Santander: The ‘Old’ Normal, and the Pundits

“If everybody minded their own business, the world would go around a great deal faster than it does.” The Duchess, Alice in Wonderland by Lewis Carroll

I have been watching with amusement the recent swell of opinion from various market participants regarding Banco Santander and its upcoming first call date of the 03/19 CoCo bonds. These went from a definitive ‘no call’ just six weeks ago to ‘99.9% call’ ten days ago to being ‘outraged/shocked’ on the non-call event. Ominous statements such as ‘special place in hell for Santander’ and ‘severe implications for the AT1 market’ from otherwise reputable financial commentators followed.

Fast forward to today, Santander did not call the 03/19 CoCos, they did not drop 10 points, and the floor under the rest of the AT1 market did not disappear. And rightly so. Let me remind you that one of the defining characteristics of the CoCos is the lack of incentive to redeem (by, amongst other things, eliminating the ‘step up’ in spread that issuers have to pay after the first call date has passed). This removes the pressure on issuers to replace bonds at uneconomical terms. Back to Econ 101, this is in all investors’ best interest long term too. It is very simple to understand, yet I continue to be amazed by the number of people who fail to grasp it.

A quick cross-Atlantic parallel reveals a pretty similar, perfectly functioning bond market that has long operated on economic call premises (and continues to do so) but without the drama. Logically, there is absolutely no reason why it should be any different in Europe. If anything, today’s decision by Santander to skip the call (and I will ignore for now the theories regarding the technical nature of the non-call) is merely a sign of a maturing market, which arguably € AT1 has become.

Reputational damage arguments should have long given way to rational investment decisions. How much of a premium did Deutsche Bank have to pay when reputation WAS the main call driver? Why would it be any different now that economic call policy is the new ‘old’ norm? Banco Santander (and Credit Agricole for that matter) have been very vocal that it would be primarily an economic decision. This, combined with the particular structure of the bonds in question, as well as the current size of Santander’s AT1 bucket, ought to have left very little to the imagination regarding the call for anyone sporting a decent size calculator.

Thus I struggle to understand any investment decision built solely around the ‘reputational damage’ case. If you were surprised by the decision not to call, there is probably a better future awaiting you in a different occupation. If your investment case was solely based on ‘reputational call’, you are doing it wrong. If you don’t understand why it is better to replace debt with cheaper debt, not more expensive debt, you should go back to basics.

We at Kames aim to capture alpha by building investment cases around strong business fundamentals, attractive valuations, and compelling risk/reward, not around reputation. That said, the now busted call Santander 6.25% 19c may prove to have been a fairly interesting proposition down the line.

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Is there going to be a Dutch Auction?

Last Friday, news broke that Brookfield Asset Management was speaking to Dutch pension funds to try and engineer a takeover of KPN, the Dutch telephony company. This follows a move by Macquarie last year to achieve a similar deal to buy TDC (a Danish telecom company), with Danish pension funds.

No formal bid has been seen, but KPN was subject to a bid in 2013 from America Movil. This was prevented by the KPN Foundation (or ‘Stichting’) which controlled voting rights.

If Brookfield followed a similar approach to that used to take TDC private, it would mean increasing the leverage of KPN and a likely move into junk bond status. Most bonds include a change of control clause which would be triggered on this presumed downgrade to high yield, meaning bonds could be called or put at par. This should lead to a “pull to par” move for bonds, with consequent mark-to-market gains/losses depending on where the price was before the news broke.

KPN also has hybrid capital with fixed call dates. Any bid would likely lead to the hybrids being called at the first opportunity to avoid a 5% increase in coupons.

Whether Friday’s news was a “cheap” attempt to gauge the attitude of the Stichting, KPN management, and the Dutch public to a deal, or whether it was a genuine leak, the news may prompt other players to look at whether there could be value in a deal. America Movil is unlikely to want to buy, as it now holds its stake as a financial investment, but it will not be an uninterested bystander. The final ownership of KPN remains uncertain and will make for more volatility in bond prices.

It could provoke interest from others such as Deutsche Telekom, although they may need to exit their recent joint venture with Tele2. Macquarie might also be interested if it thinks it has been successful in Denmark.

Bonds are likely to be volatile, depending on how the story develops, and this may present opportunities to play the technicalities of the bond documentation.

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You can’t escape the truth – fundamentals matter

Years of a beta-driven market rally have let some get away with forgetting about corporate fundamentals. But central banks are no longer buying corporate bonds en masse, liquidity is being withdrawn, and interest rates are beginning to rise. It seems that the markets will soon remind those who have forgotten the old lesson: fundamentals really do matter.

Our focus remains on businesses that we are happy to hold throughout the cycle. While calling the exact peak or trough of the cycle is near-impossible, a sense of where we are in the pendulum swing is important. We’re certainly much closer to the end than the beginning, and with quantitative easing being slowly but surely unwound, conditions will be unfavourable to businesses with weak fundamentals.

The chart below demonstrates that when complacency in the market fades away, like in the sell-off we saw at the end of last year, fundamentals matter. Companies with the weakest free cash flow, a key metric for us in credit analysis, were punished much more than those with strong fundamentals.

Chart: Consistent FCF weakness priced in a lot more from November
(Average z-spread of representative bonds for ten weakest and ten strongest ranked issuers in terms of five different FCF measures over several time periods, e.g. FCF/gross debt over five years and LTM FCF/EBITDA)

Source: Company Information, Bloomberg, BofA Merrill Lynch Global Research estimates

Last November, we participated in a new European high yield issue from a company called Intertrust. It’s a great example of the kind of business we like to lend to. They provide administrative services globally to other firms; for example, if a company wants to open a new corporate entity, Intertrust will set it up. Then they can provide ongoing services like legal and tax compliance, accounting etc. If the customer decides to close that entity, Intertrust closes it for them.

While 90% of Intertrust’s revenues are from recurring, non-discretionary services, the ability to open and close corporate entities for their customers helps create an incredibly non-cyclical business. In an economic upswing, businesses expand to operate in new jurisdictions or to undertake M&A, so they open new entities. In a downturn, they might close entities and consolidate their footprint. Intertrust can do these things for them. This creates a very stable revenue profile and a business that is able to weather cyclical storms – regardless of how their customers do.

Intertrust also has high margins, a sensible amount of leverage, very strong interest coverage metrics and significant free cash flow. Combine that with the attractive business profile and you can see why we like this business. It’s possible that rating agencies could upgrade them to investment grade in the future. Furthermore, this operating profile has been rewarded in the recently volatile market. In EUR terms, since new issue-to-date, Intertrust has outperformed the Bloomberg Barclays Pan-European High Yield index by 0.65%.

A key cornerstone of our philosophy is that you can’t day-trade carry. Kames focuses on fundamentally sound businesses that will persist through the cycle, and deliver to our clients a steady income stream with minimal capital losses. So we are cautiously optimistic for 2019, a year that will provide ample opportunity for us to demonstrate our ‘stock picking first’ approach and deliver positive outcomes for our investors.

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Beating the liquidity freeze in bond markets

Compared to a decade ago there is significantly less liquidity in global bond markets. Last week I presented on this topic at a specialist bond-market conference in London.

I enclose a paper which summarises my presentation. I explain the extent of the liquidity challenges and consider the implications for investor expectations, pricing, capacity management, and the prospects for active investment fixed income strategies.

Download paper

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UK Retail – a new year, but familiar struggles

The British Retail Consortium reported that December 2018 was the worst December sales performance for a decade, with total retail sales showing 0% year-on-year growth during the month. We’ve had a number of Christmas trading updates from UK retailers in the last few days, with the common theme that numbers were not as bad as gloomy investors had feared. This does not mean that the results were encouraging!

Tesco has been the relative winner with respectable Christmas trading in the UK. They say they remain on track to deliver on their margin targets (3% in H2 2019). However, although Q3 2018 like-for-like sales were up 0.7%, this was still a slowdown in growth from earlier in the year.

The Discounters once again took the spoils, and we are seeing food retailers responding to price gap widening by introducing further price cuts.

Next’s trading update was broadly in line with expectations. However, full-year profit guidance was marginally reduced, as we continue to see the traditional ‘bricks & mortar’ stores act as a drag on performance, with the shift to online continuing to impact margins.

John Lewis also had a reasonable update with 7-week sales growth of +1.4%, but the company reiterated its guidance that profits will fall substantially short of last year, with the Board considering whether to pay a staff bonus. The company will repay its 2019 maturity bond with a mix of cash and medium-term bank debt.

Marks and Spencer was more mixed, with food marginally ahead of guidance at -2.1% in Q3, and general merchandise softer than expectations at -2.4%. However, this was not as poor as many analysts had been expecting. The company is endeavouring to address the changing competitive landscape with a multi-year turnaround plan.

This year we have once again seen a decline of in-store customer numbers, reflecting the continuing strong growth of online shopping. In addition, heavy discounting, which has been a feature of Black Friday, now seems to have continued throughout December. Consumer confidence – as measured by market researcher GfK – was at a five-year low in November, which typically signals a scaling-back of discretionary purchases.

In the context of the broader credit market, retail bonds don’t look particularly cheap and there remain significant challenges to the sector – and that’s without even considering potential disruption caused by a disorderly Brexit! The first quarter of this year is unlikely to yield much fundamental improvement in the sector.

2019 may be a new year, but the same struggles remain.

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Renault stalls – do investors need more Va Va Voom?

Renault is a strong BBB credit and a relatively rare issuer in the sterling corporate bond market.  Yet despite last week offering an optically attractive premium to invest in a £250m 5yr transaction, they failed to ‘capture’ sufficient demand and were forced to cancel the deal.  Such events are rare and hence noteworthy.

In recent months the global auto sector has come under increasing pressure from a multitude of headwinds.  US tariffs on steel and aluminium alongside higher oil prices have led to increased input costs and lower margins.  Higher interest rates, particularly in the US, are driving up the cost of finance for consumers and leading to concern about the future trajectory of sales volumes. Emissions related litigation and investigations in the wake of the Volkswagen scandal are ongoing.  New emissions regulations and changing consumer preferences in Europe are increasing costs and depressing sales volumes, particularly of diesel cars.  Evidence of a marked slowdown in the Chinese market, linked to reduced tax incentives and tightening consumer credit conditions, is becoming a cause for concern given that China has long been seen as an engine for growth.

Companies including Daimler, BMW and Ford, as well as auto-parts suppliers Continental and Valeo, have all issued profits warnings in recent months.  Sector credit spreads have reacted accordingly with performance in the past couple of weeks being particularly poor.

Given that backdrop you would be forgiven for wondering why Renault chose to issue a new 5yr sterling bond.  But why not?  Absolute yield levels remain low and so attractive from a borrower’s perspective, even if they have to offer some additional spread to attract investor appetite.  Common practice is for the initial price guidance to be revised tighter (i.e. more expensive from an investor’s perspective) once a solid order book is in place.  Yet in this instance, demand was insufficient and instead the deal was pulled.

Despite choosing not to participate in the deal, it was still a surprise to see it cancelled.  This rare event perhaps reflects not only the cautious stance of many credit investors towards the sector (given the multitude of headwinds highlighted) but also guarded risk appetite in the sterling credit market more broadly as Brexit uncertainty peaks.

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