning of 2000, the average credit spread within our index is +174, and the median is +158.
Fed Surprises Market; Long-Term Rates Headed Lower in Near Term
In the short term, it appears that long-term interest rates are headed lower. While rates had been rising as the market was pricing in that the Fed would begin to taper its asset-purchase program, the Fed surprised the market at its September meeting and kept its asset purchases steady. Considering that the express intent of the Federal Reserve's asset-purchase program is to push long-term rates down below where interest rates would clear the market on their own, we would not fight the Fed here. However, once the Fed does begin to reduce its purchase program, we'll see a repeat of this summer as every bond trader and fixed-income portfolio manager in the world will try to front-run the rise in rates, likely compounding how quickly and how far rates will rise. Who in his right mind will want to buy long-duration securities once the single-largest buyer of Treasury bonds (the Fed) begins to reduce its purchases?
Over the long term, fundamentally we think interest rates will 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 200-250 basis points over a rolling three-month inflation rate. Even at the currently low inflation rate of 1.5%, the yield on the 10-year Treasury could increase to 3.50%-4.00% to reach historical norms.
While we expect interest rates will normalize at higher levels whenever the Fed decides to stop manipulating rates lower, 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 in 2015, the yield of the 2-year Treasury bond should be well anchored. Based on where this spread has historically peaked, it appears that the 10-year yield could increase up to another 50 basis points over the 2-year.
After peaking in November 2012, a few months after the most recent quantitative easing program was 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, they should also moderate how high interest rates would rise. However, after the Fed surprised the market with its decision to leave the existing asset-purchase program in place, the decline in inflation expectations appears to have bottomed out. The Fed will need to keep a watchful eye on his metric, lest inflation expectations begin to spike back up toward 3%, which has been the level that expectations have risen to after each of the Fed's quantitative easing programs was announced.
Fights Over Debt Ceiling and Continuing Spending Resolutions to Fund Federal Expenditures Heating Up
Political fighting in Washington is heating up as the U.S. government needs to address the debt ceiling, which is expected to be reached in mid-October. In addition, Congress has to pass continuing spending bills to fund expenditures as the government enters a new fiscal year. If the past is precedent in politics, then over the next few weeks we'll see the politicians posturing in the headlines and making dire warnings of government shutdowns. The most likely outcome will be an agreement made at the last minute to fund federal expenditures and avert a shutdown and a deal to increase the debt ceiling in return for some additional reductions in the rate of spending increases. If agreements are not made in time to avert a shutdown or the debt ceiling is not raised, then credit spreads will probably come under pressure as investors look to reduce risk in their portfolios. However, as we've seen in past flights to safety, Treasuries would probably rally and the lower yields would offset widening credit spreads.
Emerging Markets' Central Banks Raising Short-Term Rates to Defend Plunging Currencies
Among Morningstar's fixed-income indexes, emerging markets have been some of the worst-performing categories since the beginning of the year. Through Sept. 17, Morningstar's Emerging Market Composite Bond Index has declined 5.65%. Among the constituent members of this index, the Emerging Markets Sovereign Bond Index has suffered a 7.91% loss and the Emerging Markets Corporate Bond Index has declined 4.85%. Morningstar's Emerging Markets High Yield Bond Index has declined 6.39%. Over the past few years, easy money policies for the developed world have sent substantial capital flows to the emerging markets in search of higher yields. However, as investors became increasingly convinced that the Federal Reserve was going to begin tapering its asset purchases this fall, those capital flows reversed. Losses have been driven by a combination of capital outflows as well as rising interest rates as many countries' central banks have been raising their short-term lending rates to defend their currencies.
For example, Brazil's central bank raised its short-term lending rate by 50 basis points to 9% at the end of August, its fourth interest rate hike since March. The real had lost as much as 20% of its value versus the dollar this year through mid-August, but has since regained some of the deterioration and is currently only down about 10%. In a surprise move, the Bank of Indonesia has become increasingly aggressive in defending its currency and recently raised its benchmark interest rate by 25 basis points to 7.25%. This move came just two weeks after Indonesia's central bank increased its rate by 50 basis points. The rupiah has fallen 14% this year. While Turkey kept its short-term rate steady at its September meeting, it increased its overnight lending rate by 50 basis points to 7.75% at its August meeting. The lira has fallen 9.5% this year. In July, the Reserve Bank of India hiked its short-term rate by 200 basis points to 10.25% to defend the rupee. At the end of August, the rupee had fallen as much as 25% against the dollar for the year, but has since recaptured some of its losses in September and is currently down 15% versus the dollar for the year.
As these countries raise their short-term interest rates in defense of their currencies, the risk is that they may raise rates to levels that begin to slow their economic growth, which could have a domino effect on other emerging-market countries. If their economies slide into recession, it could further affect resource-rich nations, such as Australia and Canada, which derive a significant amount of their GDP from mining and minerals.
Downgrades Outpace Upgrades as Acquisitions and Share Buybacks Raise Debt Leverage
During the third quarter, rating downgrades outpaced upgrades. Downgrades were spread throughout our sector coverage, but the two most common causes were acquisitions leading to increased leverage and debt-funded share-buyback programs. The most significant example was Verizon's (VZ) (rating: BBB, narrow moat) mammoth $49 billion debt offering to fund the buyout of Vodafone's (VOD) (rating: UR+/BBB+, narrow moat) equity stake in Verizon Wireless. We downgraded Verizon to BBB from A- as pro forma leverage including unfunded pension obligations increased to approximately 3.5 times, which we believe is high for an investment-grade telecom carrier. Another example of a debt-funded strategic acquisition is Rockwell Collins (COL) (rating: A-, narrow moat) which doubled its debt leverage to 2 times to buy an aviation supplier. We downgraded the firm by one notch after the announcement. Among other companies that we downgraded because they raised their debt leverage targets to fund share-buyback programs was Viacom (VIA) (rating: BBB+, narrow moat) and ADT (ADT) (rating: BB+, wide moat). While we downgraded Viacom only one notch, we took a harsh view of ADT's increased share-buyback program and downgraded our issuer credit rating by three notches, taking the rating to below investment grade.
Not all of our downgrades were self-inflicted. We downgraded Potash Corporation of Saskatchewan (POT) (rating: A-, wide moat) and K+S Aktiengesellschaft (SDF) (rating: BB, no moat) after we revised our projections for potash prices significantly downward. Russian potash producer Uralkali announced it was withdrawing from a joint venture that marketed potash to pursue a strategy of volume over price, which shook up the industry’s oligopoly-like cartel arrangement.
Upgrades were due to either an increase in our assessment of a company's economic moat or an improvement in our forecasts. For example, we upgraded BorgWarner (BWA) (rating: A-, narrow moat) and Tenneco (TEN) (rating: BB+, narrow moat) as we revised our economic moat ratings to narrow from none, which improved our Business Risk score for both companies. We expect BorgWarner will generate excess returns over the long term as its customer relationships and product positioning benefit from the continued secular trend toward improved fuel efficiency. Within the auto supply universe, Tenneco's products hold either the number-one or number-two share in their markets, which supports our narrow economic moat. Tenneco is a leader in supplying emissions- and ride-control systems that meet the regulatory requirements of customers around the globe. As developing countries suffer greater vehicle congestion and pollution, Tenneco's emissions-control products are likely to benefit from clean air legislation. Lastly, we upgraded Boeing (BA) (rating: A, narrow moat) after updating our intermediate-term fundamental view, leading to an improved financial outlook.
We expect global economic growth will continue to be sluggish for the remainder of 2013, limiting opportunities for organic growth. To enhance shareholder value, management teams are likely to continue to pursue nonorganic ways to support their equity prices. We saw a resurgence in strategic acquisitions during 2013 and expect that trend to continue. Depending on how these acquisitions are structured, the credit implications may be either neutral or negative based on the amount of debt and equity used to fund the buyouts. The number of leveraged buyouts in 2013 has thus far been modest, as many private equity firms have been more interested in selling many of their portfolio companies through initial public offerings while the equity market is hot and harvesting gains. However, with capital available from portfolio sales, private equity sponsors have significant amounts of dry powder and may look to use any pullbacks in the equity market as an opportunity to purchase quality businesses.
Sector Updates and Top Bond Picks
Recent actions by the Eastern European potash cartel member Uralkali to exit its partnership in Belarusian Potash Company has caused significant volatility and uncertainty in the agricultural input market. As the second-largest potash producer, behind Potash Corporation of Saskatchewan, Uralkali's announcement to implement a volume-over-price strategy caused significant disruption in global potash markets and widespread speculation that prices could decline as much as 30%. We expect the impact of Uralkali's recent actions to continue producing uncertainty for market participants as it has caused political strife between two large producing countries, Russia and Belarus. The impact on global prices will depend on the path taken by these parties: confrontation or reconciliation.
In light of these market-altering actions, we recently reviewed each potash producer in our coverage universe to access the impact on overall credit quality. As a result of this analysis, we downgraded PotashCorp (POT) (rating: A-, wide moat) from A, reflecting the expected increase in leverage caused by lower product margins coupled with the impact of a planned $2 billion share-repurchase program. However, we continue to assign the company a wide moat rating based on its production cost advantages. We affirmed our ratings for Mosaic (MOS) (rating: BBB+, no moat) and Agrium (AGU) (rating: BBB, no moat).
While signs of an accelerating Chinese economy suggest an improvement in metal demand, we view China’s credit-dependent and infrastructure and real estate-led turnaround as unsustainable longer term. Furthermore, we doubt China's iron ore demand can maintain its current growth trajectory. We continue to expect slowing demand growth along with a bumper crop of new supply to pressure iron ore prices in the quarters to come, eventually pushing prices down to $90 per metric ton (real dollars). Among our coverage list, we continue to recommend avoiding Cliffs Natural Resources (CLF) (rating: BB+, no moat) as we see these trends putting continued pressure on its bonds.
We see a similar story playing out in other "investment-oriented" commodities, such as copper, although we believe low-cost producers such as Vale (VALE) (rating: BBB+, narrow moat) and Southern Copper (SCCO) (rating:BBB+, narrow moat) are both in a position to continue generating sufficient cash flow for maintenance and expansionary capital expenditures, even in the face of weaker Chinese demand.
Contributed by Dale Burrow, CFA
Our focus for the coming quarter will be on companies that may take actions that are unfavorable to bondholders, such as debt-funded share repurchases, dividends or acquisitions. Two such recent examples are Viacom (VIA) (rating: BBB+, narrow moat) and Kohl's (KSS) (rating: BBB+, narrow moat). Viacom increased its leverage target to 2.75-3.0 times from 2.0-2.25 in order to issue debt to pay for share repurchases. The board authorized an increase to the current share-repurchase program to $20 billion from $10 billion, and Viacom then issued $3.0 billion in debt. While Kohl's has not made such an announcement regarding its current leverage target of 2.0-2.25 times, it recently issued $300 million in debt, and with no refinancing needs, we assume the use of proceeds will be for share repurchases; management indicated it planned to repurchase $325 million in shares for the third quarter. We are disappointed the firm is using debt to repurchase the shares, adding leverage as earnings have been flat due to lackluster comparable sales. The firm's balance sheet has steadily been more leveraged over the past few years; pro forma for the new deal, we estimate lease-adjusted leverage at 2.3 times, up from around 2.0 times in 2010.
Even though no debt has been issued as of yet, we still think Royal Caribbean's (RCL) (rating: BB-, narrow moat) announcement that it will double its dividend takes the firm further from its stated goal of achieving an investment-grade credit rating. This will slow the pace of debt reduction, which was already expected to be slow, as management has stated that upcoming maturities would probably be partially refinanced and partially paid down with free cash flow. Lease-adjusted leverage is still high at 5.3 times, and we forecast that it will decrease by only 1 turn to 4.3 times over the next five years.
On a more positive note, we have a constructive view on the credits of the home superstores, Home Depot (HD) (rating: A, wide moat) and Lowe's (LOW) (rating: A, wide moat). They have both delivered strong comparable sales gains, riding the wave of the recovering U.S. housing market. Although they face near-term headwinds, including the threat of rising interest rates and the subsequent impact on mortgage availability and reduced benefit from lumber and copper commodity pricing, we believe private fixed residential investment, household formation, and housing turnover trends will support strong results through at least the back half of 2013.
Contributed by Joscelyn MacKay
Agricultural prices for corn, wheat, soybeans, and sugar peaked a year ago. Since then, they have tumbled 40%, 28%, 17%, and 15%, respectively. We expect lower agricultural prices will relieve a significant amount of the pricing pressure that food manufacturers had previously been pushing through to the supermarket sector. Because of high unemployment rates and stagnant real personal income growth, supermarkets had been reluctant to raise prices at the shelf over the past few years as quickly as their cost of goods grew. Grocers feared consumers would push back against higher prices or switch to lower-cost substitutes. Over the next few quarters, we expect domestic supermarkets will be able to regain some of their lost margin as they are able to slowly raise prices. However, while consumers in emerging markets typically should disproportionately benefit, as spending on food constitutes a larger amount of their household budgets than in the developed world, the benefit of lower commodity prices have been substantially offset by an increase in the foreign exchange rate of the dollar versus emerging-market currencies. Food manufacturers expect the rate of supply-chain inflation will decrease in the second half of this year compared with the first half. However, we don’t foresee a significant increase in those companies' gross margins as the benefit from lower agricultural prices appear to be largely offset by foreign exchange movements and higher spending to support increased new product introduction.
For the sector, we expect 2013 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 smaller, strategic acquisitions rather than large, transformational or private equity-sponsored deals. We view the private equity buyout of Heinz earlier this year as a one-off exception. We believe it is more likely that firms will continue putting excess cash to use by building out their distribution platforms at home and abroad, pursuing smaller bolt-on transactions.
Contributed by Dave Sekera, CFA
In our last quarterly outlook, we highlighted three issues that could affect credit spreads in the energy sector. After a slew of long-term contract announcements for ultra-deep-water drilling rigs, we do not anticipate additional market-moving data points in the fourth quarter. This leaves us focused on the two remaining issues: natural gas price volatility and crude price differentials in the United States.
Although a hot summer that could have significantly drawn down natural gas inventories did not materialize, we think the outlook for natural gas prices remains promising. Natural gas storage levels of 3,188 billion cubic feet, as of Aug. 30, are about 6% below 2012 levels and close to the five-year average. Offsetting this positive data point, recent storage injection levels have run close to or above the five-year average. Supporting our positive view of prices, U.S. dry gas production levels were around 66.3 bcf per day as of June. While this level is about 1.4% higher than the prior year, the growth rate is sharply lower compared with the 5% experienced in 2012. In addition, the number of active gas-focused rigs in the U.S. has ticked up to close to 400 from about 354 in June, indicating that more rigs are needed to keep natural gas production levels flat. As growth in the economy moves natural gas demand steadily higher, we consider this increase in rig activity a signal that higher gas prices will be forthcoming to encourage producers to increase drilling activity to replace naturally declining production levels. Devon (DVN) (rating: BBB+, narrow moat), Cimarex (XEC) (rating: BBB–, narrow moat), and Chesapeake Energy (CHK) (rating: B+, narrow moat) have exposure to near-term price increases.
In the refining sector, credit spreads underperformed the broader market in the third quarter because of the collapse in the price differential between West Texas Intermediate and Brent crude, which is a key determinant of refining profitability. The collapse led to softer second-quarter earnings across the sector and should continue to pressure earnings in the second half of the year. Despite the near-term pressure on earnings, we recently raised our credit ratings on the six independent refiners in our coverage universe based on our decision to upgrade their economic moats to narrow from none. Our new moat ratings are predicated upon continued growth in U.S. crude production from unconventional drilling, as seen in North Dakota and Texas. With U.S. crude demand essentially unchanged from 2012, the increase in domestic crude will displace foreign imports. We believe this will cause the WTI/Brent price differential to re-emerge in 2014 and remain at a sustainable level, thus earning U.S. refiners an economic moat due to the feedstock cost advantage. As such, if refiners' spreads continue to widen in the fourth quarter, we would view it as an attractive opportunity to take advantage of this paradigm switch in U.S. refiners' profitability.
Contributed by David Schivell
Five years ago this month, the U.S. financial sector was perched on the precipice. The forced bankruptcy of Lehman Brothers nearly jolted us into another Great Depression. Since then, the financial system and the economy have remained on massive monetary medication. The Federal Reserve's balance sheet has swelled to $3.7 trillion as of Sept. 13, 2013, from $905 billion on Sept. 1, 2008, as Chairman Bernanke helped solve what he viewed as an asset problem in the U.S. financial system.
Attention will focus on the effects of tapering and the nomination of the next Fed chairman, but we think credit investors should not overlook the implications of two notable events during the third quarter.
First, the perpetual financial sector bailout has shown signs of subsiding. Citigroup (C) (rating: A-, narrow moat) rid itself of the government bailout when the FDIC sold its remaining $2.42 billion holding in September. Citi had already repaid its Troubled Asset Relief Program funds, so the operating implications are minor, but we think the sale is emblematic of the recovery in capital markets. Citigroup received more assistance than any other U.S. bank during the crisis, with the government brokering three rescues that gave U.S. taxpayers as much as 36% ownership. The firm's Tier I ratio now sits above 12% today versus 7% in 2007, suggesting that the most feeble of the large institutions can finally function on its own.
Second, the potential template to unwind systematically important financial institutions appears to be taking shape through Title II of the Dodd-Frank Act. Although the implementation and the market ramifications remain unknown, the progress and eventual removal of government support caused Moody's to place the six large U.S. banks on review for a possible downgrade.
In our February piece, "U.S. Banks: Senior Holdco Versus Operating Subordinated Debt," we argued that the Washington Mutual bankruptcy was an anomaly-- subordinated bank-level creditors received zero value while senior holding company investors received a respectable recovery--since Title II liquidation assumes that the bank holding company will remain solvent.
So, as more clarity and progress evolve on Title II, we think investors will ultimately reprice the riskiness of subordinated notes, which we believe should be at least on top of senior holding company debt. Therefore, we suggest investors consider senior subordinated bank holding company notes such as the Regions Bank 7.5% subordinated notes due 2018, which trade approximately 65 basis points wide of the 2% Regions Financial (RF) (rating: BBB, no moat) holding company senior notes due 2018.
Contributed by Basili Alukos, CPA, CFA
During the past quarter, higher interest rates appear to have somewhat slowed debt-funded M&A activities and shareholder returns at health-care firms. However, the major factor influencing those activities--slow fundamental growth--remains a source of concern in the industry. Therefore, we believe health-care management teams will continue looking for ways to boost growth through acquisitions or placate equity investors in the meantime with higher dividends and share repurchases, which creates an ongoing negative credit bias in the industry.
Amgen (AMGN) (rating: A, wide moat) and Mylan (MYL) (rating: BB+, narrow moat) are prime examples of health-care firms with weak financial outlooks that have or could cut into their credit profiles. Amgen, a firm we previously highlighted for its intriguing, albeit intermediate-term, pipeline candidates and deleveraging plan, showed impatience with its internal prospects last quarter when it decided to make the $10 billion debt-funded acquisition of Onyx Pharmaceuticals (ONXX) (rating: SUS, no moat). This acquisition will boost Amgen's top-line growth by nearly 200 basis points to about 4% annually during the next five years. However, it will also boost net debt/EBITDA to about 1.25 times by the deal's close in late 2013, versus Amgen's previous goal of reaching a net cash position. Because of that leverage-increasing planned acquisition, we downgraded Amgen's credit rating by a notch.
In August, Mylan outlined ambitious growth goals during an investor meeting, which keeps us cautious about its credit rating. During that meeting, management provided an outlook of annualized 13% revenue and 16% earnings per share growth through 2018. We remain skeptical about the firm attaining those goals, especially through internal means, and we continue to estimate mid-single-digit annualized growth in revenue and earnings for Mylan. With that relatively tame outlook, we believe debtholders should expect significant share repurchases and debt-funded acquisitions, if management intends to reach its lofty goals. Overall, we see the potential for substantial negative credit events in Mylan's future, and we believe investors should require more compensation for the risk in its bonds, which appear indicated at rich levels even for the agencies' BBB-/Baa3 ratings.
Contributed by Julie Stralow, CFA
While we expect rising interest rates to put a short-term cap on homebuilding activity and pricing, we still have a constructive intermediate-term view of the sector based on consumer confidence, job creation, and household formation trends. We expect gross margins to expand in the fourth quarter as strong pricing built into backlogs rolls into sales. We have an overweight on Toll Brothers (TOL) (rating: BBB-, no moat), given attractive relative spreads and lower impact from land shortages and rising mortgage rates. However, M&A may heat up as Weyerhaeuser's (WY) (rating: BB+, no moat) homebuilding business is on the block along with private seller Shapell Homes, reportedly worth $1.5 billion. Any cash deals could adversely affect credit quality.
In autos, we expect the recent acceleration in the U.S. seasonally adjusted annual rate to nearly 16 million units to continue in the fourth quarter. We see many reasons for consumers to buy a new vehicle, including the fleet reaching another record age of 11.4 years, ample credit availability, high used-vehicle prices, and plenty of desirable new products. Our per capita sales analysis incorporating new U.S. light-vehicle sales since 1951 suggests a long growth runway for all players, foreign and domestic. The 10.4 million units in 2009 was the lowest per capita sales year since at least 1951; we think normal demand, ignoring about 17.5 million units of pent-up demand, is 16.1 million-18.1 million. In 2013, the industry will probably end up around 15.5 million in unit sales. In Europe, we see last year's fourth-quarter production cuts leading to an easier comp this year and general stabilization of the market, which should benefit auto suppliers like Delphi (DLPH) (rating: BBB, narrow moat), a name we continue to like. We also see sequential improvement in the Brazilian market and continued growth in China, albeit at slower levels, supporting global auto original-equipment manufacturers. We continue to like Ford (F) (rating: BBB-, no moat) and see further positive rating actions, although the 10-15 basis points of tightening after S&P's long-awaited move to investment grade removed some of the upside.
In defense, we expect strong second-quarter results to give way to a cloudier outlook as the impacts of sequestration and any debt ceiling negotiations flow through. The sector has performed well recently, but spreads could reverse course as uncertainty prevails. Offsetting that could be positive headlines driven by any further flareups out of the Middle East. Outright war could drive higher spending in the other contingent operations budget, which is not constrained by sequestration. Finally, higher interest rates will have a favorable impact on pension liabilities and thus adjusted leverage for most credits in this group. Higher oil prices could take some of the froth out of the aerospace side, although we expect strong backlogs to support credits including recently upgraded Boeing (BA) (rating: A, narrow moat). M&A could ramp up, particularly among second-tier suppliers; we've seen recent deals out of Rockwell Collins (COL) (rating: A-, narrow moat) and Alliant Techsystems (ATK) (rating: BB+, narrow moat) in commercial properties. Both were credit negatives (although we maintained our ATK rating) and will lead to new supply in the corporate bond market.
Contributed by Rick Tauber, CFA, CPA
Technology and Telecommunications
The past couple of months have seen a heavy emphasis on mobility across the technology and telecom markets. Most notably, Verizon (VZ) (rating: BBB, narrow moat) reached an agreement to acquire Vodafone's (VOD) (rating: UR+/BBB+, narrow moat) 45% stake in Verizon Wireless for $130 billion, with a record-stomping $49 billion bond offering to match. Beyond Verizon, Microsoft (MSFT) (rating: AAA, wide moat) dropped $7 billion to acquire Nokia's (NOK) (rating: BB+, no moat) phone business, rounding out its mobile device strategy, and Intel (INTC) (rating: AA, wide moat) continues to push hard into the phone and tablet processor market. The emphasis on mobility reflects the shift in computing power from the PC toward a more diverse array of devices.
Of these developments, Microsoft's Nokia purchase holds the greatest long-term implications, in our view. Nokia/Microsoft and Blackberry have been making last-ditch efforts to emerge as a viable third smartphone ecosystem alongside Apple's (AAPL) (rating: AA-, narrow moat) iOS and Google's (GOOG) (rating: AA, wide moat) Android. Nokia's Windows-based Lumia phones haven't gained much traction thus far, and clearly Microsoft hopes to better align the Windows Phone ecosystem.
However, Microsoft faces challenges as it shoehorns Nokia into its broader corporate strategy. For example, Microsoft has delayed offering a full version of Office 365 on iOS or Android devices as it hoped the popularity and network effect of Office would help spur sales of Windows mobile devices. However, Apple's recent decision to offer iWork for free will challenge Office 365's limited-functionality iOS app. Given Apple's dominant tablet market share, we believe the iWork move may force Microsoft's hand, compelling it to defend its Office franchise at the expense of its push into devices. Microsoft is still a cash flow machine and has a long way to fall before its credit strength is jeopardized, but its strategic choices warrant close watching as new leadership takes the helm.
Verizon's greatly expanded debt load, now equal to about 2.9 times EBITDA, also gives investors plenty to consider. The firm's need for cash and desire to get financing in place quickly pushed concessions on its bond deal out to very attractive levels. Verizon now nicely fills a niche at the lower end of the investment-grade spectrum in the telecom sector, and investor demand for its bonds has been remarkable. Since the offering, spreads on the 5.15% notes due in 2023, issued at 225 basis points over 10-year Treasuries, have tightened dramatically to +168 basis points. We believe Verizon will do its best to reduce leverage in the next several years, but we don't expect it will pass up on attractive opportunities to enhance its competitive position, such as spectrum auctions or potential M&A transactions. As such, we would look for its bonds to widen back out 15-20 basis points before getting interested in building new positions.
Contributed by Michael Hodel, CFA
Two 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). Recently, 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 August 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 petitioned the Supreme Court to review the D.C. Circuit's decision. In June, the Supreme Court granted the U.S. petition to review the Circuit Court's decision, and on Sept. 4, 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. Additional environmental rules could follow in 2013 specifically addressing water cooling intake (nuclear and gas plant impact) and coal fly ash disposal (coal plant impact). We believe these rules are likely to raise costs for consumers and place increased rate pressure on regulated utilities. Additionally, we believe President Obama will provide continued support for carbon emission regulations.
Despite environmental compliance risks, we continue to view fully regulated utilities as a defensive safe haven for investors skittish about ongoing domestic and European-induced market volatility. As economic and geopolitical uncertainties begin to fade, we expect moderate spread contraction, particularly down the credit quality spectrum. However, given historically tight parent company spreads on higher-quality utilities facing lackluster earnings growth and the prospect of allowed returns on equity declining (in line with historically low interest rates), we urge bond investors to approach investment-grade utilities with caution. We advise investors to focus on shorter- to medium-term durations, as any further increases in Treasury rates in 2013 could quickly erode spread outperformance, given historically tight trading levels in the utilities sector. Moreover, we believe investors seeking yield should tread lightly when considering opportunities at diversified parent companies. Elevated downgrade risks exist particularly at these entities, given continued weakness at their unregulated genco subsidiaries.
We expect high-quality, fully regulated utility issuers to maintain their elevated pace of debt market issuance in 2013, taking advantage of low rates to refinance or prefinance as much as $85 billion of projected maintenance and rate base growth capital investments. We expect environmental capital expenditures also to be a significant component of debt-funded capital expenditures, though highly dependent on the severity of ongoing regulatory rulings, implementation timelines, and energy-efficiency initiatives. Utilities are eager to secure financing ahead of potential allowed return on equity cuts as regulators align their outlook with the sustained lower interest rate environment. In 2012, several state regulators approved or proposed allowed ROEs below 10%, limiting creditors' margins of safety as regulatory lag diminishes.
Unregulated independent power producers continue to face high uncertainty in 2013 and beyond. Power prices will remain severely strained as long as natural gas prices remain low. Excess natural gas supply and an unseasonably cool 2013 summer could push gas prices, currently hovering around the $3.70/mmBtu mark, back down close to 2012's historic lows ($1.91/mmBtu). Furthermore, we reduced our midcycle power prices in December 2012 to reflect a $5.40/mcf midcycle gas price (versus $6.50/mcf), negatively affecting independent power producers' projected margins. We do note moderately rising natural gas storage levels, totaling 3,253 billion cubic feet (as of Sept 6), are now 1% above their five-year average of 3,207 billion cubic feet (although down 5% year over year). Moreover, we believe coal prices will generally remain under pressure in 2013 as myriad environmental regulations stymie coal demand.
We continue to expect stand-alone merchant power producers to experience elevated liquidity constraints as well as those embedded in diversified utilities that own older coal plants in need of control upgrades. We believe Energy Future Holdings (formerly TXU) will file for Chapter 11 bankruptcy, probably by year-end 2013, creating one of the largest bankruptcies in U.S. history (about $47 billion of debt), given weak natural gas prices and extremely high leverage. Edison International's (EIX) (rating: BBB-, narrow moat) merchant generation company, Edison Mission Energy, was the first casualty following Dynegy's (DYN) (not rated, no moat) 2011 bankruptcy (2012 fourth-quarter emergence) and continues to move slowly through the bankruptcy process with increasingly contentious debtor/creditor negotiations. We also believe Ameren's (AEE) (rating: BBB-, narrow moat) March 14 announced merchant generation sale of Ameren Energy Resources Generating Company to Dynegy reflects the changing diversified utility landscape (shedding merchant generation) despite our belief that select coal generation should garner much higher asset values in the future (dollar per kW).
The industry's broad desire to accumulate regulated assets fueled M&A activity in 2012. While we expect this pace to moderate in 2013, we highlight MidAmerican's Energy's (owned by Berkshire Hathaway (BRK.B)) $5.6 billion cash acquisition of Las Vegas-based NV Energy in May for a 23% premium. NV Energy's high concentration of renewables (solar and wind) and increased cash flow were the primary drivers of value. Representative deals that closed in 2012 include all-stock mergers between Northeast Utilities (NU) (rating: BBB, narrow moat) and Nstar; Exelon (EXC) (rating: BBB+, wide moat) and Constellation Energy; and Duke Energy (DUK) (rating: BBB+, narrow moat ) and Progress Energy. Additionally, independent power producer NRG Energy (NRG) (rating: BB-, no moat) acquired peer GenOn Energy in 2012 for $1.7 billion in an all-stock transaction highlighting greater scale (NRG's retail expansion), generation fuel and revenue diversity, and reduced liquidity needs. Although we currently view GenOn as the weaker performer of the two, albeit with high operating leverage upside, NRG has reduced GenOn debt by more than 25%, down $1.3 billion, since acquiring the company, split between a $681 million secured term loan and $575 million of senior unsecured debt.
We expect any further industry consolidation to capture cost efficiencies, geographic diversification, and growth opportunities in new retail markets, particularly in Ohio. Along these lines, we highlight ongoing regulatory action in Ohio that could force American Electric Power (AEP) (rating: BBB+, narrow moat) to divest its power generation business from its transmission and distribution business by 2015.
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 9-17-13.
Price, yield, and spread are provided by Advantage Data.
Zimmer (ZMH) (rating: AA, wide moat)
Issuer Rating: AA
Spread to Treas: 140
We believe Zimmer remains a much better credit than the agencies' Baa1/A- ratings suggest. The firm has dug a wide economic moat, in our opinion, as a top-tier provider of orthopedic implants. We think the orthopedic industry is highly attractive for debtholders because of limited effective options for patients and suppliers' very sticky relationships with surgeons, which result in solid ongoing demand for implants and glacial market share shifts. Therefore, we believe Zimmer will maintain a top-tier position in this attractive niche and generate abundant cash flow for a very long time. Because of that solid outlook for free cash flow, we remain less concerned about Zimmer's small top line ($4.5 billion in the past 12 months) and focus on orthopedics than the agencies appear to be. For more than a year, the firm has maintained credit metrics that were previously described by Moody's as upgrade catalysts (cash flow from operations/debt around 50%, free cash flow/debt around 35%, and debt/EBITDA below 1.25 times). As of June, we estimate Zimmer's CFO/debt around 64%, FCF/debt around 46%, and debt/EBITDA at 1.0 times. With those metrics, we see upgrade potential by the agencies. Also, compared with key competitor Stryker's (SYK) (rating: AA, wide moat) 2020 notes (indicated around 90 basis points over the nearest Treasury), Zimmer's notes remain a compelling relative value.
KLA-Tencor (KLAC) (rating: A+, wide moat)
Issuer Rating: A+
Spread to Treas: 130
While KLA is modest in size and concentrated in the niche it serves, we believe its entrenched position with customers, as well as the feedback loop this creates, reduces technology risk relative to other firms in the industry. The firm's results have been choppy recently as swings in the economy affect overall demand for semiconductor equipment. KLA has managed to outperform the broader semiconductor equipment industry, though, because of the important role its products play in enabling the production of faster chips at reasonable cost. KLA has also continued to strengthen its balance sheet, with cash on hand rising to $2.9 billion from $1.5 billion at the end of fiscal 2010 despite increased share repurchases, thanks to the consistent cash flow that it generates. While buybacks are likely to continue, we'd note that the firm has carried at least $1.5 billion in cash during the past several years, roughly twice its current debt load. KLA's entire debt load consists of the 2018 bond, which trades at spreads more typical of a BBB rated issuer in the Morningstar Industrials Index. Although the firm operates in a very cyclical industry, it is well prepared to handle a downturn in demand.
Scana (SCG) (rating: BBB+, narrow moat)
Issuer Rating: BBB+
Spread to Treas: 200
Benefiting from leading regulated shareholder returns (mid-10%), Scana operates in a highly supportive Southeastern regulatory environment. Scana will further profit from a vast pipeline of infrastructure investments that will earn it leading utility returns on equity. Scana's 2022s trade 86 and 91 basis points wide of similar-duration paper issued by comparably rated regulated utility peers Duke Energy (DUK) (rating: BBB+, narrow moat) and Xcel Energy (XEL) (rating: BBB+, narrow moat), respectively. We believe Scana's 2022 bonds represent a compelling positive carry opportunity that is positioned for upside upon the successful completion of two new units at its V.C. Summer nuclear power plant (South Carolina), expected in 2017-18. In the worst-case scenario, assuming Scana's nuclear plant is stalled or permanently derailed, we believe South Carolina laws will allow Scana to recover its capital investment as well as any stranded costs through rate base increases. Last March, Scana successfully attained its combined license from the Nuclear Regulatory Commission. Clearing this last significant regulatory hurdle, Scana secured the right to construct and operate its planned V.C. Summer nuclear plants.
Hewlett-Packard (HPQ) (rating: BBB+, narrow moat)
Issuer Rating: BBB+
Spread to Treas: 208
While HP faces a long road as it works to turn around its various business lines, we believe creditors can take solace in the firm's continued commitment to repairing its balance sheet. Share repurchases have run at a very low level recently, and the firm has held off on acquisitions. Net debt has dropped more than $8.7 billion over the past year (through the third quarter of fiscal 2013). Net leverage is now at 0.9 times EBITDA, down from a peak of 1.6 times despite the pressure on the business.
HP is now sitting on $13.3 billion in cash, which should cover most of the large maturities it faces through fiscal 2014. With net leverage excluding the financial services unit now nearing zero, we expect that the firm will start to look for strategic acquisitions. However, we expect any deals will be relatively small as the memory of Autonomy remains fresh in management's mind. We also like HP's emphasis on turning around existing operations rather than acquiring its way into new segments. We believe the firm has carved out strong, defendable positions in several key areas, including services, enterprise hardware, and printing. Focusing on these areas should enable the firm to return to health over time. In the shorter term, macroeconomic concerns, especially in Europe, continue to hurt spending on information technology and HP's exposure to the price-competitive PC business has hurt sales as well. We expect HP will maintain profitability in its PC segment despite heavy pressure on sales.
The buyout at Dell (DELL) (not rated, no moat) has caused some concern that HP could be next in line. We don't believe a leveraged transaction is likely at HP, given the firm's large size, complex operational challenges, and relatively weak existing balance sheet. We'd view an asset sale as a more likely course for HP, and we believe the divestiture of the services business would be in the firm's best interest. Selling the old EDS business would reduce complexity and allow management to reach its balance sheet goals more quickly.
Ford Motor Credit (F) (rating: BBB-, no moat)
Issuer Rating: BBB-
Spread to Treas: 215
We view Ford's capital allocation policy, which was recently revealed in greater detail, in line with our view of steadily improving credit quality. Increased spending on dividends and capital expenditures will somewhat constrain free cash flow relative to our prior expectations, but ultimately we believe investment in the business globally will strengthen the overall portfolio. This should serve to minimize the sharp peaks and valleys experienced by the firm in the past. Management is also committed to investment-grade ratings throughout the cycle. Gross manufacturing debt peaked at $16 billion during the first quarter after a $2 billion debt offering. Debt declined $200 million during the second quarter, while cash increased $1.5 billion to $25.7 billion. An additional $1.2 billion of debt is due in the next year, and we expect the firm to retire that with cash on the way to its mid-decade target of $10 billion of debt. We continue to recommend the above issue as it trades more than 75 basis points wide of Daimler's (DAI) (rating: BBB+, no moat) finance company bonds due in 2021. We also expect further positive rating actions that could drive spread tightening of about 50 basis points while providing investors with attractive risk-adjusted compensation.
Dave Sekera, CFA has a position in the following securities mentioned above: AAPL INTC
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