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Yield pick-up available in off-the-run paper as new issuance surges

| May 29, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The influx of new issue activity has resulted in some off-the-run bonds being overlooked, particularly in the long end, where there are now opportunities for attractive yield pick-up. In high quality paper, the DIS 4.75% 11/15/2046 (New Disney notes) is a good buy candidate given the g-spread pick up relative to other DIS long bonds.

The DIS 4.75% 11/15/2046 is currently 19 bp g-spread behind the newly issued DIS 3.6% 1/13/51 bonds. These bonds also offer a considerable spread pick-up to other similarly dated off-the-run DIS issues, including the DIS 4.125% 6/1/44 and DIS 3.0% 7/30/46 bonds (19 bp and 13 bp, respectively). While all the aforementioned DIS issues are index eligible, the DIS 4.75% 11/15/2046 bonds have the smallest notional outstanding of roughly $400 million.

Exhibit 1. Single A – Media 30-year curve

Source: Bloomberg; APS

Debt Exchange and Capital Structure  

As part of the June 2018 amended merger plan, The Walt Disney Company (TWDC) and 21CF became wholly owned subsidiaries of the New Disney (DIS – A2/A- (*-)/A- (n)). The New Disney is the parent and will be the issuing entity going forward. The New Disney and the existing TWDC debt will be unconditionally cross guaranteed. In an effort to simplify its capital structure, DIS conducted an exchange for any and all 21CF bonds ($18.13 billion) into New Disney notes. Participation was high in the exchange with the majority of tranches achieving a 95% or higher participation rate.  Notably the 21CF debt that was not exchanged does not benefit from the aforementioned cross guarantee structure and is located under the TFCFA ticker. As such, Moody’s withdrew its ratings on the remaining TFCFA debt.

Given the cross guarantee structure of the TWDC and the New Disney notes, there does not need to be such a large trading differential between the different entities. In cases where debt is assumed but not guaranteed, large trading differentials are common. Even different operating subsidiaries could warrant trading differentials given the underlying assets of each subsidiary. However, in this case, an unconditional cross guarantee structure means that while the operating subsidiary may be in a better asset position to the parent, the cross guarantee limits the trading differential due to the equalized ratings.  As an example, the Comcast Corp and NBC Universal paper (both A3/A-/A-), which also are cross guaranteed, have historically traded only 5 bp apart.

Dividend Suspended in an Effort to Preserve Ratings

As DIS continues to be negatively impacted by the pandemic, the company was downgraded by S&P to A- with its ratings still on review for a downgrade. S&P’s rating action was largely based on their estimate that leverage will increase well above 3.0x for the next two years. S&P does not foresee leverage falling below 3.0x until fiscal 2022, as they believe theme parks are not likely to return to normal capacity utilization rates until long after stay at home orders are lifted. While the company has shored up liquidity and addressed upcoming debt maturities with its two recent bond deals, S&P will look to resolve its credit watch only after it can assess the rate of return to theme parks as well as any long term negative affects to the company’s out of home entertainment business. Management did take a bold step by suspending its July 2020 semi-annual dividend, which will save $1.6 billion from being paid to shareholders.  The suspension not only helps to modestly improve net leverage, but demonstrates management’s commitment to both reduce leverage and to its current ratings.

The New Normal

While DIS reopened its Shanghai theme park on 5/11/20, the Chinese government has placed restrictions on capacity, limiting it to one-third. Currently, the park is welcoming 20,000 guests per day which is roughly 25% of capacity. DIS announced earlier this week that it will be looking to open Magic Kingdom and Animal Kingdom on 7/11/20 with Epcot and Hollywood Studios to follow on 7/15/20. Capacity will be limited by the company to less than 50%. A new reservation system will be added for entry into the parks, ending the ability for guests to walk up and buy a ticket. Temperature checks and face masks will be mandatory.  Seats on rides will be purposely left empty to adhere to social distancing rules and parades and fireworks displays will be on hold to limit crowds.  Menus will be disposable to limit cross contamination.

While there is limited visibility into what type of capacity the theme parks need to operate at to turn a profit, the cash drain of opening them at a reduced capacity is less than keeping them closed all together. To that extent, DIS expects the reopening to be a “positive net contribution” to the parks business.  Furthermore, DIS does not plan to offer discounted tickets to bring back guests to the park as they believe there will be enough demand for the limited reservation slots.

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