What is truth?

Today was a day when not one but two credit analysts, Citi’s Hans Lorenzen and BofA’s Barnaby Martin, both declared that the ECB was doing “too much” QE.

As Lorenzen showed in one or his slides to the presentation we highlighted previously, the ECB is now officially dominating the secondary € credit market, by purchasing approximately 50% of the traded volume of bonds.  This was part of a presentation which alleged not only that the ECB has injected “too much money & not enough supply”, but that the costs of QE in general are now outweighing the benefits.

BofA’s Barnaby Martin likewise wrote in a report today that the ECB’s “CSPP is simply “too big”, by which he means that it is “Too big – in buying terms – not to remain a consistently bullish tailwind for credit spreads.” He further notes that despite a jump in near-term supply, spreads will head tighter into year end and that “European credit can continue to rally. We look for Euro IG spreads to end the year at 95bp, Sterling IG to end at 105bp and Euro HY spreads to end the year at 340bp… the ECB have waited three months for decent primary, and now it is here we believe they are keen to buy in size.”

However, with seemingly nothing in the world capable of impairing the relentless grind tighter in spreads as everything trade is now merely frontrunning future ECB purchases, Martin does point out something worth contemplating, namely “that CSPP could quickly become its own worst enemy if it leads to a rapid rise in releveraging.” Specifically, Martin believes that an outbreak of the most extreme form of “animal spirits” , i.e., LBOs is imminent, to which he then adds:

And lo and behold, over the last few weeks TDC has confirmed that it has received private equity interest (which the company later rejected), and last week Bloomberg reported that KKR was one of the bidders for Repsol’s stake in Gas Natural.


The last European LBO cycle in 2005 and 2006 was relatively light in deals compared to the US LBO cycle. Many of the obstacles then to European take-privates – such as the prevalence of government shareholdings (chart 4) – are still relevant today. But there were enough big European LBOs a decade ago (TDC, VNU, ISS, Boots) for the risk to become a systemic one for spreads. And the LBO rumour mill was often enough to drive credit spreads of a highlighted company much wider.

A surge in LBOs in itself, is not a problem; what Martin is far more concerned about is a thought experiment in which “the unthinkable” happens, namely  BB yields going negative. As we explains, “such has been Draghi’s influence across the whole credit market that we are close to seeing our first negative yielding BB-rated bond. But if debt costs for speculative grade companies become “inverted”, then the economics of LBOs will be transformed, and the quality of the assets they are buying will become secondary. We see a growing risk that another private equity cycle emerges in Europe now, and the severe rating deterioration that LBOs pose would become the greatest challenge to central banks’ credit buying.”

To emphasize this point, the BofA strategist, in Chart 5, shows the most negative yielding corporate bond (or the
smallest if positive) over time in each rating category. He notes that we
are very close to having our first negative yielding BB-rated bullet
bond (HeidelbergCement €18s yield 18bp and Peugeot €18s yield 20bp).
Moreover, the lowest-yielding single-B (bullet) bond is now just above 1%.

Why are BB-yields turning negative considered an unthinkable outcome? He explains:

The concept of negative debt-costs for high-yield companies will transform the traditional economics of LBOs. Take interest coverage, for instance, as chart 6 shows. Private equity pushed the envelope with interest coverage during the last LBO cycle. Interest coverage fell to just over 2x for European LBOs in 2007. But now, with the rapid decline in non-IG yields, note that interest coverage of European LBOs has begun to rise this year. Cheap debt can suddenly make unviable candidates appear “viable” for private equity.

Which brings us again to the TDC case study, a “very telling” example of what may be about to happen, according to Martin: “TDC was a previous large take-private in late 2005. With the cost cutting that has been implemented since, profit margins for the company are now high, so news of a second LBO seems strange. Low debt costs can alter the equation, however. Recall that in 2006, the high-yield debt  financing that accompanied the TDC LBO had coupons of 8%+ (second lien debt). But today we stand close to the reality of negatively yielding speculative grade bonds, and private equity firms will realise that using debt to go “long” the European equity market has never been easier.

In other words, we are about to enter a world in which the debt tranche may actually pay itself down, an outcome even more perverse than the recently reported deal where the ECB was directly funding the acquisition of Krispy Kreme by JAB Holdings.

Putting it all together, Martin’s conclusion is that the inevitable surge in LBOs may prove to be the catalyst that forces the ECB to step back from its frenzied corporate bond-buying pace:

Full article at source:http://www.zerohedge.com/news/2016-09-05/bank-america-thinks-unthinkable

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