05 Mars 2014

Credit investors entered February wondering whether the large and repeated number of negative headlines across EM experienced in January would spoil their party. In turn, the month delivered significant spread tightening, leaving many segments of European credit markets at new post-crisis lows – yield-wise – and tights – spreads-wise. A decent earnings season for European HY, IG and financial issuers, combined with still powerful technicals drove the February rally and positive market sentiment. The iTraxx Xover and Main indexes ended the month at 257bps and 70bps, respectively, whereas financials spreads reached new lows on an index basis with the iTraxx Financial Senior and Financial Subordinated indexes at 86bps and 129bps, respectively.

In this rosy context, we would however highlight an area of potential concern. Indeed, we regard the development of corporate Europe’s credit profile as uneven, with some split between the more levered and less diversified HY corporates – which are benefiting from the recovery in their domestic markets – and more international and less levered IG corporates – many of which are now considering more aggressive financial policies. Last month’s transaction between France-based L’Oréal and Switzerland-based Nestlé is an interesting example of a releveraging strategy implemented by a high-quality IG corporate. Specifically, L’Oréal bought back its own shares for €6bn, as Nestlé reduced its 29.4% stake in the company to 23.3%. L’Oréal paid Nestlé by contributing its 50% stake in a JV that both companies jointly own in the dermatology sector and by paying the remaining €3.4bn balance in cash, thereby releveraging it balance sheet from the net cash position it had enjoyed since 2010.

In our view, debt-financed acquisitions, share buybacks, special dividends, spinoffs and other credit-unfriendly corporate actions – the so-called “event risk” – should become again an increasingly prominent feature of the European IG corporate market in 2014. Interestingly, Citi Research recently published a note on this theme, highlighting the rising leverage of European IG corporates since the end of 2011 by 0.3x at ca. 1.8x. Beyond those numbers, we believe that a few points support our thesis and are worth noting:

  • Current leverage is higher than during the 2004-2008 period when IG corporates also benefited from high earnings but maintained conservative financial policies post the trauma they experienced during the tech bubble implosion; this evidences today’s more aggressive financial policies.
  • The recent rise in leverage is not driven by falling EBITDA but more by a growth in corporate debt; this is, again, in stark contrast with the 2004-2010 period when European IG corporate leverage developments were mainly driven by EBITDA swings and not by corporate financial policies.
  • Most of the recent leverage increase is taking place on the large cap issuers’ balance sheets, as those benefit from a higher degree of financial flexibility.
  • IG corporate liquidity remains healthy with large cash balances, undrawn bank facilities and long average debt maturities, leaving many firms with ample room for releveraging.
  • Interest coverage ratios are close to historical highs as IG corporates benefit from record-low funding costs – say between 1% and 2.5% for term financing at the moment.

As we expect this trend to play out for longer, we will progressively add up to our book of short IG positions, mainly via two types of situations: (i) some high-quality names which are prone to renewed event risk and (ii) some companies in sectors which are particularly vulnerable to growing regulatory, technological and competition headwinds such as telecoms and electric utilities. Specifically for the first category, the Fund is short two of the global consumer goods companies and one of the leading wine and spirits groups, which are potential consolidators in their respective markets. With regards to the second category, the Fund is short two telecom incumbent operators in core Europe, which could potentially implement credit-unfriendly actions now that they have adjusted their business to the new competitive environments in their core markets; one France-based mobile operator, which we expect to suffer from the current turmoil experienced in the French market as a result of the entry of a fourth mobile player and of the consolidation discussions currently taking place in the sector; one Nordic electric utility with significant exposure to electricity generation in EM and which is refocusing its business away from low-risk transmission and distribution activities into the more volatile generation business.


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