07 Février 2015

The end of a frozen market

There is little doubt that the ECB’s announcement of a new set of non-conventional measures on 22 January 2015 already was one of the most important – probably the single most important – event(s) for European credit markets in 2015 as it incepted a regime of market defrost that contrasts with the later part of 2014.

The second half of 2014 was indeed characterized by a kind of market freeze in European credit. With regard to fundamentals, the credit profiles of most European corporates and financials were stable or improving, but geopolitical concerns and high-profile credit accidents, such as UK-based retailers Tesco and Phones 4U or Portuguese bank BES contributed to limit risk appetite among investors. On the technical side, flows and liquidity were more muted although there were no significant redemptions. As a result, there was no market momentum and valuations started to go sideways with a strong rally in IG, a mild selloff combined with greater dispersion in HY, and a significant repricing of the nascent bank hybrid capital instruments market. Finally, as expectations of new non-conventional measures from the ECB built up, the primary and secondary markets both went in a state of frost.

By announcing that it will buy €60bn per month of fixed income securities – mostly govies and agencies plus a bit of Covered Bonds and senior tranches of ABS – in the secondary market until September 2016 at least, for a total of €1.14trn, the ECB exceeded market expectations. This new package should impact credit markets in 3 ways, in our view: (i) it sends a powerful signal of the ECB’s commitment to fight deflation in the Eurozone and to support a normal functioning of credit flows, (ii) it will lower risk-free rates further, and (iii) it will encourage many market participants to increase their portfolio allocations towards higher-risk credit assets such as crossover, HY and subordinated hybrids instruments. While the first two effects can be felt almost immediately, we believe that the third one – namely portfolio rebalancing – will play out over time and should support a strong momentum throughout the year and possibly longer.

European banks and HY corporates are major beneficiaries of the ECB package in the medium term

Two key constituents of our current portfolio positioning should be significant beneficiaries: banks and HY corporates. Banks because they have already been operating in a credit-friendly environment where the focus on balance sheet reduction, solvency increase – witness the €7.5bn equity increase announced by Spain-based bank Santander in January – and liquidity improvement drive their strategies. The new rally in eurozone govies combined with the newly improved terms for the TLTRO also announced on 22 January 2015 will contribute to enhance their credit profile at the margin. On the technical and sentiment sides, there will be enhanced capital allocation into subordinated bank instruments as well as in HY corporate bonds at a time when both markets are becoming more mature. We already saw the first signs of such trends with Netherlands-based Rabobank making its debut issuance in the AT1 market, while an equivalent €12.5bn of new bonds were issued by 17 European HY borrowers in January, i.e. almost twice as much as the volume issued during the entire Q4 2014. Importantly, for the first time in six months, HY new issuance was balanced between repeat high-quality issuers such as Dutch cable operator Ziggo and UK-based Virgin Media, another M&A-related jumbo €5.3bn issued by French cable and mobile conglomerate Altice, and a highly stressed credit situation, namely Norway-based pulp and paper producer Norske Skog.

Defaults and stressed situations; lumpy but real

While we are pleased that our market environment is back to more active and constructive roots, we do not forget that situational credit remains a risk asset and requires a skilled and disciplined investment process. Here are some examples of our credit accidents du jour. 20 months after tapping the HY market, UK-based insurance broker Towergate announced a radical restructuring of its ca. £950m debt, where unsecured creditors will likely end up being fully converted in equity and senior secured creditors will have to contribute new money and get exchanged in newly-issued secured and subordinated notes with a haircut of ca. 30cts. On the bank side, Greek bank senior risk remains at best a binary investment proposition in the current environment – with senior debt trading in the 60’s and 70’s – while Austria-based banking group Raiffeisen is suffering from huge volatility due to its large exposure to central and eastern Europe as some of its subordinated instruments trade as low as 50cts.

Overall, we believe that the ECB’s injection of massive liquidity will progressively flow towards the riskier segments of European credit markets. But make no mistake about it, such liquidity will not fix the rotten business models, overleveraged balance sheets and flawed capital structures that populate our credit markets. There will be more defaults and credit accidents in 2015 and avoiding them will be key to delivering performance and capital protection.