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Credit Markets Finish Retracing Emerging-Markets Sell-Off

Dave Sekera, CFA

While the S&P 500 was largely unchanged last week, the corporate credit market continued to recapture the spread widening that occurred at the end of January and beginning of February. Concerns that disruption in emerging markets could spread into the developed markets led to a brief sell-off. However, this sell-off was short lived and the average spread within the Morningstar Corporate Bond Index tightened back to +117, nearly matching the tightest levels reached earlier this year and the tightest levels since before the 2008/09 credit crisis. We continue to believe that from a fundamental, long-term perspective, corporate credit spreads are fairly valued based on our outlook for GDP this year; however, at current levels, credit spreads are at the tight end of the range that we consider fairly valued, leaving only modest room for additional tightening.

Economic indicators released last week appeared to point in all directions. Robert Johnson, Morningstar's director of economic analysis, stated that he found it difficult to reconcile the seemingly divergent data from Markit’s Purchasing Managers Index, the regional Federal Reserve surveys, and several housing-related reports. After adjusting for the weather impact, he does not see an economic disaster looming, but believes the recently released economic metrics show that the economy is not growing in the 3%-plus range that other economists have been forecasting. Robert continues to expect that the US economy will grow between 2.0%-2.5% this year. For greater detail regarding last week’s economic news and Robert’s dissection of the data, please see his weekly Economic Insights.

New Issue Market Picks Up Steam as Week Rolls By; Kinder Morgan’s Offering Cheapest
Coming off the three-day weekend, the new issue market started off slowly on Tuesday, but picked up pace on Wednesday and Thursday. Whereas all of the new issuance two weeks ago was concentrated in 5-year notes, there was plenty of 10- and 30-year paper to go around last week. Among the new issues priced last week, we thought Kinder Morgan Energy Partners (KMP) (rating: BBB+, wide moat) 7- and 30-year notes were the most attractive. For investors looking for medium duration notes, KMP priced the 7-year notes at +143, which compares favorably to our fair value estimate of +130. For investors looking for long duration assets, KMP’s 30-year notes priced at +185, some 20 basis points wider than our fair value estimate of +165. We rate KMP’s notes as an Overweight.

Among the other new deals priced, several provided us with further evidence to back up a few of our recommendations. For example, after initially being whispered at +110, Comcast (CMCSA) (rating: A-, wide moat) 10-year bonds priced at +93, which was much tighter than our fair value estimate of +100; however, we think the Comcast's 10-year at +93 highlights the relative attractiveness of AT&T's (T) (rating: A-, narrow moat) 2.625% senior notes due 2022 which were trading at +122. We currently rate AT&T’s bonds as an overweight and rate Comcast’s notes as a Market Weight. In addition, while we are certainly comfortable with the credit risk of Google (GOOG) (rating: AA, wide moat), we think the market is overpaying for the company’s debt and rate the firm’s notes as an underweight. Google priced 10-year bonds at +63, which is inside our fair value estimate of +70. Comparatively, we recommend overweighting Oracle (ORCL) (rating: AA, wide moat) 3.70% senior notes due 2023, which were indicated at +79 basis points over Treasuries.

Are Larger LBO Transactions Coming Back?
As part of its fourth-quarter earnings release, Safeway (SWY) (rating: UR-/BBB, no moat) announced it is in discussions to sell the company. We don't envision any strategic buyer, domestic or foreign, has an interest in buying the company outright and assume the most likely buyer is private equity. Considering the company has publicly stated that it is already in discussions to sell the company, we suspect the firm is well down the path with at least one buyer. By announcing the firm is discussing its possible sale, management has effectively put the company in play to entice any other would be buyers to step up to the plate in order to maximize its sale price. As such, at this point we think the likelihood of a sale is greater than not. If Safeway is sold, it would be one of the larger LBO’s that we have seen since Heinz was bought a year ago and Dell’s LBO was completed last fall. This will be an excellent opportunity for the private equity community to test the appetite of the banks to provide hefty commitment letters to fund large LBOs.

Even though the economic recovery is still only growing at historically low rate, that hasn't slowed down the private equity sponsors, who are in the midst of raising record amounts of capital that needs to be put to work. In 2013, according to Preqin (a data provider for the alternative asset class), private equity funds have increased their amount of dry-powder by 14% to over $1 trillion, an amount slightly over the previous high registered at the end of 2008. However, according to Preqin, the value of buyout investments only averaged totaled $264 billion over the past three years. With over $1 trillion of capital looking to be put to work, it has raised concerns about the ability of these private equity funds to be able to put this amount money to work, thus potentially leading to larger deals.

In addition to the record amount of equity capital to support a resurgence of large LBOs, the market for collateralized loan obligations (CLOs) has also staged a resurgence in 2013. In order to launch the new CLOs, fund managers have been scrambling to purchase loans to fill their warehouse lines and are willing to purchase loans made at higher debt leverage and with fewer protections for investors. For example, the percent of first-lien loan volume that is covenant-lite has risen to over 90%, significantly higher than the proportion of covenant-lite deals during the heyday in the mid-2000s. Considering most private equity sponsors were busy harvesting gains in 2013 by selling down equity stakes among their portfolio companies, with record dry-powder available and easy terms in the bank debt market, a successful LBO and financing of Safeway could be the catalyst to set off a new round of buyouts.

Click to see our summary of recent movements among credit risk indicators (http://news.morningstar.com/articlenet/article.aspx?id=636624).

New Issue Notes

Medtronic Issuing New Notes with Attractive Initial Price Talk on Longer Maturities (Feb 20)
Medtronic (MDT) (rating: AA, wide moat) is in the market issuing new 3-year (floating-rate and fixed rate), 10-year, and 30-year notes. The proceeds will likely be used to redeem debt due within the next three years, including $1.7 billion in commercial paper borrowings and about $2.9 billion in senior unsecured notes. Initial price talk of +35, +100, and +105 basis points for the 3-year (fixed), 10-year, and 30-year notes, respectively, looks fair on the 3-year and moderately attractive on the 10-year and 30 year. We view fair value closer to where Medtronic's existing 2016s, 2023s, and 2043s are currently indicated around +35, +80, and +80 basis points over their nearest Treasuries, respectively.

Our credit rating for Medtronic remains AA, which reflects its highly diversified medical device business and manageable leverage. Medtronic remains one of the most diverse medical device firms in the world with devices to treat various cardiac, diabetes, spine, and structural heart conditions. We believe Medtronic has dug a wide moat around its diverse set of patent-protected medical devices. Typically, Medtronic's size and diversity is rewarded in the bond market, but if initial price talk holds, investors may be able to gain relatively attractive compensation on this strong credit. By comparison, we typically see St Jude Medical (STJ) (rating: AA-, wide moat) as a better relative value than Medtronic. St. Jude's 2016s remain a better relative value than Medtronic's notes around +60 basis points over the nearest Treasury. However, St. Jude's 2023s and 2043s are indicated at +101 and +109 basis points over their nearest Treasuries, respectively, which we note is close to initial price talk on Medtronic's new notes. However, we do not expect that dynamic to last long, as bond investors typically view Medtronic notes as significantly more attractive than St. Jude notes.

Initial Price Talk on Eli Lilly's New Issuance Looks Slightly Attractive (Feb 20)
Eli Lilly (LLY) (rating: AA, wide moat) is in the market Thursday issuing new 5-year and 30-year notes. The initial plan is to issue $800 million, which could help refinance notes coming due in March ($1 billion). Previously, management had planned to merely redeem notes coming due, which kept Lilly off our Potential New Issue Supply list, but recent success in its pipeline (including Phase III lung cancer trial results released Wednesday) and low available borrowing costs appear to have enticed management back to the debt market. Initial price talk around +55 basis points and +95 basis points over Treasuries for the 5-year and 30-year, respectively, look slightly wider than fair value, which we see at +45 basis points and +85 basis points over Treasuries, respectively.

Our fair value on the 5-year is determined by the average (mid-40s) of existing 2018 and 2019 maturities from other similarly rated pharmaceutical firms, including

Pfizer (PFE) (rating: AA, wide moat), Allergan (AGN) (rating: AA-, wide moat), Bristol-Myers Squibb (BMY) (rating: AA-, wide moat), Merck (MRK) (rating: AA-, wide moat), Roche Holding (RHHBY) (rating: AA-, wide moat), Sanofi (SNY) (rating: AA-, wide moat), and Eli Lilly's own 2018s, which are indicated around +40 basis points over the nearest Treasury. For the 30 year issue (fair value of +85 basis points over Treasuries), we note that key peer Novartis NVS (rating: AA+, wide moat) issued new 30-year notes on Tuesday at +77 basis points over Treasuries, which looked about fair to us. Given Novartis's higher credit rating because of its more diverse operations, we believe Lilly's 30-year notes should price moderately outside Novartis's 30-year notes, which are now indicated around +79 basis points over Treasuries.

Lilly faces daunting growth prospects in the foreseeable future because of patent expirations on key drugs. Through 2017, patents expiring on several key blockbusters, including antidepressant Cymbalta in December 2013, osteoporosis drug Evista in early 2014, cancer treatment Alimta in 2017, erectile dysfunction drug Cialis in 2017, and ADHD drug Strattera in 2017. To reinvent itself, Lilly is placing big bets a late stage pipeline that could start offsetting these losses around 2014 and 2015. In the pipeline, we see several promising diabetes, cancer, and Alzheimer's treatments. However, even with the probability-weighted success of these new drug programs, we think free cash flow may remain constrained under $5 billion annually during the next five years, or similar to what it produced in 2013. The good news for debtholders is Lilly operates with a very conservative balance sheet. At the end of December, Lilly held $13.0 billion in cash and investments compared with $5.2 billion in debt. However, given its stagnant growth prospects, we wouldn't be surprised to see Lilly make capital allocation decisions that are unfriendly to debtholders in the future, especially if pipeline candidates do not succeed.

Google’s New 10-year Offering Looks Attractive (Feb 20)
Google plans to issue $1 billion of 10-year notes. Google intends to use the proceeds to repay its $1 billion 1.25% notes which mature in May. The firm clearly does not need cash, as it held $58 billion at the end of 2013, including $25 billion domestically. Initial price talk on the new 10-year notes is in the area of +75 basis points, a level we find moderately attractive. We would peg fair value at about +70 basis points. Google’s 3.625% notes due in 2021 were recently indicated at +46 basis points over the nearest Treasury, while the AA tranche of the Morningstar Industrials Index currently sits at +66 basis points. For comparison, Apple’s (AAPL) (rating: AA-, narrow moat) 2.4% notes due in 2023 are indicated at +78 basis points over the nearest Treasury, Oracle’s 3.7% notes due in 2023 are indicated at +79 basis points, and Microsoft’s (MSFT) (rating: AAA, wide moat) 3.625% notes due in 2023 are indicated at +66. Among this group of cash-rich firm, we believe Oracle offers the best value.

Google’s debt load is a tiny fraction of cash on hand and could be repaid out of cash flow in less than six months. As the de facto standard for the majority of Internet users, Google has carved out a very strong competitive position in the search market, in our view. More than 80% of Google's revenue--and likely more than all of its reported profit--is tied to the search business. Google has consistently said that it views its large cash balance as a strategic weapon given the pace of innovation around it and the investment options it sees. We expect that the firm will continue to make heavy use of acquisitions as it looks to build new products and services. However, we also expect the firm will remain very conservative with its balance sheet, maintaining access to the debt markets primarily to enhance financial flexibility should its domestic cash balance ever run low.

Kinder Morgan to Issue 7- and 30-Year Notes; Initial Price Talk Looks Attractive (Feb 19)
Kinder Morgan Energy Partners (KMP) (rating: BBB+, wide moat) announced that it is issuing 7-year and 30-year notes in benchmark size. In addition to the debt offering, Kinder Morgan is selling 6.9 million common partnership units for approximately $540 million. Kinder Morgan intends to use the proceeds from both the debt and unit issuance to repay its commercial paper debt, which stood at $2.75 billion as of February 14, and for general partnership purposes. Initial price talk is mid-100s for the 7-year and +190-195 basis points for the 30-year. We peg fair value at +130 bps and +165 bps, respectively, making initial price talk attractive for both issues.

Kinder Morgan’s credit metrics remain strong despite the increase in total debt resulting from its 2013 acquisition of Copano. On a LTM basis, gross leverage of 3.9 times is lower compared with 4.0 times leverage in the third quarter; interest coverage of 6.0 times decreased from 6.3 times. Debt/capitalization was roughly flat at 54%. Based on our estimates for 2014, we project that year-end leverage will be 3.6 times, while interest coverage is roughly unchanged at 6.1 times and debt/capitalization increases to 58%.

We view Williams Partners (WPZ) (rating: BBB, wide moat) and Enterprise Products Partners (EPD) (rating: BBB+, wide moat) as fair comparables for Kinder Morgan. Williams' 4.0% notes due 2021 recently traded at +140 bps above the nearest Treasury while its 5.80% notes due 2043 traded at +172 bps. We view both Williams notes as slightly rich to fair value. Enterprise's 4.05% notes due 2022 recently traded at +107 bps over the nearest Treasury, while its 4.85% bonds due 2044 traded at +130 bps. We view Enterprise's notes as trading close to fair value. Prior to today's announcement, Kinder Morgan’s outstanding 5.80% notes due 2021 were indicated at +148 bps over the nearest Treasury and its 5.00% bonds due 2043 traded at a spread of +172 bps. We view Kinder Morgan as cheap to fair value and maintain an overweight recommendation. Given our moat and credit ratings of Kinder’s comparables, and spread levels on Kinder’s outstanding debt, we believe fair value is +130 bps for the 7-year and +165 bps for the 30-year.

D.R. Horton Offering 5-Year Notes; We See Fair Value at 3.75% (Feb 19)
Homebuilder D.R. Horton (DHI) (rating: BB+, no moat) is in the market with a $400 million 5-year bond offering. We see fair value on the new notes at about 3.75%, and a spread of around +225 basis points over Treasuries. Horton's outstanding 3.625% senior notes due February 2018 are indicated at a yield of 3.16% and a spread of +215 basis points over the nearest Treasury, which we view as fair. Other homebuilders' bonds include Toll Brothers ' (TOL) (rating: BBB-, no moat) 4% senior notes due December 2018 which are indicated at 3.54% and a spread of +214 basis points over the nearest Treasury, which we view as somewhat cheap. Meanwhile Lennar's (LEN) (rating: BB, no moat) 4.125% senior notes due December 2018 are indicated at 4.00% and a spread of +260, which we also view as fair.

Proceeds are for general corporate purposes. That said, the firm retired a $146 million bond in January and has another $138 million due in September. The firm also has a $487 million convertible bond due in May which is well in-the-money with a strike price of $12.96. The company has indicated that it will settle this expected conversion with stock. As such, the new bond issuance will offset the convertible debt retired by the likely equity issuance keeping leverage relatively stable. At the end of the first quarter, net total debt to capital was 37%, with cash of $800 million and total homebuilding debt of $3.3 billion.

D.R. Horton posted strong first quarter results in January, but the real highlights were the encouraging orders and optimistic demand outlook provided by management on the conference call. December quarter order units rose 6% sequentially in a quarter that normally sequentially contracts by around 10%. On a year-over-year basis, unit orders expanded 4% versus the 2% decline in the prior quarter despite a more difficult comparison. Further, management noted that the weekly order sales pace accelerated in January ahead of the spring selling season. In contrast to last quarter when the company warned of possible ramping of sales incentives if sales did not improve in the early part of the important spring selling season, management sounded highly optimistic that this spring selling season will be a strong one. If that’s the case, we expect D.R. Horton to be a prime beneficiary given its significant supply of move-in-ready speculatively built homes.

Comcast Offering Looks Fair; We Prefer AT&T (Feb 19)
Comcast (rating: A-, wide moat) announced today that it will issue 10- and 30-year bonds in benchmark size. Initial price talk is in the area of +110 and +125 basis points, respectively. We note however that the firm’s on-the-run 2.85% notes due in 2023 tightened since the announced acquisition of Time Warner Cable (TWC) (rating: BBB-, wide moat) last week. These notes were indicated recently at +86 basis points over the nearest Treasury versus about +90 basis points prior to the deal announcement. As such, we would expect Comcast’s new 10-year notes to price tighter than initial talk and place fair value at about +100 basis points, which is in line with the A- bucket of the Morningstar Industrials Index. However, we prefer AT&T among investment grade rated telecom issuers, as AT&T’s 2.625% notes due 2022 were recently indicated at +122 basis points over the nearest Treasury.

Comcast reaffirmed its commitment to a medium-term leverage target of 1.5-2.0 times EBITDA and its current credit ratings when it announced the TWC acquisition. The combined firm would begin life with net leverage of 2.4 times, up modestly from Comcast’s 2.2 times level at 2013 year-end. We however believe this transaction, if approved by regulators, will widen and stabilize the moat of the combined firm. We also believe the merger will provide cost savings that should boost cash flow enabling Comcast to buy back shares, as planned, while still reducing leverage. Should the deal close as planned, we expect that Comcast will retain its A- rating.

This transaction will create a mammoth cable company. Comcast and TWC networks pass a combined 84 million homes, or about 70% of the U.S. population. In terms of fixed-line network reach, only AT&T would come close to the combined company, with an estimated 50 million homes passed. As Comcast asserts, this merger will not reduce competition in any given market, as Comcast and TWC networks don't overlap. However, the transaction is sure to draw plenty of regulatory and political scrutiny, given the massive influence Comcast will have over both television distribution and Internet access.

In connection with the proposed merger, Comcast has said it is willing to divest itself of 3 million television customers to win approval for the transaction. At current penetration rates, that equates to about 7.5 million homes served. We doubt that level of divestitures, at less than 10% of the combined company, will change the course of debate among regulators. Comcast would still extend its reach to around two thirds of the United States from about 45% today.

PG&E Corp. to Issue $750 Million of 10- and 30-Year Bonds; Initial Price Talk Appears Cheap (Feb 18)
Pacific Gas & Electric (PCG) (rating: UR-/A-, narrow moat) announced today that it will issue in aggregate $750 million of 10- and 30-year bonds. Initial price talk is +120 basis points on the 10-year and between +125-130 basis points on the 30-year. When compared with peers Duke Energy’s (DUK) (rating: BBB+, narrow moat) 3.95% due 2023 trading at +95 basis points over the nearest Treasury and CMS Energy’s (CMS) (rating: BBB-, narrow moat) 4.7% due 2043 trading at +116 basis points, initial price talk on both Pacific Gas & Electric’s 10-year and 30-year bonds appears cheap. We believe fair value on Pacific Gas & Electric Corp’s 10-year is roughly +105-110 basis points while fair value on its 30-year is roughly +120-125 basis points. We also note that PG&E’s 3.25% notes due 2023 recently traded at +100 basis points over the nearest Treasury, which we view as rich to fair value.

Pacific Gas & Electric remains exposed to approximately $1.3 billion of additional unrecoverable costs in 2014 and beyond, absent any punitive damages resulting from ongoing regulatory reviews, related to the San Bruno pipeline explosion ($2.7 billion of already incurred or committed costs as of 2013 year-end). Thus, we previously placed Pacific Gas & Electric’s A- rating under review with negative implications. However, we believe the company operates in a generally constructive regulatory environment with an above average allowed ROE of 10.5%. Moreover, we note that Pacific Gas & Electric continues to grow its stable regulated electric rate base as it projects roughly $2.0 billion (mid-point) of electric distribution infrastructure build-out in 2014. Finally, we expect Pacific Gas & Electric Corp to raise roughly $900 million of additional equity to partially offset its San Bruno expenses in 2014, which does not include future potential penalties.

Illinois Tool Works Is in the Market for 3s, 5s, and 10s (Feb 18)
Illinois Tool Works (ITW) (rating: A, narrow moat) is in the market today, looking to issue to 3-, 5-, and 10-year bonds in benchmark size. The firm, which was listed in our January 2014 Potential New Supply List, intends to use the net proceeds to repay its short-term debt associated with its commercial paper program--currently $2.1 billion outstanding--and for general corporate purposes. Initial price talk is a spread of +35, +60, and in the low +90s above Treasuries for the 3-, 5-, and 10-year offerings, respectively.

We think that the indicative spreads on the 5- and 10-year bonds are fair, but believe fair value on the 3-year note is closer to +40 over Treasuries. For comparables, we look to Parker Hannifin PH (rating: A, narrow moat) 3.50% senior notes due 2022, which are indicated at +88 over the nearest Treasury and consistent with the average spread of the single A tranche within Morningstar’s Industrials Corporate Bond Index. Honeywell International's (HON) (rating: A, narrow moat) 3.35% senior notes due 2023 are indicated at +63 over the nearest Treasury, which we also view as fair.

Generally, we view ITW as the weaker credit of the bunch given its aggressive share-repurchase activity and leverage (2.1 times at the end of 2013), which weigh on our credit rating. Still, ITW is underway in its five-year plan that consists of the firm selling the most commodified and slowest-growing business, which the firm believes these measures will increase operating margins nearly 400 basis points to 20%. For example, ITW recently agreed to sell its industrial packing segment to The Carlyle Group for $3.2 billion on Feb. 6.

Initial Price Talk Moderately Attractive on New Novartis Notes (Feb 18)
Novartis (NVS) (rating: AA+, wide moat) is in the bond market on Tuesday issuing new 10-year and 30-year notes, which may be used to help the firm boost its cash reserves after repaying $2 billion in debt that came due in early 2014 and also continuing to return cash to shareholders and make tuck-in acquisitions. Initial price talk of +90 and +95 basis points over Treasuries, respectively, looks moderately attractive to us. However, we would not be surprised to see those notes price at tighter spreads, or closer to where notes from other large pharmaceutical firms and Novartis are indicated. We currently see fair value on AA rated pharmaceutical firms around +80 and +85 basis points over Treasuries, respectively for 10-year and 30-year notes. For example, Pfizer, Merck, and Bristol-Myers Squibb have maturities around 10-years indicated at +80, +70, and +80 basis points over the nearest Treasury, respectively; their notes with maturities around 30-years are indicated at +80, +80, and +90 basis points over the nearest Treasury, respectively. With Novartis rated slightly higher at AA+ due to its significantly diversified operations, we see for the new 10-year and 30-years notes a little tighter than its peers around +75 and +80 basis points over Treasuries, respectively. Novartis' existing notes are indicated modestly tighter than that at +70 and +65 basis points over the nearest Treasury for its 2022s and 2042s, respectively.

Morningstar's AA+ rating for Novartis reflects its high-quality, diversified business model and manageable leverage. Novartis derives its strength from a diversified operating platform that includes branded pharmaceuticals, generics, vaccines, diagnostics, and consumer products. By running complementary operations, Novartis can reduce overall volatility in its business. Going forward though, the firm aims to divest businesses where it does not boast leading market positions, including its animal health operations. However, we do not believe Novartis' business risk profile will change substantially because of its potential divestitures, although debt investors should be aware that the company's scope of businesses may decline somewhat. We still believe Novartis will remain competitively advantaged in the businesses its operates, which probably will remain quite diverse compared to most of its large pharmaceutical peers. Also, Novartis' projected EBITDA growth and overall fundamental outlook, including a solid new product pipeline and positive outlook for existing product growth, appears healthy compared with peers.

Click here to see more new bond issuance for the week ended Feb. 21, 2014 (http://news.morningstar.com/articlenet/article.aspx?id=636624).