Republished from: “Morningstar.com”
The corporate credit market continued its march higher last week. Credit spreads tightened another 7 basis points, as the average spread of Morningstar’s Corporate Bond Index declined to +211 basis points over Treasuries. Economic indicators released last week were generally positive and were capped off Friday with a much stronger-than-expected nonfarm payrolls report. The bulk of fourth-quarter earnings reports have generally been in line with expectations. A few exceptions aside, credit metrics across our coverage universe continue to point toward strong credit quality.

As earnings season dies down, the new issue market is picking up in earnest. Once corporations released their earnings reports, they have been using the opportunity to lock in long-term financing at all-time-low yields. Between the recovery in credit spreads and near-record lows in Treasury rates, corporations are finding that they have been able to issue bonds at historically low all-in yields. For example, Procter & Gamble (PG) (rating: AA) issued 10-year bonds at 55 basis points over Treasuries, resulting in a record-low interest rate of 2.30%. We expect many more corporations to come to market during the next month to lock in these low long-term rates while they can.
Credit spreads have tightened so much so fast (40 basis points since the beginning of the year) that it appears many traders are having a hard time keeping up with the price movement. We have seen several instances in which their price indications have lagged the market’s movement. For example, when McDonald’s (MCD) (rating: AA-) announced it was doing an add-on to its recently issued 10-year note deal, one trader we talked to said he thought the existing bonds were trading wrapped around +60. Another trader we spoke with thought the bonds were in the mid-50s. However, the new bonds were priced at +52, well inside both indications, and the bonds still continued to trade up in the secondary market. The voracious demand for corporate bonds that we’ve been commenting on during the past few weeks shows little sign of subsiding.

European Credit Markets Quickly Healing
The credit markets in Europe have recovered to such a degree that an Italian bank, which would have been considered persona non grata in the new issue market just a few short weeks ago, was able to sell new bonds. Granted, the bond only has an 18-month maturity, but Intesa Sanpaolo (ISP) (rating: BBB) successfully placed a new EUR 1.5 billion senior unsecured bond issue. In addition, Commerzbank (CBK) (rating: BBB+), which we consider to be one of the weakest German banks, was also able to place new five-year senior unsecured bonds.
Sovereign credit spreads tightened across the board in Europe, in many cases returning to levels of late summer and early fall, before the latest round of sovereign debt worries sent the credit markets into a tailspin. However, the rate of gain among the sovereigns appears to be slowing. Many of the credit default swap levels and actively traded sovereign bonds we watch peaked during the middle of the week and either flattened out or gave back some of their gains by week’s end. We don’t have a view yet whether this indicates a pause as buyers reassess risk and reward at these levels, or if investors who bought at cheaper levels are using the rally to book profits.
There was no new news out of Europe to derail the strengthening in the credit markets. Greece’s attempt to negotiate debt forgiveness from its public bondholders continued to play out in the media, but it doesn’t appear that they are any closer to a deal. We continue to believe that the negotiations will drag on until at least the second half of this month or the beginning of March before substantive progress to avert default will be made (if a default can even be averted). Our assessment on the timing is based on statements from the European Union and International Monetary Fund, which have both reported that they need a few weeks’ time before the March 20 debt maturities in order to properly document and fund another bailout loan.

New Issue Commentary
We Expect McDonald’s New Issuance to Price Very Tightly (Feb. 2)
McDonald’s (rating: AA-) is coming to market with 10- and 30-year bonds today. The 10-year notes are an add-on the existing 2.625% notes due 2022. Those notes were trading around 60 basis points over Treasuries before the deal was announced. Typical to where the popular issuer trades, this is 20 basis points tight to the Morningstar AA- index. This seems about right to us, given that Procter & Gamble (rating: AA) priced a new 10-year last week at 55 basis points over Treasuries. The 30-year notes should price around 25 basis points wide of the 10-years. The high investor demand in this market, coupled with the cachet of the McDonald’s name, should push these bonds even tighter. Despite our positive credit opinion on the name (we rate the firm higher than the agencies do), this deal is too rich for our blood.
Our positive view of McDonald’s creditworthiness reflects a belief that the company operates with a meaningful and sustainable competitive advantage–a wide economic moat–that permits it to generate returns well in excess of its cost of capital. We expect this wide moat will translate to strong, low-volatility cash flows available to meet contractual obligations to creditors–just as it has in the past. Because roughly 89% of U.S. McDonald’s restaurants are franchise-owned, franchise performance is the linchpin of McDonald’s creditworthiness. We consider McDonald’s franchise system to be the strongest of all quick-service restaurant operators. U.S. franchisees have fared relatively well during the past year, generating more than $2 million in sales and $314,000 in cash flow per location.
In the restaurant industry, we prefer Darden Restaurants (DRI) (rating: BBB+), despite its weaker credit quality. As one of the largest casual dining chains in North America, Darden earns a narrow economic moat because of its bargaining power over suppliers, scale advantages, and convenient restaurant locations. Its brands have consistently outperformed the Knapp-Track industry same-restaurant sales benchmark, which we attribute to strong brand loyalty and an increasing emphasis on everyday value offerings. Given the firm’s continued success, coupled with moderate lease-adjusted leverage in the mid-2 range, we believe the bonds trade much too wide and could tighten over time. The firm’s 10-year bonds trade around 230 basis points over Treasuries–more than 20 basis points wide of our BBB+ index.

Price Talk on B of A’s New 30-Year Seems Rich (Feb. 2)
Bank of America (BAC) (rating: BBB) announced last week that it will reopen its 10-year note issuance and issue new 30-year notes. Whispers on price forecasts are 335 basis points over the Treasury curve for each issuance. From a credit perspective, Morningstar continues to take a skeptical view on Bank of America. Our rating reflects Morningstar’s updated assessment of possible mortgage-related losses due to legal claims associated with past underwriting as well as more conservative estimates around the extent and timing of the company’s return to “normalized” earnings.

Considering our rating, we think the price guidance on the 30-year note is too rich. Citigroup’s (C) (rating: A-) recently issued 30-year note trades with a 250-basis-point spread to the Treasury curve. When accounting for the two-notch rating difference and a reasonable new issue concession, we think Bank of America’s new 30-year should come at a spread of 360 basis points to Treasuries. If the new deal is issued at the price talk, we would recommend investors look to Citigroup’s recently issued 30-year notes.

Shareholder-Friendly Limited Brands Intends to Tap Debt Market (Feb. 2)
Limited Brands (LTD) (rating: BB+) plans to issue $750 million consisting of 10- and 12-year bonds. In our view, based on where the firm’s 2021 notes and other strong below-investment-grade credits trade, the 10-year notes should price in the mid-300s, with the 12-year notes slightly behind that. Still, investors have been clamoring for paper, and the bonds could price inside that level, which we believe would be too expensive. In our view, with Limited Brands’ high lease-adjusted credit metrics, excessive shareholder-friendly activities (special dividends), and lack of an economic moat, the firm merits a below-investment-grade rating.
There aren’t many bonds in the retail industry that we find attractive these days, particularly in the below-investment-grade area. For investors looking for yield, we would suggest Hanesbrands (HBI) (rating: BB), which has 2021s trading more than 400 basis points over Treasuries. The firm’s weak yet improving credit metrics merit a second look from investors. The firm was spun off from Sara Lee (SLE) (rating: BBB) in 2006 and started out with more than $3 billion in debt. Since then, Hanesbrands has consistently paid down debt through free cash flow (roughly $650 million during the past three years). Management has a stated goal of bringing leverage below 3 times (currently around 4), which we believe is attainable by the end of 2012.
Initial Pricing Indicates IBM Offering May Be Attractive (Feb. 1)
International Business Machines (IBM) (rating: AA-) is planning to offer benchmark three- and five-year notes, four months after its last debt issuance. The firm’s three-year notes issued last October priced at a spread of 40 basis points above Treasuries, a level we thought was attractive. Although those notes have since tightened to around 25 basis points above Treasuries, it now appears that the new three-year notes also will price around 45-50 basis points above Treasuries, which we view as attractive. Given the strength of IBM’s business and balance sheet, the odds of distress during the next three years are extremely low. IBM last issued five-year notes last summer at a spread of 65 basis points above Treasuries, tightening modestly since then. We’re now hearing that the new five-years will price around 65-70 basis points above Treasuries, which we also believe is moderately attractive. Among large-cap tech issuers, we’ve long preferred Cisco Systems (CSCO) (rating: AA) over others, including IBM. Spreads on Cisco debt have tightened recently–we removed the firm from our Best Ideas list in January. Cisco’s 3.15% notes due 2017 are currently priced at about 50 basis points above Treasuries, probably tighter than IBM’s new notes. For larger-cap tech exposure, we’d now look to Applied Materials (AMAT) (rating: AA-), whose 2.65% notes due 2016 currently trade at around 100 basis points above Treasuries.

Toll Brothers to Issue 10-Year Bonds (Jan. 31)
Homebuilder Toll Brothers (TOL) (rating: BBB-) intends to place $250 million of new 10-year bonds. We have seen minimal new bond offerings in the homebuilding sector and meaningful debt paydown, so we believe this represents a good opportunity for investors to gain exposure to the sector. Toll has $140 million of notes due November 2012, but also very strong liquidity. We have had Toll on our Best Ideas list for several months and note that the firm’s 2019 bonds recently were indicated at about 5.25%. We expect spreads and yields to continue to grind in as homebuilding fundamentals gradually improve. We see fair value for a 10-year bond at around 5.0%, in line with weak BBB levels but expect the new deal to price closer to 6.0%.
Our investment-grade rating is based on the firm’s strong balance sheet, including more than $1 billion of cash and net debt/cap at around 15%, along with the firm’s strong position at the high end of the market. Toll is the only homebuilder we cover with a moat, as its well-established national brand and ability to procure choice properties allow it to maintain above-average margins. The firm’s fourth-quarter results announced in December included an increase in revenue, deliveries, and signed contracts, reflecting improved sentiment in the homebuilding market.

Ford Motor Credit Issuing Five-Year Bonds (Jan. 31)
Ford Motor Credit (rating: BBB-) is tapping the market for the second time this month with a five-year benchmark-sized offering. The firm sold $1 billion of add-ons to its existing 5% due 2018 and 3.875% due 2015 on Jan. 4. These bonds are trading at spreads just north of 300 basis points over Treasuries, which we view as fairly valued to slightly cheap. In comparison, Daimler’s (DAI) (rating: BBB+) finance subsidiary recently priced five-year bonds at 210 basis points above Treasuries, and these were recently indicated at about 185. We see 100 basis points as a reasonable differential between Ford and Daimler. The Morningstar weak BBB index is also just north of 300. As such, we would view fair value on a new five-year at about 3.75%. We continue to have a constructive long-term view of the Ford credit. However, given that the rating agencies all moved to high BB ratings in October and the firm has produced somewhat soft operating results in the face of higher commodity costs and foreign market headwinds, we believe it may be a few quarters before Ford reaches investment-grade status at the rating agencies. Thus, the firm remains in the high-yield market for now, and we suspect that the flood of paper coming out of Ford Credit will restrain any meaningful spread tightening for the near term.

TE Connectivity Talk Tightens, Notes Unattractive, in Our View (Jan. 31)
TE Connectivity (TEL) (rating: BBB+) has announced plans to issue $700 million of new notes split between three- and 10-year maturities. The firm’s existing debt hasn’t traded much recently, but appears roughly fairly valued given our rating, which is one notch higher than the agencies’. TE has about $700 million of debt maturing in 2012 and is also preparing to fund the $2 billion acquisition of Deutsch Group. The firm’s balance sheet is in good shape heading into the Deutsch deal, with net debt sitting at 0.6 times earnings before interest, taxes, depreciation, and amortization. Pro forma for the deal, we expect net leverage will remain comfortable at around 1.3 times EBITDA. Still, management’s predisposition to use cash flow to fund share repurchases and dividends gives us pause, especially in light of our view that TE doesn’t possess a strong competitive advantage in the connector and electrical component business.
TE’s 4.875% notes due 2021 are priced to yield in the range of 200 basis points over Treasuries, which is in line with the typical BBB+ rated nonfinancial issuer in the Morningstar Corporate Bond Index. We’ve recently heard that the proposed 10-year notes are now likely to price with a spread in the range of 180 on heavy demand. At that level, we believe the notes are unattractive. TE’s closest peer, Amphenol (APH) (rating: A), issued 10-year debt earlier this month that currently offers a Treasury spread of around 185 basis points. Given our higher rating on Amphenol, we like the firm’s debt to relative to TE’s. For those looking for exposure to smaller technology hardware firms, we’d prefer a firm like Juniper Networks (JNPR) (rating: A). We think highly of Juniper’s competitive position in the network equipment market. Its 4.6% notes due 2021 also offer a spread in the neighborhood of the high 100s.