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No end in sight for bond sellers moving into stocks.Inflation Expectations May Be Heating Up
As commodity prices skyrocket around the world, interest rates have been steadily rising.
By Dave Sekera, CFA
| 02-07-11 | 06:00 AM | E-mail Article
The Morningstar Corporate Bond Index ended last week at a spread of 144 basis points, essentially unchanged from the prior week and 6 basis points tighter since the beginning of the year. We believe credit spreads will tighten further over the course of the year as credit metrics and the economy continue to improve. However, credit selection and covenant protection will be extremely important, as we expect private equity funded leveraged buyouts to increase.
Dave Sekera is a Senior Securities Analyst with Morningstar. Contact Author
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Continued withdrawals from municipal bond funds are causing further dislocations in the municipal bond market. As we highlighted last week, this turmoil is forcing portfolio managers to sell what they can, not what they want to. While the negative headlines have caused an increase in near-term default expectations, we believe the risk is overblown. Tax-exempt municipal bond yields are now trading at or above taxable bond yields for similar credit risks. This has provided an attractive opportunity for investors willing to conduct their own due diligence to pick up extra return on a tax-equivalent basis. Some of the best opportunities exist where the underlying credit risk is a corporate entity that issued debt through a municipal entity that is essentially just a tax-exempt conduit, such as industrial development revenue bonds and pollution control revenue bonds.
Inflation expectations have become a hotly contested issue in the credit markets. Recent economic indicators such as the ISM Index, Purchasing Managers Index, and regional Federal Reserve surveys have revealed an underlying trend in their prices paid components. Morningstar's consumer product team has also highlighted this trend in underlying raw-material costs. As commodity prices skyrocket around the world, interest rates have been steadily rising. Indicative of this concern is the increase in the 10-year Treasury, which rose 30 basis points last week to 3.63%--133 basis points off the low in October 2010 and the highest yield since May 2010. The steepening of the yield curve also suggests that investors are becoming increasingly worried about inflation. For example, the spread differential between the 2-year and 30-year Treasury is currently 400 basis points, the widest it has ever been.
Sovereign credit spreads gapped tighter across the board on seemingly no new news. Credit default swaps in Portugal, Ireland, Greece, and Spain each tightened by 50 basis points or more over the course of the week. The trading levels are similar to where the credit risk was priced last October before the runup caused by Ireland's credit crisis. Corporate credit spreads in Europe followed this trend and tightened as well. With the pressure being taken off the sovereign credit spreads, the European financial sector outperformed last week and tightened about 10 basis points.
New Issue Market
Johnson Controls (ticker: JCI; rating: A), a maker of batteries, seats, and electronics for automotive customers and control systems for industrial users, sold $1.6 billion of notes in a four-part offering. The firm issued $800 million of 3-year debt split between a 1.75% fixed rate piece (T+75) and a floater at L+41. The other pieces were a 10-year at T+90 and a 30-year at T+110. Our credit rating is two notches higher than the rating agencies' based on our favorable view of the outlook for the auto industry combined with strong growth expected in the building efficiency segment (which includes HVAC systems). The bonds appear to have priced slightly cheap to our rating, based on where other diversified industrials trade, and rich to the rating agencies. They are also somewhat rich to the Morningstar A index. Nonetheless, with our narrow economic moat and medium fair value uncertainty ratings, we would be comfortable buying these bonds relative to other diversified industrials.
L-3 Communications (ticker: LLL; rating: BBB+) issued $650 million of 10-year senior unsecured bonds with proceeds used to retire senior subordinated debt due in 2015. The subordinated bonds were called at $101.958 and carried a coupon of 5.875%, so the new 4.95% coupon bonds result in modest interest savings for the firm. The 10-year bonds were priced in line with L-3's other senior unsecured bonds outstanding due in 2019 and 2020, at a spread of T+153. We were surprised that this issuance wasn't larger, considering L-3's $700 million convertible bond that is putable imminently; the firm also has a 6.375% senior subordinated issue that is currently callable. As such, we expect further supply to come. Our current rating is two notches higher than the rating agencies', although the bonds priced only slightly cheap to the Morningstar BBB+ index. High-grade defense companies trade well inside the implied rating agencies' spreads and more in line with our ratings, so we view L-3's bonds as only slightly cheap to comps such as Raytheon (ticker: RTN, rating: A), Northrop Grumman (ticker: NOC, rating: A), and Lockheed Martin (ticker: LMT, rating: A+). We prefer BAE Systems (ticker: BAE, rating: A-), which trades wide of L-3, also considering potential additional supply from L-3.
Ford Motor Credit issued a $1.25 billion benchmark 10-year bond at T+225, which implies the market's perception of BBB- credit risk, although the rating agencies have the bonds rated in the mid- to weak BB category. We rate Ford Motor Company (ticker: F) BBB-. While we don't rate the captive finance debt specifically, we would view the risks as similar to our corporate rating, given the highly intertwined relationship between the automotive company and finance subsidiary, along with the existing maintenance agreement. As such, we view these bonds as being priced fairly. If the rating agencies were to upgrade their ratings to investment grade and in line with our rating, we believe the credit spread could tighten further as investment-grade-only investors begin to build positions in the name. We are thus comfortable buying the bonds at these levels for potential longer-term outperformance.
Microsoft (ticker: MSFT; rating: AAA) returned to the capital markets this week, issuing $2.25 billion of new notes, with $750 million maturing in 5 years, $500 million in 10 years, and $1 billion in 30 years. The credit spreads were slightly wider than where Microsoft issued bonds last September. For example, the new 10-year bond was issued 5 basis points wider at +45, although that is still tighter than the Morningstar AAA corporate bond index at +52 basis points. Microsoft continues to enjoy exceptional financial strength, with more than $41 billion in cash and investments sitting on the books versus $10 billion in debt as of the end of its fiscal second quarter. Following this debt offering, gross debt stands at about 0.4 times EBITDA. The firm continues to produce copious cash flow, with more than $11 billion in cash generated through the first half of fiscal 2011. Microsoft also continues to buy back stock aggressively, though, and it is probably looking to enhance its domestic cash position to ensure it has flexibility going forward.