Fixed Income Weekly Review & Preview

Transcription

1 Fixed Income Weekly Review & Preview January 26, 2004 Fixed Income Research Joseph W. Jasper, CFA Director, Fixed Income Strategy & Marketing Private Client Research Treasuries recorded their first losing week in three over concerns ranging from a general disdain for low absolute yields to fears over this week s FOMC meeting and the outcome of next month s G-7 meeting. We continue to believe we are trading at the low end of the market s recent range and that the risks are tilted toward a decent correction. We therefore recommend refraining from making new purchases until after the release of the January employment report. HIGHLIGHTS Treasuries Treasuries recorded their first losing week in three after yields fell earlier in the week to 3.92% on the ten-year. The Treasury will conduct its two-year note auction this week. Agencies The agency market had a strong performance, tightening versus both Treasuries and swaps. We highlight various return scenarios for callables vs. bullets Corporates Spreads finished mostly unchanged last week. We continue to suggest investors look to the lower-rated, higher-beta credits for the best relative performance. We highlight our opinions in the utility sector. Municipals Yields rose in concert with Treasuries last week. Given current tight valuations and low absolute yields, we would wait to make new purchases until after next week s January employment report. The next Fixed Income Weekly will be published on Monday, February 9. Piper Jaffray does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decisions. This report should be read in conjunction with important disclosure information, including an attestation under Regulation Analyst Certification, found on the back pages of this report or at the following site: Fixed Income Weekly Review Page 1 of 10 Piper Jaffray

2 YIELD, COMMODITY PRICE, CURRENCY, AND STOCK MARKET CHANGES FOR THE WEEK LAST WEEK PRIOR WEEK CHANGE (BP) 3 Month 0.88% 0.88% 0 2 Year 1.66% 1.67% (1) 5 Year 3.06% 3.06% 0 10 Year 4.07% 4.03% 4 30 Year 4.94% 4.89% 5 Curve 2s-10s Curve 2s-30s CRB Crude Oil (0.13) Gold Yen (0.60) Euro Wilshire ,157 11, Dow Jones Ind. Avg. 10,568 10,601 (33) NASDAQ Comp. 2,124 2,140 (16) Source: Bloomberg ECONOMIC HIGHLIGHTS Last week was fairly light in terms of economic data points, but those released continued to point toward recovery. Jobless Claims fell 1,000 to 241,000 from a revised 342,000 the previous week. Continuing claims also fell, declining to 3.14 million (for more on this, see the Macro Themes section). The index of leading indicators gained 0.2% in December, in line with expectations. Gains were driven by the continued decline in unemployment insurance claims, stronger vendor performance, and rising equity prices and building permits. Looking ahead, the FOMC meets on Tuesday and Wednesday this week, which promises to be a non-event. We believe there is near-zero chance of any policy change, and believe the wording of the official statement will again contain the considerable period language. The most closely anticipated event on the horizon will be next week s release of the January employment report. Most economists are calling for a gain in nonfarm payrolls of at least 154,000. In light of the current richness of the curve, we believe that any number relatively close to this estimate is likely to be met with a decent correction, sending yields basis points higher. We therefore suggest accounts limit new purchases, given that the balance of risk is tilted in favor of such a correction. LAST WEEK S ECONOMIC RELEASES DAY STATISTIC ACTUAL CONSENSUS ESTIMATE Wed. Housing Starts 2,088,000 1,950,000 Thurs. Initial Claims 341, ,00 Continuing Claims 3,143, Leading Indicators 0.2% 0.2% Source: Bloomberg Fixed Income Weekly Review Page 2 of 10 Piper Jaffray

3 THIS WEEK S ECONOMIC RELEASES DAY TIME STATISTIC CONSENSUS PREVIOUS (CDT) ESTIMATE Tues. 9:00 Consumer Confidence Wed. 7:30 Durable Goods 2.0% -3.1% 7:30 Less: Transportation 2.2% 3.7% Thurs. 7:30 Initial Claims 340, ,000 7:30 Continuing Claims 3,100,000 3,143,000 Fri. 7:30 GDP: Q4 5.0% 8.2% 7:30 Personal Consumption 3.0% 6.9% 8:50 Univ. of MI Confidence :00 Chicago Purchasing Mgrs Source: Bloomberg FIXED INCOME STRATEGY Macro Themes The big focus of last week for market participants was the surprise drop in initial claims for the week of January 17 - the survey week for the January employment report. While the decline was a modest 1,000 to 341,000, the 4-week average tumbled 3,250 to 344,500, a three-year low. The takeaway is that the data may be hinting at further improvement in the labor market, which has yet to materialize in recent monthly employment reports. Economists are now forecasting a significant 275,000 gain in January payrolls. Should this gain materialize it could take a significant amount of wind out of the bond market, sending yields basis points higher. A report showing more muted job growth during January, we believe, would pave the way to a retest of the 3.90% support level on the ten-year Treasury. We believe the most likely outcome is a number near consensus, which prompts some selling. We would therefore refrain from making new purchases until after this report on Friday. Treasuries The Treasury market saw solid gains that took five- and ten-year yields back below 3% and 4%, respectively, to the lowest levels since the beginning of October. Those gains evaporated late Friday after traders took profits ahead of the upcoming FOMC meeting and the January employment report. On the week, yields rose between zero and five basis points. The front end remained anchored, with the two-year yield down one basis point at 1.66%, while the 5-year, 10-year and 30-year yields all rose about five basis points to 3.06%, 4.07% and 4.94%, respectively. Agencies As Agency market investors map their 2004 investment outlook, they are presented with an investment landscape that looks substantially similar to that which dominated the second half of Treasury yields remain rangebound, although the recent rally is moving yields towards the lower end of the range, and volatility remains relatively stable. Nonetheless, we believe there are reasons for concern. A breakout of the trading range to lower yields will likely lead to callables underperforming their bullet counterparts. Alternatively, should the Fed begin to raise short-term yields, many buyers of Agencies, especially banks, may find Agency yields versus funding costs Fixed Income Weekly Review Page 3 of 10 Piper Jaffray

4 less attractive. To assess the potential near term performance of the Agency market, we examine the total return of selected bullet and callable structures over four yield curve scenarios. The scenarios are defined as: Unchanged: The yield curve remains unchanged over the holding period 25 basis point Flattening: Short-term yields increase 25 basis points 50 basis point Flattening: Short-term yields increase 50 basis points 25 basis point Bull Flattening: Short-term yields remain unchanged, five-year yields decline 25 basis points. For each yield curve scenario, we examine the projected total return relative to an equal duration combination of Treasury securities. The holding period in each case is six months. We consider the projected performance of bullet issues as measured by the current two-, three-, and five-year FHLB TAPs. For callables, we consider the projected performance of two benchmark callable structures, the recently priced three-year non-call one-year FNMA and five-year non-call two-year FHLMC, as well as a number of alternative structures that are favored by short maturity callable buyers. Our results are summarized in Chart 1 below. CHART 1 PROJECTED TOTAL RETURN ADVANTAGE: AGENCIES VS. COMPARABLE DURATION TREASURY (SIX-MONTH HONDING PERIOD, CONSTANT OAS) Issue Excess Return (in basis points) 25bp 50bp 25bp Bull Flattening Flattening Flattening Effective Duration Unchanged 2yr TAP yr TAP yr TAP FNMA 3yr NC 1yr FHLMC 5yrNC2yr FFCB 2yrNC6mo FHLMC 3.5yrNC 1yr FHLB 5yrNC1yr Source: Piper Jaffray, Bloomberg As we consider the results shown in Chart 1 we are drawn to a number of interesting comparisons. For the issues with effective durations of three years or less, callables often offer considerably more excess return relative to Treasuries than do their bullet counterparts. Consider the comparison between the FHLMC 3.5-year NC one-year callable against the comparable duration three-year TAP. Over each of the scenarios considered, the FHLMC callable offers considerably more excess return than the TAP. In the case of the short duration FFCB two-year NC 6mo, while it underperforms the longer duration two-year TAP in an unchanged and 25 basis point Bull Flattening scenario, it substantially outperforms the TAP in each of the flattening yield curve scenarios. For those issues with effective durations longer than three years, our recommendation is to consider bullets as attractive alternatives to callables. In Chart 1, the projected returns of the five-year TAP compare favorably to the FHLMC five-year NC twoyear and FHLB five-year NC one-year callables. Even in the flattening yield curve scenarios, the five-year TAP provides sufficient roll-down gains to outperform the Fixed Income Weekly Review Page 4 of 10 Piper Jaffray

5 callable issues in most cases. While the effective duration of the five-year TAP is somewhat longer than that of the FHLMC and FHLB callables, we feel that investors are better served by extending duration slightly as opposed to taking on call risk. To further illustrate our belief that callables offer value in the short end of the Agency market, while bullets are preferred in the longer end, we consider the performance of both short and long maturity callables relative to an equal duration combination in TAPs. We examine the projected six-month holding period total return advantage for the FHLMC 3.5-year NC one-year and FHLMC five-year NC two-year. For parallel yield curve shifts, our results are shown in Graph 1. GRAPH 1 PROJECTED HOLDING PERIOD EXCESS RETURN: CALLABLE VS. BULLET (SIX-MONTH HOLDING PERIOD, CONSTANT OAS) Source: Piper Jaffray, Bloomberg FHLMC 3.5yrNC1yr vs. 3yr TAPs FHLMC 5yrNC2yr vs. 5yr TAPS We believe the results displayed in Graph 1are compelling. In the case of the FHLMC five-year NC two-year, the roll-down gains of the TAPs are sufficient to offset the incremental yield of the callable in the unchanged yield curve scenario. Alternatively, the excess return of the FHLMC 3.5-year NC one-year over TAPs is compelling as the callable is projected to outperform over parallel yield curve shifts in excess of 50 basis points. Corporates Investment-grade corporates finished the holiday-shortened week mostly unchanged. The autos inched tighter on the heels of Ford s better than expected Q4 earnings report. Yield spreads on Ford s ten-year paper tightened by five basis points on the week mostly after the Company reported that its North American operations returned to profitability. Other big movers included Eastman Kodak, which saw its bonds tighten by 20 basis points on the week as investors cheered its announced Fixed Income Weekly Review Page 5 of 10 Piper Jaffray

6 restructuring plan. Lastly, the bonds of Duke tightened by roughly 20 basis points after Moody's affirmed its ratings and maintained its stable outlook on the utility. We suggest investors continue to focus on high beta names, with continued emphasis on economically sensitive sectors, which we expect will continue to perform well over the next few months. The benefits of the unusually steep Treasury curve warrants focus on five-year and ten-year maturities, as we believe this portion of the curve represents the best relative value. Utilities This week we focus further attention to the utility sector. We have been ardent supporters of maintaining utility exposure over the past year. Spreads on the Moody s Average Utility Index have tightened 106 basis points year over year, and now stands at However, the average spread for a BBB-rated utility is +140 and continues to offer buyers decent value. We summarize the major themes affecting the utility sector and highlight offer our opinion for the credit trends on several issuers. Most companies are refocusing on regulated operations as an earnings growth vehicle. Investments in nonregulated businesses have decreased dramatically for many companies based on investor criticism, rating agency pressure, and poor returns on invested capital. While this remains the theme in the sector, there are still a number of companies such as Black Hills, MDU Resources, and Great Plains Energy that continue to invest heavily in their nonregulated ventures. We expect continued negative ratings actions in the near term, albeit at a slower pace than the last couple of years. In 2002, S&P downgraded 182 holding companies and operating subsidiaries, compared to only 15 upgrades. For the first three-quarters of 2003, there were 102 downgrades compared to 11 upgrades. With this credit deterioration, the average credit rating for the utility sector is now in the BBB category, down from the A category just a few years ago. Furthermore, S&P has stated that the prospects for credit quality remain challenging, as indicated by ratings outlooks, 40% of which are negative. We expect merger and acquisition activity to continue in Private equity funds and financial buyers continue to invest in the sector such as Kohlberg Kravis Roberts & Co s purchase of Unisource, Goldman Sachs purchase of Cogentrix, and a group led by Texas Pacific Group bidding on Portland General Electric. Asset sales were also notable as many companies looked to unload assets to shore up liquidity and reduce maturing debt. We believe passage of the energy legislation with PUHCA repeal could be a catalyst for more activity in the future. Operating costs are coming under pressure with increases in pension expense, employee benefits, and insurance. Many companies, using assumed rates of return as high as 10% on pension assets, are being pressured by the SEC and auditors to reduce assumed rates to more conservative levels. The revisions to assumed rates of return are increasing the pension expense and consequently reducing the cash flows of companies. Operating costs are coming under further pressure as employee benefits and insurance costs are rising at rates higher than previously anticipated. Some of the costs can be built into future rate cases, but Fixed Income Weekly Review Page 6 of 10 Piper Jaffray

7 underfunded pensions and increasing operating expenses are negatives to credit quality. High natural gas prices are once again an issue for utilities. The recent increase in natural gas prices is a negative for the credit quality for most gas utilities, despite the fact that most gas utilities pass on the costs of natural gas directly to their customers. High prices have led to lower gas consumption by consumers putting stress on gross margins and working capital requirements of many gas utilities. The large gas bills are also causing larger write-downs in accounts receivable. On the other hand, the high price of gas is providing upside for companies with exploration and production assets. Companies that have a large percentage of their electric generation mix weighted toward coal or nuclear generation are also benefiting. Taking into account these considerations, we highlight below our forecast for the credit trends of several utilities. CHART 2 SELECTED UTILITY COMPANY FINANCIAL RATIOS Company EBITDA/Interest Exp Total Debt/EBITDA Dividend Total Payout Debt 2003E 2004E 2003E 2004E 2004E 3Q03A Avista AVA 2.72x 2.68x 4.45x 4.56x 52.60% $1,132 Black Hills BKH 3.95x 3.64x 3.68x 3.85x 64.20% $771 El Paso EE 3.96x 4.41x 3.43x 3.14x 0.00% $630 Great Plains Energy GXP 6.15x 5.57x 2.83x 3.20x 69.10% $1,355 IDACORP IDA 3.00x 3.87x 5.65x 4.39x % $1,100 MDU Resources MDU 9.28x 8.46x 2.19x 2.28x 42.90% $1,012 OGE Energy OGE 4.95x 4.66x 3.37x 3.53x 79.10% $1,599 Portland Gen Elec ENRNQ 5.04x 5.11x 2.64x 2.55x 0.00% $1,046 Puget Energy PSD 3.40x 4.16x 3.80x 3.41x 69.60% $2,623 Vectren VVC 4.32x 4.91x 4.04x 3.37x 70.70% $1,303 Wisconsin Energy WEC 4.15x 4.45x 4.85x 4.56x 38.10% $4,302 Xcel Energy XEL 4.13x 4.44x 3.89x 3.70x 65.50% $7,006 Universe Average 4.59x 4.70x 3.74x 3.55x 57.50% $1,990 Source: Piper Jaffray, Standard & Poor's CHART 3 SELECTED UTILITY COMPANY CREDIT TRENDS Company Ticker Piper Jaffray S&P Corporate S&P Outlook Credit Trend Credit Rating Avista AVA Improving BB+ Stable Black Hills BKH Declining BBB- Negative El Paso EE Improving BBB- Stable Great Plains Energy GXP Declining BBB Stable IDACORP IDA Stable A- Stable MDU Resourses MDU Declining A- Negative OGE Energy OGE Stable BBB+ Stable Portland General Electric ENRNQ Developing BBB+ Developing Puget Energy PSD Improving BBB- Positive Vectren VVC Stable A- Negative Wisconsin Energy WEC Declining BBB+ Stable Xcel Energy XEL Improving BBB CreditWatch Positive Source: Piper Jaffray, Standard & Poor's For a more in-depth discussion on the utility sector in general and our specific recommendations please reference our Electric and Gas Utility Guide, dated January Fixed Income Weekly Review Page 7 of 10 Piper Jaffray

8 Municipals Municipal yields rose in line with Treasuries last week, but remain expensive on a percentage of Treasury basis. Given our view of the balance of risks being tilted toward correction in the bond market, we would refrain from making new purchases until after the January employment report. MUNICIPAL CONSENSUS YIELD CHANGES FOR THE WEEK MUNICIPAL CHANGE % TO TREASURY YIELD (BP) LAST WEEK PREVIOUS WK 5-YEAR AVG. 2 Year % 79.5% 77.1% 5 Year % 75.2% 80.2% 10 Year % 83.8% 85.2% 30 Year % 92.4% 94.5 Source: Municipal Market Advisors CORPORATE MARKET DETAIL SELECTED NEW ISSUES FROM LAST WEEK Issuer Coupon Maturity Spread Amt. Rating (bp) (MM) Moody s S&P MORGAN STANLEY /12/2007 NA 1600 Aa3 A+ HALLIBURTON COMPANY /26/2007 NA 500 Baa2 BBB /* GOLDMAN SACHS GROUP INC /28/ Aa3 A+ EUROPEAN BK RECON & DEV 0 2/6/2009 NA Aaa AAA JOHN HANCOCK GLOB FDG II 3.5 1/30/ Aa3 AA DEVELOPERS DIVERS REALTY /30/ Baa3 BBB UAP HOLDING CORP 0 7/15/ Caa2 B- JEFFERSON-PILOT CORP /30/ NA AA CORP ANDINA DE FOMENTO /26/2007 NA 200 A2 A PORTOLA PACKAGING INC /1/ B2 B- COMTECH TELECOMMUNICATIO 2 2/1/2024 NA 90 NA NA TEVA PHARMACEUT FIN BV /1/2024 NA 600 NA BBB TEVA PHARMACEUT FIN BV 0.5 2/1/2024 NA 400 NA BBB REPUBLIC OF PANAMA /28/ Ba1 BB ALLIED WASTE NORTH AMER /15/ Ba3 BB- ALLIED WASTE NORTH AMER /15/ Ba3 BB- MAIL-WELL I CORP /1/ B3 B FEDERAL REALTY INVS TRST 4.5 2/15/ Baa2 BBB FIFTH THIRD BANK 2.7 1/30/ Aa1 AA- MBIA GLOBAL FUNDING LLC N 1/26/2007 NA 150 Aaa AAA UNITED RENTALS INC 7 2/15/ B2 B+ UNITED RENTALS INC 6.5 2/15/ B1 BB- KINGSWAY AMERICA INC 7.5 2/1/ NA BBB- REPUBLIC OF CHILE N 1/28/2008 NA 600 Baa1 A KOMAG INC 2 2/1/2024 NA 70 NA NA CIA SIDERURGICA PAULISTA /30/2009 NA 175 B2 B+ Fixed Income Weekly Review Page 8 of 10 Piper Jaffray

9 CASELLA WASTE SYSTEMS /1/ B3 B Issuer Coupon Maturity Spread Amt. Rating (bp) (MM) Moody s S&P PROCTER & GAMBLE CO 5.5 2/1/ Aa3 AA- BANK OF AMERICA CORP /17/ Aa2 A+ NATIONWIDE BUILDING SOC /30/2007 NA 400 Aa3 A+ Source: Bloomberg Fixed Income Weekly Review Page 9 of 10 Piper Jaffray

10 Analyst Certification Joseph W. Jasper, CFA The views expressed in this report, including the Key Points and Risk sections in particular, accurately reflect my personal views about the subject Company and the subject security. In addition, no part of my compensation was, is, or will be directly or indirectly related to the specific recommendations or views contained in this report. Research Disclosures The following disclosures apply to stocks mentioned in this report if and as indicated: (#) Piper Jaffray was making a market in the Company s securities at the time this research report was published. Piper Jaffray will buy and sell the Company s securities on a principal basis. (^) A Piper Jaffray analyst who follows this Company or a member of the analyst s household has a financial interest (a long equity position) in the Company s securities. (@) Within the past 12 months, Piper Jaffray was a managing underwriter of an offering of, or dealer manager of a tender offer for, the Company s securities or the securities of an affiliate. (>) Piper Jaffray has either received compensation for investment banking services from the Company within the past 12 months or expects to receive or intends to seek compensation within the next three months for investment banking services. (~) A Piper Jaffray analyst who follows this Company, a member of the analyst s household, a Piper Jaffray officer, director, or other Piper Jaffray employee is a director and/or officer of the Company. (+) Piper Jaffray and its affiliates, in aggregate, beneficially own 1% or more of a class of common equity securities of the subject Company. Disclaimer Piper Jaffray research analysts receive compensation that is, in part, based on revenues of Piper Jaffray Equities & Investment Banking which include overall investment banking revenues. Piper Jaffray research analysts who follow this Company report to the Head of Investment Research who, in turn, reports directly to the Chief Executive Officer of Piper Jaffray. This material is based on data obtained from sources we deem to be reliable; it is not guaranteed as to accuracy and does not purport to be complete. This information is not intended to be used as the primary basis of investment decisions. Because of individual client requirements, it should not be construed as advice designed to meet the particular investment needs of any investor. It is not a representation by us or an offer or the solicitation of an offer to sell or buy any security. Further, a security described in this release may not be eligible for solicitation in the states in which the client resides. Officers or employees of affiliates of Piper Jaffray & Co., or members of their families, may have a beneficial interest in the Company's securities and may purchase or sell such positions in the open market or otherwise. Notice to customers in the United Kingdom: This report is a communication made in the United Kingdom by Piper Jaffray & Co. to market counterparties or intermediate customers and is exclusively directed at such persons; it is not directed at private customers and any investment or services to which the communication may relate will not be available to private customers. In the United Kingdom, no persons other than a market counterparty or an intermediate customer should read or rely on any of the information in this communication. Securities products and services offered through Piper Jaffray & Co., member SIPC and NYSE, Inc., a subsidiary of Piper Jaffray Companies. Additional information is available upon request. No part of this report may be reproduced, copied, redistributed or posted without the prior consent of Piper Jaffray & Co Piper Jaffray & Co., 800 Nicollet Mall, Suite 800, Minneapolis, Minnesota Fixed Income Weekly Review Page 10 of 10 Piper Jaffray