You Should Keep Your Eyes Focused on Credit
Federico is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The market has experienced the largest sell-off in Treasuries since October 2011 and the largest widening of credit spreads since May 2012. The logic seems to indicate that this trend should continue in the foreseeable future. Sectors with high financial leverage and low operational leverage (such as utilities and tobacco companies) should underperform in such a scenario. Meanwhile, companies with high pension deficits as well as those with high operational leverage and low financial leverage should out-perform as yields continue to rise.
Here I chose two companies that should be hurt from the coming scenario as well as one company that should largely benefit from it.
Two losers within the current credit context
Time Warner Cable (NYSE: TWC), the US cable operator, shares all the characteristics that I am looking for. The company has a net debt to EBITDA above three times, negative earnings revisions and negative correlation with the ISM index (which is a proxy for operational leverage). Even when the company is a good cash flow generator (its free cash flow yield is 8.4%) and pays a good 2.7% cash dividend yield, I think the company is overly exposed to rising bond yields. Besides, higher CapEx needs and a higher churn are motives for concern. Trading at 2013 15.6x P/E I would sell Time Warner Cable.
Oneok Partners (NYSE: OKS) owns an interstate pipeline system that transports natural gas. The company not only has a negative 49% correlation to the ISM index. It also has a net debt that represents 4.65 times the company's expected EBITDA. Oneok has a fee-based business model built on assets secured by long term contracts. Hence, the company's cash flows are low-risk, and the company resembles a perpetuity bond with its coupon tied to gas prices. Paying a 5.7% cash dividend yield, I think Oneok shares are at risk in the context of rising bond yields.
One potential winner
As I mentioned before, companies with high pension deficits should benefit from rising bond yields. Boeing (NYSE: BA) is not only a correctly managed organization that owns a business with huge barriers to entry. The company also has enormous pension obligations. Boeing's pension obligations represent 36% of the company's total market capitalization. Besides, the company's earnings are positively correlated with the ISM index, and its valuation looks compelling at 16 times earnings. Boeing's net debt to EBITDA is extremely low at 7%, and its 6% free cash flow yield (the company pays a growing 1.9% cash dividend yield) make it a great candidate when thinking of companies that will benefit from higher bond yields.
The main idea behind my proposition is that bond-like stocks (low expected growth but high dividend yields) represent a risk as bond yields rise. Why would you hold a company with low expected top-line growth if you could get a comparable return by investing in high grade bonds? That said, there are some opportunities that arise as yields go up. Companies such as Boeing or Caterpillar will not only benefit as the US economy improves. They will also benefit since their future long term obligations (pension obligations), which are huge, can be discounted at higher rates. Yields are rising--your portfolio should be prepared.
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Federico Zaldua has no position in any stocks mentioned. The Motley Fool recommends ONEOK Partners, L.P.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!