César Pérez, EMEA Chief Investment Strategist at J.P. Morgan Private Bank, looks back at the events of 2012 and examines the case for the European credit market’s “fallen angels.”
“As 2012 comes to a close, we look back at the events that have taken place throughout a year in which political power from almost 60% of world GDP changed hands (the last major election of the year was in Japan on the 16th of December). From a European perspective, we have to conclude that 2012 has been “the year of the Draghi”.
“The measures taken by the ECB at the end of 2011 (LTROs) were supplemented with others equally significant in 2012 (OMT). We note that Draghi’s famous bumblebee speech on the 26th of July was unrivalled in terms of the impact six words can have on the markets: “Believe me, it will be enough” prompted a rally (Euro Stoxx had a 5% intraday jump), which proved that the markets finally believed that the ECB would be the buyer of last resort, if so required.
“Effectively, the newfound conviction in the power of the ECB to take the right measures has made European assets investable again for international investors. We count ourselves among them, as we added back to European equities during the summer months of 2012.
“In this commentary we aim to analyse the European credit market and especially European high yield names. Some of these are considered “fallen angels”: companies which have seen their ratings downgraded to align with the sovereign ratings of their country rather than based on the fundamentals of the companies. We believe the credit returns of some of these companies look attractive given that the tail risk of a break up of the euro has been significantly reduced during 2012.
- The European Crisis – The crisis is still ongoing- we are still watching for the economic growth of the Eurozone to improve
- The European Credit Market – Deleveraging, funding problems in the banking sector and ratings of European corporates have all been affected by the crisis well into 2012
- ECB Intervention – The ECB has intervened via liquidity provision to the banks and a new support framework to the market – but what about the case for countries already in a programme?
- ‘Fallen Angels’ – Thesecompanies have seen their ratings downgraded to align them with the sovereign ratings of their countries rather than based on the fundamentals of the companies
The European Crisis
“The European crisis had two interlinked catalysts:
- Periphery countries had become less competitive than the core ones
- Some of these countries owned a leveraged banking sector supporting a housing bubble
“As both core and periphery countries are supported by a common currency and a monetary union, but do not have a fiscal union in place yet, these two elements among others created severe fiscal imbalances between the core and the periphery.
“As a consequence, the lack of credibility in the European project made foreign capital flee periphery assets. To compensate for the assets outflow, there was an acute need of a backstop to avoid a potential default in Europe after Greece’s first bailout. The ECB stepped in to fill this need, and it has expanded its balance sheet to compensate for this effect (the balance sheet has grown by 130% between 2009 and now, from EUR 646bn to EUR 1,481bn).
“The crisis is still ongoing and the ECB role as a backstop is temporary. While the measures the ECB took to restore private investors’ confidence were well received by the market, we are watching for the economic growth of the Eurozone to improve. Until all the pending structural reforms are carried though legislation and implemented successfully, the ECB will have to continue acting as the safety net to keep the common currency in place.
“The ECB has intervened in two ways:
- It provided liquidity to the banks through large repos and relaxed collateral. The two 3-year LTRO operations injected EUR 1trillion into the banking sector at an interest rate of 1% for three years, substantially helping banks in their deleveraging process
- The ECB also brought the OMT to the market, a new support framework which follows the Securities Market Programme. The condition to get access to this facility is to sign a Memorandum of Understanding (MoU) with the EU. Once the conditional MoU is signed, the country can get unlimited support through the purchase of bonds with a maturity of up to three years until the cost of funding for the country becomes appropriate. (The ECB is yet to clarify what this level would be).
“We believe that if Spain or Italy would sign an MoU, the ECB would aggressively purchase their respective 3-year bonds to bring them down to a lower spread versus the German bunds (the Spanish government wants the ECB to fix the spread at 200 basis points; we believe it is unlikely the ECB will publicly set it at a given level). Some clients have been asking us why the ECB has not already started buying Portuguese or Irish bonds given those countries are complying with the austerity measures and have already signed MoUs with the EU/ IMF. However, the countries already in a programme are different: their fiscal adjustment and structural reforms are on their way, having started in 2010. We believe the ECB would only act once those countries have come back to fund themselves in the public markets in the years to come.
The European Credit Market
“The European crisis has forced banks, companies and households to deleverage. The funding problems in the banking sector have caused a decrease in the volume of financial bonds in Europe of more than EUR 200billion and an increase of EUR 300billion of non-financial ones. The rating quality of the European corporates has also been affected by the crisis.
“The sub-investment grade now represents more than 15% of the market and the AAA is close to 0% after having been close to 10% in 1999. The duration of the European high yield market for non-financials has come down to 3.0 from 3.9 years.
“When analysing the European high yield markets, we question if implied default rates are not too high when compared to the fundamentals of the companies.
“Despite the recession, austerity and deleveraging taking place in Europe, there has not been meaningful corporate distress across the board in the region. Furthermore, corporate balance sheets are in decent shape, with overall leverage low and cash balances high; in addition, interest coverage has steadily increased since the lows of 3Q 2009.
“Moody’s and S&P show default rates for the last 12 months of 2.6% and 2.7% respectively. However, these numbers include loan market defaults, which do not fall into our definition of investable European high yield.
“The European high yield market has experienced an increase in size over the past few years, mostly because of the “fallen angels,” which account for more than 75% of the growth of the market since 2008. Sovereign ceiling downgrades pushed a lot of companies into high yield territory despite their good fundamentals. As can be expected, this has mainly happened in the Euro area periphery countries.
“For most corporates in the periphery, the funding market was closed for most of 2012, but it reopened after Draghi’s speech at the end of July. This window is still being used aggressively by companies at attractive yields for investors in both EUR and USD, especially as short-selling of European government bonds has become difficult in the last part of 2012.
“One of the key challenges Europe has is the difference in the funding cost for companies in the core versus the periphery.
“Until this funding gap is closed it will be difficult for the periphery to achieve economic growth. This discrepancy in funding costs has led to companies listing their foreign subsidiaries in order to raise cash and transfer some of their debt to cheaper funding countries.
“The “fallen angels” offer an opportunity to invest at attractive yields in good companies with low ratings that are not based on their fundamentals. The first public issue of a senior bond in over two years from a Portuguese bank is an example: in October, Banco Espirito Santo was able to issue three-year unsecured paper at a yield of 5.87%. This occurred even before its own sovereign, Portugal, was able to come back to the public debt markets, proving the financial strength of the company on a standalone basis.
“European high yield has experienced inflows recently and we expect this trend to continue in 2013, given the attractive characteristics on a risk/return basis.
“As we mentioned before, investors are intensely searching for yield as we live in a world where central banks continue to keep rates at abnormally low levels. European assets are finally getting some traction from international investors as the ECB has proven it will be the buyer of last resort and the tail risk in Europe has been reduced. Fallen angels” within European high yield offer attractive valuations both in absolute and relative terms.”