(VIDEO) Fixed income outlook 2nd half 2020

Adrian Hull, Head of Fixed Income UK, is joined by Sandra Holdsworth (Rates), Iain Buckle (IG), and Tom Hanson (HY) to discuss the outlook for the fixed income markets in the second half of 2020.

Click here to download a copy of the slides used in the video.

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The Year of (Corporate) Credit

Regular readers would recall that back in March we felt that Corporate Bonds offered a once in a decade opportunity. Since then, credit markets staged an unprecedented rally both in magnitude and speed, almost as head-spinning as the sell-off earlier in the year. We continue to believe that this will be THE year of corporate credit and expect further gains well into the end of the year.

The initial snap back was fuelled by a confluence of oversold valuations as well as a remarkable policy response that we felt eclipsed that of 2009 Global Financial Crisis. Since then, a number of key developments have transpired, which we believe are enough to propel a brand new credit cycle that would bring along medium to long term positive tailwinds for the asset class as a whole.

It is by now perfectly clear that the trinity of central banks (BoE, ECB, and FED) is aggressively targeting stability in credit markets so as not to hamper the liquidity of the corporate sector. The difference compared to previous central bank intervention is that this is not only confined to corporate bond Quantitative Easing (QE). Governments have extended the reach by also throwing a lifeline to weak borrowers with little or no history of access to credit markets, as well as through regulatory forbearance via the financial services sector that further fuels credit creation.

What we like about the current developments is the resolve by which the crisis has been tackled globally by policymakers and central bankers alike. The cherry on the cake would be the pandemic acting as a catalyst for deeper EU integration – something that has been improbable and divisive to date. A deeper restructuring of the entire economic area would be transformational for risk premiums. The recent Franco-German proposal, followed by the EU resolution to de-facto redistribute wealth across the continent, has all the ingredients to be that fundamental differentiator.

In addition, this is the first time in the past decade where we see a Global shift in the balance of power between creditors and equity holders. After years of unprecedented debt-fuelled dividend pay-outs and share buybacks, the tables may now be turning. Corporate Treasurers are keenly focused on raising as much liquidity as possible to insure their business operations should the markets seize up again, while also cutting returns to shareholders either partially or completely. Issuers are well aware that the return to normality can mean many things for their companies and the economic path remains very uncertain – all concerns we, of course, have too.

Nonetheless, along the way, we have seen a rally in investment grade corporate credit that has quickly eroded at least half, if not more, of the spread tightening potential that we identified in March. However, just as the market was pricing very little in terms of defaults back in January, we believe it is over-estimating these now. There is still a lot of fear, especially in the High Yield market, which we believe presents an attractive opportunity from a total return perspective. To that end, while the upside in A-rated investment grade corporates is not nearly as interesting as it was six weeks ago, we see plenty of opportunities for Cyclicals and what is perceived to be “riskier” debt to outperform from this point.

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BoE buying is a timely boost for the corporate market

Those with a good memory will recall that the Bank of England’s last significant attempt to buy corporate bonds was in the aftermath of the 2016 EU referendum. It took them several months to build up a £10bn portfolio, finally finishing in April 2017. From an investor’s point of view it was a somewhat drawn-out, convoluted and opaque process. The Bank drew up an eligible list of bonds it would buy, then held reverse auctions three times a week in which it invited investors (via the large investment banks) to show them offers in those bonds. The eligible list itself was somewhat debatable, they refused to buy bonds that the issuer could redeem at no cost within 3-months of final maturity (a “3-month call option” and a pretty standard feature in corporate bonds), and they limited themselves to only buying a relatively small amount (10m) of an individual bond on any one day. For many investors it felt far too cumbersome and after an initial period of enthusiasm it quickly became something of a sideshow. The Bank briefly restarted its Corporate Bond Purchase Scheme (CPBS) back in August last year to re-invest some of the interest and principal they had harvested from the portfolio they bought in 2016/17.

So when the Bank announced it would restart the CBPS as part of its recently announced QE programme there was a hope, if not an expectation, that the process would have evolved to make it more user friendly. The Bank finally announced the details of its CPBS late on the 2nd of April. So what, if anything, has changed? Let’s start with the positives, at least as I see them. (1) The amount they are buying is meaningful – “at least” £10bn, with potential to grow. This becomes more important when you couple it with (2) They aren’t going to take nearly as long to go about it. They start buying on the 7th of April, and to quote the Bank themselves “It expects to make these purchases at a significantly faster pace than in the 2016 scheme”. To do this they will increase the amount they will buy of individual bonds (from 10m to 20m) at each auction. (3) They will potentially buy bonds with 3-month call options, although they are not as yet on the current list of eligible securities.

Which takes me to some of the lingering flaws in the scheme (1) The list of eligible securities hasn’t been updated since August 2019! During that time there have been a significant number of bonds issued that would have otherwise qualified for inclusion. They have promised to revise the list mid-April, but would it really have taken that much work to bring it up-to-date? I’m sure a friendly investment bank would have helped them out. (2) They still won’t buy “new issues”. Bonds must have existed for a month before the Bank will buy them. This is in contrast to how the ECB conducts its corporate bond QE purchases. They will happily buy bonds on the day they are issued. Relaxing this rule could have really helped to boost new £ corporate bond issuance. I still think we’ll see a meaningful uptick in issuance (see comments below), but this would have been a game-changer.

The pace of the buying is the most important change here. It seems the Bank has got the message that if they want to make a real impact – and not descend into an afterthought – they need to move at a much quicker pace than the last time. The other issues become somewhat secondary. The “clunkiness” of the system will no doubt frustrate £ credit market participants, but I’m sure that is well down the Bank’s list of considerations.

So will the CPBS meet its objectives? Well if the primary objective is to improve overall liquidity in the £ corporate bond market (which the Bank says it is), then I think it will, although its impact will vary widely. Since the acceleration in the Covid-19 pandemic, liquidity in the £ credit market has deteriorated rapidly, especially in certain areas such as short-dated (<5 years to maturity) bonds. This has the potential to kick some life in to that part of the market. For other parts, especially longer dated, relatively high quality bonds, it may well have the opposite effect, making them increasingly difficult to source for investors. Finally, I expect the restart of the CBPS to result in a significant increase in issuance of £ corporate bonds. This was certainly the case back in 2016 when companies rushed to issue debt in the aftermath of the Bank’s announcement. It could be bigger this time around. We have seen very little issuance in the £ market in the last few weeks, certainly relative to the $ and € markets where there has been a glut of issuance from companies looking to bolster their liquidity in these uncertain times.  Despite the quirk that the Bank refuses to buy bonds at issue, I fully expect lots of Treasurers and Finance Directors at large UK companies are eyeing up the CBPS as a means of doing the same thing.

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Another emotional week for Mr Market

Doubtless many readers will be familiar with Mr Market, who was an allegorical figure invented by renowned investor Benjamin Graham. Mr Market swings from pessimism to optimism with alarming and unpredictable frequency.

On Monday morning, Mr Market’s pessimistic personality trait was to the fore. The US Government had failed to approve a badly needed stimulus package and central bank stimulus was seen as insufficient to lift the mood. Mr Market was having a justified case of the Monday blues.

At the beginning of the week, finger in the air estimates on dollar corporate bond supply was around $20bn. As I write this on Thursday evening we have seen $70bn of new supply, which was dwarved by investor demand. Over the last week, we are close to record levels in $ supply.

We don’t have to look far for the reasons behind Mr Market’s apparent schizophrenia, Fed’s QE bazooka and significant fiscal stimulus package agreement in the intervening period goes some way towards an explanation.

The $70bn of supply has been, predominantly, from blue chip entities. At times of stress, these are the only companies able and willing to issue at elevated costs of borrowing. While COVID remains a matter of life and death for us all as individuals, we have a reasonable expectation of these companies living through the current turbulence. Strong balance sheets and a continued need for their products assures us of that.

When blue chip companies such as Procter and Gamble, Kimberly Clark, State Street and Mastercard (among others) are paying generous credit spreads to issue debt, it puts the onus on us to try to look through the challenges of the weeks and months ahead. We therefore added selectively through the supply we have seen this week. 

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Portfolio immunisation from coronavirus

To be clear, there are no winners if coronavirus continues to spread.

However, as bond investors it behoves us to make a realistic assessment of how assets will perform under a pandemic scenario. This then allows us to take prudent steps to immunise portfolios as far as possible. 

Stating the obvious to an extent, government bonds will continue to perform well – or very well – under such a scenario. The US 10-year yield is pushing towards record low levels, despite the prevailing economic data coming out of the US continuing to be reasonably firm. However, while current levels are not underpinned (thus far) by observed economic data, we should expect these bonds to continue to outperform in a pandemic scenario. 

Domestically-focused entities may also be more insulated. With companies continuing to report fourth-quarter results, many of those exposed to China specifically – and more generally global demand – have sounded the alarm. In many cases, CEOs continue to expect a recovery to come through and benefit numbers in the second half of the year. However, for those that are globally exposed, the uncertain trajectory of infection is likely to lead to investors seeking safety elsewhere.

For example, early indications are that the utilities sector will be a relative outperformer. This may be attributed not only to their domestic focus, but also to their bond-proxy characteristics. These are likely to offer stability, and are beneficiaries of lower government bond yields. On a case-by-case basis, of course, these characteristics are also shared by some names in the telecommunications sector.

On the flip side…

Cruise lines, airlines, conference providers and international hotel groups will suffer. In many cases the business model involves attracting customers from all over the world and placing them into close confinement (though often luxurious in nature). Historical references to cruise liners as floating petri dishes have garnered much publicity of late.

The auto sector remains heavily reliant on China as a growth engine. As the virus has escalated, we have seen supply chain issues (with Jaguar Land Rover reportedly flying parts out of China in suitcases to factories in the UK). We have also seen some early warning signs on the demand side of the equation, with reports of China’s car sales falling 83% year-on-year for the seven days through to 23 February. While car purchases are more likely to be delayed than cancelled, one tends to go to a showroom in order to buy, and the early signs are that in China, consumers are unwilling or unable to do so.

And lastly, there are catastrophe bonds with high yields (and in many cases, high yield ratings), with payment at maturity linked to the absence of a so-called catastrophe event. In 2017 the World Bank issued two tranches of pandemic (catastrophe) bonds, which default under a defined pandemic scenario (as funds are used to deal with the fallout of said pandemic). These bonds are set to mature in July, unless the scale of the outbreak is such that they are triggered (read default). Needless to say, we are not holders.

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Kraft Heinz in a pickle

The “57 Varieties” on ketchup bottles mean nothing – Henry Heinz simply thought it was a lucky number…..

Shortly after the Kraft Heinz merger was completed in 2015, the company issued approximately $12bln of new debt in the credit markets to help finance the transaction. At the time, management was very clear with would-be credit investors in stating that the retention of an investment grade rating was not only desirable, but also necessary given the quantum of the company’s debt relative to the size of the high yield market.

However, last Friday, following another set of mediocre operating results and a failure to take remedial action such as cutting the dividend, both S&P and Fitch Ratings finally lost patience and downgraded the company to high yield. With approximately $28bln of debt outstanding, the market reaction was relatively severe, with long-dated dollar bonds as much as 10% lower in price. Such a move confirms that Kraft Heinz is indeed a substantial pill for the high yield market to swallow, particularly given the $10bln or so of debt maturing beyond 10 years. There is low appetite in the market to lend to riskier companies for such long periods.

It also confirms the importance of not only assessing the credibility of a company’s strategy, but also understanding the commitment and incentives of management and stakeholders. Lower interest rates and compressed credit spreads mean that for the company, the incremental cost of operating as a high yield company – rather than an investment grade one – is lower than it was in 2015. This compression in spreads (between the high yield and investment grade markets) has clearly altered management’s priorities.  The company’s ongoing travails in adjusting its offering in a world of rapidly changing consumer tastes will obviously present an ongoing challenge to management although concerns over the strategic direction of the business will no doubt be assuaged in some corners of the equity market by the board’s willingness to maintain a generous dividend.

So what are the lessons for the bond market from this episode? What constituted an efficient balance sheet in 2015 is clearly not the same for some corporate treasurers in 2020. Assessing that changing market dynamic – and by definition how it can influences corporate behaviour – is integral to our ESG analysis and overall investment process at Kames, and one of the main reasons we didn’t have exposure to any of the 57* varieties of this credit.

*there are actually 58 bonds outstanding according to Bloomberg.

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A healthy source of new issuance

The inclination to form an overarching view of the broader healthcare industry can be premature and costly. Understanding the drivers of the various sub-sectors (pharma, biopharma, medical technology, drug distributors) helps investors avoid any potential landmines and, just as importantly, allows them to identify great investment opportunities. The remarkable volume of recent healthcare bond issuance – mainly but not exclusively in the medical technology sector – has made us reflect on these nuances.

As we go into US election season, prospective policy reforms designed to make the US healthcare system more affordable and transparent have taken centre stage. It helps to remind us of the complexities underlying the sector as well as how politically sensitive it can be. Pricing reforms, litigation risk, patent cliffs, the rise of generics and ‘biosimilars’ often put investors off the whole sector, and perhaps wrongly so. There is always a hidden sweet spot. One sector insulated from some of these risks is the medical technology (medtech) space.

Whilst the sector’s product offering – ranging from syringes to surgical robots – may see some limited negative pricing pressure as hospitals and healthcare systems are always on the lookout to lower costs and capex, medtech companies are generally immune to the mighty, headline-grabbing, challenges faced by pharmaceutical companies. They don’t provide drugs that are price-pressured by either regulation or competition, they don’t provide products that are facing major patent losses, and generally they don’t suffer from large-scale litigation cases either (though product failures such as the recent pelvic mesh issue has claimed some victims). Indeed, in the absence of such noise, these companies have been increasingly building on data and innovative technologies to leverage the great opportunities provided by favourable demographic trends such as ageing populations and the rising middle class in emerging markets. Unsurprisingly, to fuel and complement the often high-single-digit organic growth and achieve greater scale, companies in the sector have been fairly active in deal-making, which has kept bond investors on their toes.

Multi-year de-leveraging stories from Becton Dickinson and Abbott Laboratories have largely played out (and others such as Thermo Fisher Scientific and Stryker remain committed to mid-sized bolt-on M&A, implying elevated supply risk). But there have still been a few opportunities to add exposure to the sector. Recent examples include Danaher (its recent jumbo deal in euros and US dollars helped finance its GE Biopharma acquisition). Also attractive is Fresenius Medical Care, which is the largest (and only vertically-integrated) dialysis provider in the world, and which is strongly-aligned with the recent Executive Order to expand home-dialysis in the US.

As a result of the recent bond issuance, the medtech sector has nearly doubled in size as a proportion of the broader euro corporate index. Going forward, whilst supply should dial down into year-end, we expect the underlying trends to remain intact in 2020, manifesting in additional M&A and a healthy supply of new issuance. We remain constructive, based on the relatively defensive nature, the favourable demographic trends, and the untapped opportunities in data and improving technology that these issuers are capable of exploiting.

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Auto consolidation evidence of a challenged industry

This week’s confirmation that Fiat Chrysler and Peugeot have approved a possible merger, to create what would be one of the world’s largest auto groups, is no surprise. Fiat had been in merger discussions with Renault earlier this year, and this is the continuation of a trend seen throughout the industry. By joining forces, car companies seek to cut costs and benefit from economies of scale.

Fiat’s fortunes were transformed under the aegis of the late Sergio Marchionne, who believed that the auto sector was in desperate need of consolidation. A Fiat/Peugeot combination would offer huge cost-saving opportunities, economies of scale, and strength in areas where each group is individually under-represented; Fiat‘s North American business (Chrysler) has been outperforming, whereas in recent quarters its European auto business has been barely profitable. Conversely, Peugeot lacks North American exposure.

The combined group would have a market cap larger than Ford and on a par with BMW, although there are many hurdles to jump before these initial talks become anything more solid. What theoretically sounds like a good idea may become mired in the details of what would be largely a cost-cutting exercise – in markets where job reductions are notoriously difficult (Italy and France).

Auto companies are currently facing the double whammy of weakening consumer demand alongside the expense and time of developing an electric vehicle portfolio to comply with stringent emission targets and an increasingly environmentally conscious consumer. Whilst no other auto mega-mergers are known to be on the cards currently, collaboration across technologies and platforms will continue; Ford’s joint venture with Volkswagen on electric vehicles and autonomous driving technology is a case in point.

The global outlook for car demand is resoundingly negative. Whilst I’m not suggesting we are about to revisit the dark days of 2008/9, when European auto CDS spreads blew out to eye-watering levels and two of the big three filed for Chapter 11 bankruptcy, the direction of travel is decidedly downward and forward visibility opaque.

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Smoke signals from an unloved sector

Only a little over a decade after going their own way, Altria and Phillip Morris International (PMI) might be getting back together. The announcement will be welcome news to the investment banking community and to those looking for some distraction from near-constant coverage of geopolitical sabre rattling over Brexit and Sino-US trade tensions. In 2003, PMI rebranded itself as Altria and aimed to diversify away from cigarettes through a significant holding in Kraft, a move many perceived to be a feeble attempt to shake off the barrage of criticism around the health effects of smoking. By 2008, the two companies separated in an effort to insulate operations abroad from US tobacco. Altria became a US-only business, while PMI focused on the international stage, whilst maintaining the stake in Kraft to provide some protection against ongoing lawsuits and FDA scrutiny.

Fast-forward ten years. Both consumers and investors have become more aware of environmental issues, products’ impacts on society, and have more information at their fingertips to evaluate the company they are purchasing from. The widespread consideration of environmental, social, and governance (ESG) issues has led to the implementation of negative screening, and typically tobacco companies will be the first to feel the wrath of filters looking to remove companies that go against the ESG grain. However, despite being trapped in the “sin” bucket for several decades, both companies have been focusing on their next generation products (NGPs) in an effort to alleviate the strong stigma attached to smoking. Whilst litigation pressures may have eased from a decade ago, new threats remain in the form of restrictions on nicotine levels, a potential ban on menthol cigarettes, the ongoing debate on the dangers of NGPs, and attempting to reinvent a brand synonymous with cigarettes.

So why combine efforts again after a decade? In addition to an estimated annual cost saving of up to $1bn, as demand has fallen so too has criticism of tobacco diminished somewhat. While the two companies share the same cigarette portfolio, they have a complimentary products range in the alternatives space. The development of the IQOS product by PMI is unique, in the respect that the product will heat tobacco, as opposed to burning it. This stands in contrast to the vast majority of other businesses which have focused on promoting vaping as an alternative, of which Altria is part of. After more than a decade apart, it will be interesting to observe if a merger, new products and new marketing can breathe life into one of the most unloved sectors – or maybe it will all go up in smoke.

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The polar fortunes of Austria and Argentina

Austria and Argentina may be alphabetically close, but economically they are at opposite ends of the spectrum.

Much has been made in recent weeks of the exceptional performance of the 100-year Austrian government bond. Year to date returns have breached 80%; not what initial buyers would have anticipated for a AA+ rated issue. In a parallel universe, the Argentinian 100-year bond has lost 30% in the past week. Bond performance typically lies with the more opaque role of duration and convexity yet, in this instance, the looming Argentinian election is the cause of the decimation in the value of its local financial assets.

What is happening?
Argentinians go to the polls this October to vote for either a continuation of President Macri’s market-friendly (although frugal) orthodox economic policies, or back a return to a more populist approach. Primaries last weekend were effectively a dry run for October’s election (given the mandatory turnout) which resulted in Macri losing by a damning 16%. The now very real prospect of future default that is being priced in is being driven by two factors: (i) the leading opposition candidate Alberto Fernandez served as “Chief of the Cabinet” in 03-08; and his Vice President candidate Fernandez de Kirchner served as President in 07-15 when Argentina last defaulted; and (ii) whether or not a potential Fernandez administration wants to restructure its debt, it may have no choice should a run on the Peso leave the sovereign unable to repay its public debt which is 80% in foreign currency.

Argentina’s precedent for such actions warrants this week’s moves in prices; having defaulted in 2001 and 2014. The last default saw bondholders experience a loss of 60% on their par holding. Losses year-to-date have been significant for holders, but could become worse depending on October’s election outcome and the direction of policy thereafter. There is still time for Macri to regain ground, but for now volatility seems the only certainty.

How much does this matter for global credit?
The figures being discussed are substantial – gross external debt at the end of 2018 was $267bn. However, the spill over risk should lie largely within emerging market (EM) credit. Even within EM I suspect the damage from this episode will be somewhat contained – the damage in Argentina has been induced by domestic politics, as we have also seen to a lesser extent in Turkey, rather than induced by common stress factors like the dollar or commodities.

That this fallout has been contained to date is also indicative of an asset class which has become broader and deeper. There have been 32 sovereign EM debuts in foreign debt markets in the past decade and the concentration of the market has consequently reduced – the top 5 sovereign issuers accounted for 51% of the market value in 2011, but this has reduced to 33% today. Mutual drivers of stress will continue, but indications are that the asset class is less susceptible to contagious domestic crises than it once was.

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HSBC sell-off: A buying opportunity

Credit markets widened last week on the back of a weaker macroeconomic backdrop, increased trade tensions between the US and China, and political turbulence in the UK and Italy. This was exacerbated by the escalation of protests in Hong Kong, which in particular led to a sell-off in HSBC debt: 5-year senior widened about 10bps, while AT1’s fell on average 1% – more than double the wider market.

This market reaction is understandable. Despite being a global bank, in the first half of 2019 Hong Kong represented 52% of HBSC group’s pre-tax profits (and over 90% of profit before tax in its retail/wealth-management operation), making it significantly more exposed to Hong Kong than global peers such as JP Morgan and Citigroup.

There are also wider strategic concerns. The bank wants to expand and tilt towards mainland China, while still maintaining its European/US operations and a large USD clearing business. If global trade tensions continue to worsen this would become more challenging. The recent departure of the group CEO (as well as the head of Greater China) adds to the uncertainty. Finally, due to its large deposit surplus, HSBC is generally seen as a relative beneficiary of higher US rates, which are now unlikely to come through following the Fed’s recent action and messaging.

HSBC’s credit fundamentals nevertheless remain robust, with solid balance sheet ratios. In Hong Kong (about 30% of total lending), asset quality metrics look very strong and the average mortgage loan-to-value ratios are below 40%. The bonds have recovered some ground in recent days, and we would view any renewed widening as an opportunity to add to exposure.

Kames Capital holds bonds from HSBC in its fund range.

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Bank of England QE – the resurrection?

Flying under the radar of the recent “Super Thursday” Bank of England announcements was the news that the Bank is about to start buying corporate bonds again.

As investors ponder whether the European Central Bank will restart its CSPP (Corporate Sector Purchase Programme), the Bank was releasing some details of its upcoming purchases. Some of you may remember that the Bank bought £10bn of corporate bonds through the second half of 2016, and the first part of 2017. It was part of the quantitative easing (QE) policy they put in place after the EU referendum in the summer of 2016. Well, since then they have been collecting coupon payments and redemption proceeds from the bonds they hold, and they believe that it’s time to start investing some of that money.

They have yet to quantify the exact amount, but it’s likely to be around £500m. In the grand scheme of things this doesn’t sound particularly market moving, but it does throw out some interesting questions.

Back in 2016 the Bank drew some criticism on how it drew up the list of companies whose debt it would buy. The definition was “companies (including their finance subsidiaries) that make a material contribution to economic activity in the UK”. That sounds admirable, but the inclusion on the list of companies like American telecom giant AT&T left many scratching their heads.

Moreover, back in 2016 the Bank was happy to “hoover-up” bonds from companies whose main exposure was to the UK retail sector… but a lot has changed in three years. The sector is now facing significant structural headwinds. Will the Bank still be comfortable buying bonds from the likes of Hammerson, the owner of a number of large UK shopping centres? They will update the list of eligible bonds later this month – I have no doubt it will certainly make for interesting reading.

Finally, will the Bank treat this foray back in to the corporate bond market as something of a dry-run for a much larger programme later in the year? A number of market participants have speculated that should the UK have a disorderly Brexit, the Bank will look to stimulate the economy through another round of QE, which will presumably include a much bigger portion of corporate bond buying.

The way the current Brexit process is developing, perhaps UK credit investors need to prepare themselves for the Bank being an active participant in their market for the foreseeable future.

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Deutsche – finally a case for cautious optimism

There have been a number of Deutsche Bank restructurings in recent years, but the most recent one announced last week finally make sense. For too long it has been a bank without a coherent business model or disciplined capital allocation. Exiting unprofitable investment banking operations and tilting the bank towards corporate banking is a step in the right direction.

Yes, the financial targets are ambitious (to put it mildly) with significant room for error. The challenge of growing core revenues by 10% to 2022 cannot be overstated considering how European banks are struggling with revenue pressure – in particular in overbanked Germany – and competitors are likely to exploit Deutsche’s weakness of no longer being a full-service investment bank. To achieve a 25% cost reduction when banks’ IT and compliance spend is on the rise will be another substantial challenge.

But it doesn’t matter if the targets are not fully met, provided the direction of travel is right, i.e. costs are decreasing, legacy assets are running off and core revenues are at least holding up. For all its flaws, Deutsche has a strong position in the areas it is consolidating into, and with renewed focus should be able to see some positive momentum. No doubt there are more chapters to be written in the sad story that is Deutsche, but overall this restructuring should be positive for senior and tier-2 bonds, all else being equal.

AT1s are the exception and here we are more cautious. The bank has lowered its capital target from 13.0% CET1 to 12.5% versus a current requirement of 11.8%, and expects the CET1 ratio to fall to 12.7% in 2020 (currently 13.7%). In light of the execution risks, the difficult operating environment and regulatory uncertainty regarding future risk weight inflation, the new management buffer seems on the low side and will put AT1 holders at increased risk of a coupon restriction.

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Fixed income outlook 2nd half 2019 (video)

So far 2019 has been unpredictable. We’re yet to see Brexit come to a conclusion, new EU and ECB leaders have been announced and are poised to take on their roles, and Trump (and his Tweeting) remain an enigma. With all this in mind, Adrian Hull, Iain Buckle and Sandra Holdsworth give us their thoughts on what lies ahead for markets in the second half of 2019.

When liquidity dries-up

Suddenly the fund industry is talking about liquidity – or lack of.

Most investors will have read about Woodford Investment Management’s well-publicised challenges around managing redemptions, which led to the suspension of dealing in one of the company’s funds. Then last Tuesday we read about Morningstar suspending the rating on a bond fund managed by H2O, citing concerns over the “liquidity of certain bonds”. H2O have since challenged these concerns, although investors and regulators are increasingly asking questions of their asset managers around liquidity risks.

In my own area – the corporate bond market – liquidity is something we spend a lot of time thinking about. In January I spoke on this topic at a leading bond market conference and published a paper titled Beating the liquidity freeze in bond markets.

To summarise my argument, since the Global Financial Crisis of 2007-2008 we have seen reduced bond market liquidity. There are two main reasons for this:

  1. The greater regulatory scrutiny of banks’ balance sheets following the crisis has had an inverse (and material) impact on the appetite of those institutions to hold bond inventory (and thus provide liquidity for the market); and
  2. Consolidation within the asset management industry has led to a greater concentration of holders (of individual bonds), which has increased the risk of liquidity bottlenecks in times of stress.

I argued in my January paper that central bank QE programmes have to some degree mitigated these risks, and indeed acted to support liquidity. However, the extent to which QE will alleviate the corporate bond liquidity conundrum on any longer-term view is, by definition, limited.

One of the (unintended) consequences of a price-insensitive buyer of corporate bonds (the central banks) has been to compress credit spreads, lower volatility and increasingly push the client base into the arms of a passive industry offering the allure of lower fees. The proliferation of passive bond funds – all seeking to construct essentially identical portfolios that mirror an index of limited size – will ultimately only exacerbate the liquidity problems in the corporate bond market.

So if we accept this is an issue and that it’s here to stay, how should we protect the consumer?

We argue that active management is the answer – with liquidity a key consideration within the investment process.

Quantitative tools can form a valuable part of any liquidity assessment. However, the reality is that liquidity is a fickle beast that does not readily conform to scientific analysis. Mathematical models cannot entirely substitute for experience and market knowledge. A careful assessment of an individual bond (and by extension its impact on an overall portfolio) should form part of every investment decision.

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Fuel-hardy plans for utility nationalisation

The spectre of nationalisation of the water and energy sectors under a Corbyn government has reared its head again. Labour recently firmed up their plans to nationalise the energy sector with the release of a document entitled “Bringing Energy Home”. Perhaps the resurgence of the debate has been precipitated by newspapers having more pages to fill, with a temporary hiatus of Brexit from the news agenda.

As ever, details on how this would be achieved are sketchy, but (in the case of water) would appear to involve shareholders being compensated at less than 50% of “market value”. The energy network plans are again suggestive of an attempt to compensate shareholders at below market value. This is in spite of the fact that many UK pension funds hold substantial stakes in these companies. It is difficult to imagine trustees welcoming the latest announcements.

Bondholders and shareholders would be compensated by receiving gilts, under the latest proposals. Among the many flaws in this approach are concerns around the theoretical value of UK government debt (typically, credit holders would be keen to receive gilts as proxies for their corporate holdings, but that may be challenged) under an administration that seeks to expropriate private assets.

The proposed methodology used to assess the compensation due to stakeholders (seemingly based on a calculation of how much stakeholders have historically spent investing in assets) would be an archaic method, and this would be unlikely to stand up to legal challenge (it is worth noting that under the previous wave of UK nationalisation, the legal view was that the Government should pay compensation based on the six month period prior to announcement of the nationalisation policy). As an indication of the legal difficulties in the proposed method, a partner at Clifford Chance, Dan Neidle stated that in every UK privatisation so far, the state paid market value, so it was not up to Labour to decide what was a fair price. He stated “That’s not what the UK precedent is and that’s not what international law says”.

The ongoing investment required to maintain the infrastructure of the energy networks and the UK water sector is huge: the last Ofwat regulatory review saw the 17 companies responsible for maintaining the UK’s water sector invest a total of £44 billion. Ofwat’s regulatory regime was described as stable and predictable by rating agency Moody’s (before nationalisation pressures started to bite). It is this stable, predictable and market-leading regulatory framework that allowed investment of this magnitude to take place.

Whilst we recognised and highlighted the benefits of expedited closure of the opaque Cayman entities (used by some water companies) in terms of restoring public trust and lobbied the sector to this effect bringing both sectors back into public hands would represent a retrograde step and one that could do untold damage to the UK’s reputation as a place to do business.

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UniCommerz; no…CommerzING; no…what?

We’ve previously commented on the now failed merger saga between Commerzbank and Deutsche Bank; there are now fresh new press rumours this week linking Commerzbank with both UniCredit and ING Groep. We struggle to see either strategic rationale or real-world practicality in any of these purported combinations. What’s clear is that Commerzbank is in a need of a radical solution. What is less clear is that either of these combinations can deliver it. Not only that, but we are wary that any theoretical tie-up would be detrimental to the investment theses of the cross-border suitors without solving the underlying structural issues for the German lender.

From UniCredit’s point of view, the appeal could be any and all of the following:

1) Increase presence in Germany and consolidate its local unit HVB with Commerzbank to achieve cost synergies.
2) Reduce funding costs long term if it manages to move headquarters to Frankfurt.
3) Gain access to the excess deposits at the Commerzbank level that would, in spreadsheet land, be revenue-accretive.

However, there are many more obstacles than opportunities in our view. To name just a few:

1) The lack of a single Deposit Guarantee Fund in the EU (and unlikely to get there anytime soon, if ever) will nullify Revenue synergies from the heavy deposit overhang at Commerzbank.
2) There is severe political opposition to exposing German taxpayers’ savings to purportedly inferior-quality assets in the periphery.
3) It will be very hard, if not impossible, to achieve cost synergies (“a lot of blood will spill before we merge with the Italians” – Verdi Union official and labour representative on Commerzbank’s board.)

Looking at a potential combination from the perspective of ING – the other rumoured “suitor” – it makes even less sense. The most obvious reason for a merger would be some sort of regulatory “arbitrage”. Dutch banks currently face a 3% core capital surcharge requirement imposed by the local regulator due to the size of ING in the financial sector compared to the Dutch economy. So, in theory, a move to being domiciled in Frankfurt and a reduction in the combined ING/Commerzbank entity relative to the size of the German economy would remove this Dutch requirement, creating a one-time windfall – freeing up excess capital. Furthermore, there continues to be a 20% bonus cap on the compensation of financial services professionals in the Netherlands, which is much stricter than the general European Banking Authority’s (EBA) guideline that applies for the rest of Europe. One could therefore argue that moving the headquarters to Frankfurt would financially benefit shareholders and employees alike, at least in the first instance. The main problem here is that this relationship would be a marked departure from ING’s current strategy of being a digital/innovation leader, with a branch-light and branch-less network across many countries. Interestingly, this includes its current operations in Germany, where it is among the few banks that actually generates return on equity (RoE) near its cost of equity, precisely due to its cost-light, branch-network-light approach. The secondary issue is that any merger will be ROE negative, hardly in the long term interests of shareholders and creditors beyond a one-time theoretical gain.

Let’s not forget that Commerzbank is a structurally challenged business rather than a prized asset that everyone is fighting to acquire. Hence, if there is any deal impetus, it is driven by Commerzbank itself rather than anyone else. Its less enviable capital and revenue position is partly due to past decisions of its own (curable organically), and partly due to the structural state of the German banking landscape (not curable organically).

The main appeal of a potential transaction, according to market pundits, therefore lies in the price.  Many say that Commerzbank’s 0.4x price to net asset value (NAV) is very cheap. However, expected returns on “tangible” equity of below 5% (using market consensus figures) do not make Commerzbank “cheap”.

Further accountants’ tricks around goodwill may sweeten the deal from a potential suitor’s perspective, but the European Central Bank may take a dim view of such shenanigans.

Overall, Commerzbank does have a problem to solve, and so does the EU banking system. The lack of a common Deposit Guarantee Mechanism (a.k.a. deposit fungibility) across the European Union prohibits the creation of a true single banking market – crippling the EU banking sector. Inability to eliminate excess capacity and reduce costs via cross border mergers puts the sector in a permanently lagging position compared to US banks. On top of that, there is the incredibly fragmented banking sector in Germany. This fragmentation challenges revenue growth and the cost base of thousands of branches creating an unsustainable cost base. These factors, along with a union vehemently opposed to any significant rationalisation adds further complexity. Without solving at least one of these factors, it will be extremely difficult for any German bank, including Commerzbank, to look competitive at a Pan-EU level. No type of M&A will supplant this fundamental truth.

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Consenting to change… at a price

Prudential plc is a well-established UK insurer, with a growing international operation in the US and Asia. The company announced significant changes to its business in March 2018, with plans to spin off its UK insurance and asset management business into a new UK-listed company (M&G Pru), with a separate entity (Pru plc) retaining the Asian and US operations. Management believes that running with two distinct entities would better facilitate the pursuit of strategies aligned to their opportunities.

When Prudential came to the market in September 2018 – ostensibly to help fund the new M&G Pru entity – it was clear that the amount raised at the time would not be sufficient to fully fund the new entity. There were varying opinions on where the remaining funding for the new entity would come from, but one very logical approach was to transition the existing long-dated £ bonds into the new entity. There were two strong arguments to this being a very viable option; firstly, the existing long-dated £ debt in Pru plc would become a less natural fit for what would become a predominantly $-based business. The second reason why we believed that the company may consider such an approach was that Pru plc would likely be over-capitalised following the de-merger, as it would no longer need to be Solvency II compliant.

Any attempt to transition debt from Pru plc to M&G Pru would necessitate a fee under a Liability Management Exercise, or LME. This is essentially what was announced yesterday, when the company officially confirmed its intention to transition the debt to the M&G Pru entity, with bondholders receiving a significant fee in return for approving the change along with increased coupons of more than ½%. We believe this represents a good deal for bondholders and will be voting in favour.

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One bride, a few suitors and a keen match-maker

Commerzbank reported better than expected results yesterday. Now, “better than expected” doesn’t necessarily translate to “good”, with Commerzbank once again seeing top line revenue pressure from the low interest rate environment and intense competition in the over-banked German market. Add a somewhat bloated cost base, and you have the archetype of a commercial German bank – one that trades at a low multiple-to-book value and generates a return on equity that doesn’t cover its cost of equity.

Following the failed merger discussions with Deutsche Bank, M&A rumours surrounding Commerzbank have continued unabated. The bride does have some attractions – it’s trading at a deep discount to its book value, offers access to the largest economy in Europe and potentially – to the right suitor – material cost synergies.

Separately, and importantly, there is also a very keen match-maker. Indeed, the ECB, in its banking supervision role, views banking consolidation as a way of strengthening the wider European banking system, helping in particular with the on-going issues of deep market fragmentation and cost (in)-efficiency.

Will the suitors show their hands? The prize is undoubtedly attractive, especially for banks like Unicredit, ING or BNP that have large in-market operations and should in theory extract better synergies from a tie-up, especially under the auspices of a keen match-maker.

On the other hand, will everyone – and in particular some people based in Berlin – view such a proposal positively? And how many banking tie-ups have lived happily ever after?

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Podcast: ECB Rate Tiering – what you need to know

2019 looks to be the year of central bank synchronisation. Steadily weakening macroeconomic data is suggesting a global growth slowdown – in response, central banks across the world have drastically cut expectations for interest rate hikes.

For the Federal Reserve, this is an about-face from a hiking program that began in late 2015. The ECB, however, has been stuck at 0% since 2016. They had been promising a return to normality, but sluggish Eurozone growth has consistently thwarted those plans.

Is the ECB’s proposed plan of tiered deposit rates a sign that they are out of options? Our Head of Rates, Sandra Holdsworth and our Lead of Credit Research, Laurent Frings discuss…

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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