The Long and Short
Comparing new issue spreads for risk-adjusted compensation
Meredith Contente and Dan Bruzzo, CFA | September 9, 2022
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.
A mix of retailers and industrial issuers are coming to market with appealing new offerings as measured by spread per turn of net leverage. Recent standouts include TGT, DG, and WMT, who came with more spread than other issuers. New utility sector offerings are demonstrating some of the weaker results by spread per turn of net leverage, though the stability of cash flows helps justify the tighter spread. On a relative value basis the risk-adjusted spread compensation favors the retail segment, and Target (TGT: A2/A/A) in particular.
The annual September deluge has kickstarted a heavy new issue calendar. The first week of September delivered an excess of $50 billion in total volume, topping expectations. Next week is expected to bring another $40 billion in new issue volume. Evaluating risk-adjusted spread compensation can be helpful in determining which issues to target most aggressively.
Exhibit 1. September New Issues – Non-Financial Credits
While this approach may be an oversimplification of the complexities of credit quality, net leverage serves as an adequate proxy to quickly gauge the relative value of one deal versus the next. While qualitative factors and event driven concerns undoubtedly weigh on pricing as well, investors and rating agencies alike are ultimately inclined to place high importance on balance sheet liquidity and the ability of the issuers to meet their debt obligations.
Exhibit 2. September New Issuers’ Leverage-Adjusted Spread Compensation
Retail issuers’ leverage calculated on a lease-adjusted basis, EBITDA is unadjusted
DE net leverage presented on an adjusted basis to account for captive finance subsidiary
In the 10-year maturity bucket, which has been the most popular tranche for September debt issues so far, retail credits (DG ‘32s, WMT ‘32s) provided some of the best risk compensation. Meanwhile, utility credits (ITC, ONCRTX, SO) fell short of the other issues due to significantly higher debt burdens. Utility credits can balance higher debt burdens at these rating levels versus non-utility comps due to the consistent nature of cash flows. Consumer credit NESNVX also fell below the average when looking at bp per turn of net leverage. By far the biggest standout among this week’s new issues for risk-adjusted spread compensation are the TGT 10-year notes pricing at a level of +120, or approximately 136 bp of spread per turn of net leverage.
The average risk compensation for five-year notes issued this week is approximately 43 bp of spread per turn of net leverage for the issuers that came to market. That makes it easy to identify the outliers on the graphic above. Similarly, the average spread per turn of leverage in the ten-year bucket is 63 bp, while the average for thirty-year maturities is just 69 bp.
In the 5-year part of the curve, there were a few standout issues by risk-adjusted spread compensation. The EFX, WMT, DE and DG 27s all provided better than average spread than the rest of the duration bucket, while the worst results were seen in the ITC and NESNVX 27s, both falling well below the 43 bp average.
In the 30+-year bucket, both long-dated LOW issues (‘53s and ‘62s) provided compelling spread compensation on a leverage-weighted basis. The DG and WMT ‘52s were also well above average in this regard as well.
We take a closer look at the fundamentals of the study’s biggest “winner” to determine if the risk profile of TGT justifies the additional spread compensation. After issuing a profit warning in June, TGT’s fiscal 2Q results came in worse than anticipated, as bloated inventory levels forced management to aggressively “clear” excess merchandise. The actions led to a nearly 90% decline in EPS for the quarter. The profit miss overshadowed some of the bright spots in TGT’s 2Q results. First, management remains confident that the profit decline experienced in 2Q is ephemeral as it affirmed full year guidance, which includes revenue growth in the low-to-mid single digit area and an operating margin rate of 6% in 2H22. Second, the balance sheet remains in order and any hit to EBITDA will not impact leverage enough to warrant a ratings event.
TGT ended fiscal 2021 with lease-adjusted leverage below 1.0x, which is roughly a turn lower than its historical leverage rate in the high 1.0x leverage ratio. TGT’s low leverage to start the year has provided them with a significant amount of headroom under the 2.5x leverage threshold for the ratings. We estimate TGT ended the quarter with lease adjusted leverage of 1.8x (0.88x on a net basis). The very low net leverage coupled with the generous concession (20 bp) to already wide secondaries, provided investors with a 136bps spread per turn of leverage, which we view as very attractive given the mid-single A ratings. This compares very favorably to lower rated retail peers such as Dollar General Corporation (DG – Baa2/BBB), which issued 10-year bonds the same day, with a spread per turn of leverage of 65 bp. McDonald’s Corporation (MCD – Baa1/BBB+) also came with a 10-year bond that translated to a spread per turn of leverage of 41 bp.
TGT’s comparable store sales remains in positive territory (up 2.6% in the quarter reflecting 2.7% traffic growth) which bodes well for the credit as the rating agencies believe that TGT’s comparable store sales would need decline in the mid-single digit area for leverage to start moving closer to that 2.5x threshold level. TGT’s management team remains very committed to their current ratings and we would expect that management would pull back on share buybacks, if needed, to preserve cash or repay debt to maintain ratings. Management demonstrated its prudent financial policy during the pandemic when it dialed back share repurchases at the height of the pandemic.