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The Great Compression of peripheral to core European risk premiums

Are investors still compensated adequately for investing in peripheral rather than core European debt, or has the on-going convergence eroded debt valuation differentials altogether? In his latest blog entry, James highlighted five signs indicating that the bond markets consider the Eurozone crisis resolved. Inter alia, James pointed out that risk premiums for peripheral vs. core European high yield credit had essentially disappeared over the past two years. Here I would like to extend the periphery/core comparison by taking a look at investment grade (IG) credit and sovereign debt.

First, let’s have a look at the spread evolution of peripheral and core European non-financial (i.e., industrials and utilities) IG indices over the past 10 years. In addition to the absolute asset swap (ASW) spread levels, we plotted the relative spread differentials between peripheral and core credit. The past ten years can be divided into three distinct phases. In the first phase, peripheral and core credit were trading closely in line with each other; differentials did not exceed 50 bps. The Lehman collapse in September 2008 and subsequent market shocks lead to a steep increase in ASW spreads, but the strong correlation between peripheral and core credit remained intact. Only in the second phase, during the Eurozone crisis from late 2009 onwards, spreads decoupled with core spreads staying relatively flat while peripheral spreads increased drastically. Towards the end of this divergence period, spread differentials peaked at more than 280 bps. ECB President Draghi’s much-cited “whatever it takes” speech in July 2012 rang in the third and still on-going phase, i.e., spread convergence.

As at the end of March 2014, peripheral vs. core spread differentials for non-financial IG credit had come back down to only 18 bps, a value last seen four years ago. The potential for further spread convergence, and hence relative outperformance of peripheral vs. core IG credit going forward, appears rather limited. Within the data set covering the past 10 years, the current yield differential is in very good agreement with the median value of 17 bps. Over a 5-year time horizon, the current differential looks already very tight, falling into the first quartile (18th percentile).

Peripheral vs. core European non-financial IG credit

Moving on from IG credit to sovereign debt, we took a look at the development of peripheral and core European government bond yields over the past 10 years. As a proxy we used monthly generic 10 year yields for the largest economies in the periphery and the core (Italy and Germany, respectively). Again three phases are visible in the chart, but the transition from strong correlation to divergence occurred earlier, i.e., already in the wake of the Lehman collapse. At this point in time, due to their “safe haven” status German government bond yields declined faster than Italian yields. Both yields then trended downwards until the Eurozone crisis gained momentum, causing German yields to further decrease, whereas Italian yields peaked. Once again, Draghi’s publicly announced commitment to the Euro marked the turning point towards on-going core/periphery convergence.

Italian vs. German government bonds

Currently investors can earn an additional c. 170 bps when investing in 10 year Italian instead of 10 year German government bonds. This seems to be a decent yield pick-up, particularly when you compare it with the more than humble 18 bps of core/periphery IG spread differential mentioned above. As yield differentials have declined substantially from values beyond 450 bps over the past two years, the obvious question for bond investors at this point in time is: How low can you go? Well, the answer mainly depends on what the bond markets consider to be the appropriate reference period. If markets actually believe that the Eurozone crisis has been resolved once and for all, not much imagination is needed to expect yield differentials to disappear entirely, just like in the first phase in the chart above. When looking at the past 10 years as a reference period, there seems to be indeed some headroom left for further convergence as the current yield differential ranks high within the third quartile (69th percentile). However, if bond markets consider future flare-ups of Eurozone turbulences a realistic scenario, the past 5 years would probably provide a more suitable reference period. In this case, the current spread differential appears less generous, falling into the second quartile (39th percentile). The latter reading does not seem to reflect the prevailing market sentiment, though, as indicated by unabated yield convergence over the past months.

In summary, a large portion of peripheral to core European risk premiums have already been reaped, making current valuations of peripheral debt distinctly less attractive than two years ago. Compared to IG credit spreads, there seems to be more value in government bond yields, both in terms of current core/periphery differentials and regarding the potential for future relative outperformance of peripheral vs. core debt due to progressive convergence. But, of course, on-going convergence would require bond markets to keep believing that the Eurozone crisis is indeed ancient history.

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Seeking relative value in USD, EUR and GBP corporate bonds

In terms of investment grade credit, it has been a common theme for global fixed income investors to think of EUR denominated credit as relatively expensive versus USD credit. Conversely, many see GBP corporate bonds as relatively cheap. But can it really be as simple and clear-cut as this? To answer this question, I have compared monthly asset swap (ASW) spreads of IG credit, issued in these three currencies, both on an absolute spread and a relative spread differential (EUR vs. USD and GBP vs. USD) basis.

At first, I looked at the three BoAML corporate master indices for publicly issued IG debt, denominated in USD, EUR and GBP. As shown below, until the onset of the financial crisis in the middle of 2007, USD IG credit was trading at spread levels of around 50 bps, which is almost exactly in line with GBP and on average only 15 bps wider than EUR IG credit. During the financial crisis, USD spreads widened more dramatically than EUR and GBP spreads. At peak levels in November 2008, when USD spreads reached 485 bps, EUR and GBP credit spreads were significantly tighter (by 215 bps and 123 bps, respectively). Subsequently, GBP IG spreads surpassed USD spreads again in May 2009 and have been wider ever since.

Slide1

In contrast, EUR IG credit spreads have been consistently tighter than USD spreads. Even at the height of the Eurozone crisis in late 2011, the EUR vs. USD credit spread differential was negative, if only marginally. Over the past three years, USD IG credit has been trading on average at a spread level of 166 bps, i.e., nearly 30 bps wider than EUR IG credit (137 bps average spread) and c. 50 bps tighter than GBP IG credit (215 bps average spread). Hence, when only looking at an IG corporate master index level, it is justified to say that subsequent to the financial crisis EUR credit has been looking relatively expensive and GBP credit relatively cheap compared to USD credit.

Taking only headline master index spreads into consideration is an overly simplistic approach. A direct comparison between the USD, EUR and GBP corporate master indices is distorted by two main factors: index duration and credit rating composition. As shown below, there are substantial differences in terms of effective index duration between the three master indices. Over the past ten years, the effective duration of the USD master index has been on average 6.2, whereas the EUR and the GBP indices exhibited values of 4.4 and 7.3, respectively. Currently, index duration differentials account for -2.1 (EUR vs. USD) and 1.4 (GBP vs. USD).

Slide2

These significant deviations in duration, and thus sensitivity of bond prices towards changes in interest rate, render a like-for-like index comparison problematic. The same applies to differences in credit rating composition. Take, for example, the rating structures of the USD and the EUR master indices in March 2010. Whereas the USD index hardly contained any AAA (below 1%) and only c. 18% AA rated bonds, the EUR index comprised nearly 6% AAA and c. 26% AA bonds. In contrast, the ratio of BBB bonds was significantly higher in the USD index (almost 40%) than in the EUR index (c. 22%). The credit quality on that date was distinctly higher for the EUR index than for the USD index, and directly comparing both indices would therefore be a bit like comparing apples to… well, not necessarily oranges but maybe overripe apples, for lack of a more imaginative metaphor.

Duration and credit rating biases can be removed from the analysis – or at least materially reduced – by using bond indices with narrow maturity and credit rating bands. As an example, I plotted relative spread differentials (i.e., EUR vs. USD and GBP vs. USD) for the past 10 years, based on the respective BoAML 5-10 year BBB corporate indices. To add another layer of complexity, this time I did not use headline corporate index level spreads but differentiated between financials and industrials instead. As only relative spread differences are shown, positive values indicate relatively cheap credit versus USD credit and, conversely, negative values signal relatively expensive credit.

Slide3

Until October 2010, the graphs follow a very similar path, EUR and GBP credit spreads trade fairly in line with USD spreads up to the financial crisis, when USD spreads widen more strongly than both EUR and GBP spreads, pushing spread differentials temporarily into deeply negative territory (below -220 bps in the case of financials). Then things got more interesting as spread differentials seem to decouple to a certain extent from October 2010 onwards. At this level of granularity it becomes clear that it is an inaccurate generalisation to refer to EUR credit as expensive and GBP credit as cheap versus USD credit.

In terms of 5-10 year BBB credit, EUR financials have in fact been trading consistently wider than USD financials, although the spread difference has been falling considerably from its peak Eurozone crisis level of 201 bps in November 2011 to currently only 10 bps. EUR industrials have been looking more expensive than USD industrials since early 2007 (c. 35 bps tighter on average over the past 3 years). The trajectory of GBP financials spread differentials has been broadly following the EUR financials’ humped pattern since late 2010, rising steeply to a maximum value of 259 bps in May 2012 and subsequently falling to current values at around 115 bps. GBP industrials have been looking moderately cheap compared to USD industrials since late 2010 (c. 37 bps wider on average over the past 3 years), but the spread differential has recently vanished. Hence, regarding 5-10 year BBB credit, currently only GBP financials are looking cheap and EUR industrials expensive versus the respective USD credit categories, whereas GBP industrials and EUR financials are trading in-line with USD credit.

To sum things up, when comparing USD, EUR and GBP IG credit, headline spreads are merely broad-brush indicators. To get a greater understanding of true relative value, it is worth analysing more granular data subsets to understand the underlying dynamics and the evolution of relative credit spread differences.

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Technical support for Euro IG; around 4% of the market set to mature this month

Benjamin Franklin said that death and taxes were the only inevitabilities in life. I’d like to add the discussion of the January effect to his list. Every year I receive at least one piece of commentary telling me that January is always a good month for risk assets (we’re far from innocent ourselves – see here).

Basing investment decisions purely on seasonal anomalies isn’t a particularly reliable investment process and the sensible investor should take other, more robust information into account when making changes to their portfolio.

The improving economic outlook for Europe and the general lack of pessimism should help the European credit market rally this month. So too should the fact that about €64bn worth of investment grade bonds are set to have matured by the end of the month. I think it rather unlikely that we’ll see enough supply to offset the bonds that are maturing. J.P. Morgan recently publishing a research piece pointing out that gross European investment grade issuance has only ever been higher than €64bn a month on four occasions in the past, and all were prior to 2008.

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J.P. Morgan also point out that January has been on average the month when most issuance takes place throughout the year. The primary market has been true to form since 2014 began but it will need to maintain the pace of the roughly €16bn that was issued in the first week of the year to give investors with maturing bonds somewhere to put their cash.

If net issuance turns out to be negative in January it will be a key technical support that could see Euro investment grade spreads continue to tighten further. It will also give us all another nice data point to talk about come next January.

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The year of the Snake – 2013 returns in fixed income markets

2013 has offered another injection of both adrenaline and performance to fixed income investors. A rapid sell-off shook emerging markets just before the summer while the Fed was conducting a “tapering yes/tapering no” ballet that lasted for more than six months. European peripheral countries finally came out of recession, although unemployment levels remain alarmingly high. In parallel, global high yield markets delivered further stellar performance, while Japan started to feel the effects of the unprecedented monetary and fiscal revolution driven by Shinzō Abe.

However, a common theme clearly emerged: the developed economies appear to be finally growing at a reasonable pace. Markets largely normalised as volatility and correlations returned to pre-crisis levels. While central bank intervention (set to continue for some time) has been the mantra in a liquidity driven environment, the world is transitioning back towards a growth based model. The US is well positioned to lead the pack, although high debt levels in Europe may continue to leave governments with limited room to support the recovery via fiscal stimulus. However, the good news here comes from a healing and deleveraging banking system, as well as rock solid support and a clear accommodative stance by the ECB and its leader Super Mario Draghi.

In this context, many fixed income asset classes offered satisfactory returns. Which assets have been top performers? The results are surprising. Who would have said, back in January 2013, that – together with a new Pope from Argentina, China landing on the moon and an economic bailout in Cyprus – Spanish “Bonos”  would have offered total returns in excess of 11% YTD, for example? Let’s take a closer look at government bonds, corporate bonds and major currencies compared to the US dollar (all total return YTD figures are measured from 31 December 2012 to 17 December 2013 in local currency).

Government bonds

Risk-free government bonds have been negatively affected by expectations over rising rates and tapering uncertainty. The UK gilts index – with an average duration of over 9 years – has been the most negatively hit, followed by US Treasuries (5+ years duration) and finally by less volatile German bunds (6+ years). It was a different story for some countries in the European periphery, where Greek government bonds offered tremendous total returns above 50%, followed by Spanish and Italian sovereign debt. Following the May debacle, emerging market government bonds in hard currency (measured by the commonly used JPM EMBI Index) took a significant hit and offered a negative return below 6%, despite a decent rebound after the summer, while the local currency index (JPM GBI-EM) looks set to end the year broadly flat (while once translated in USD, it is negative by around 8%)

Following 2012’s fall from grace for linkers, due to both falling inflation expectations and very low inflation in Europe and US, 2013 has continued to see the US, European and EM markets negatively affected while the UK market is about to close in a marginally positive territory thanks partly to the decision to maintain the link to RPI earlier this year (here’s a blog from Ben on the topic).

Looking back: government bonds

Corporate bonds

A great degree of value over the past year was to be found in corporate bonds. Companies are benefitting from the broad-based economic recovery around the developed world and from the subsequent increase in consumer demand (higher consumption = higher corporate revenues) and public investments. A conservative management of financial resources and balance sheets by bond issuers on average (especially in Europe), improving economic prospects, forward guidance on interest rates and a low inflation environment have all supported the ride of corporate bonds. Names active in the high yield space – especially in the US and Europe – have been amongst the standout performers within credit. Financials have also had a very strong run, especially in the subordinate space, helped by a healthy investor demand for higher yielding and more cyclical paper, as well as a general financial deleveraging process that is going in the right direction to restructure their balance sheets.

Performance highlights include European high yield (+9.9%), European subordinated financials and US high yield banking (+7.1% and +8.9% respectively) and an overall good showing from BBB non-financial corporates in Europe (+4.4%, to compare against -0.8% in the US). Emerging market corporate debt was in negative territory overall (-1.0%), while the high yield portion was marginally positive (+1.1%).

Looking back: corporate bonds

Currencies

The most noticeable development amongst major currencies has been a general lack of excitement around the US dollar from global investors, probably due to the ongoing tapering tantrum together with fears around the US fiscal cliff and the recent government shutdown. The USD index (DXY in Bloomberg) has generated a rather lacklustre  performance of +0.4% YTD. We need to make a clear distinction between two separate trends this year: the index generated positive returns for around 6% between January and early July, while it lost ground in the second part of the year (around -5.6%) due to uncertainties around the US government shutdown and Fed’s decision to maintain loose monetary policy. However, today the US economy is growing, its current account deficit is decreasing, the nation is moving towards energy independence, and Fed policy is now clearer following its tapering announcement on 18 December: we strongly believe that US dollar is good value and is set for a strong rebound.

Amongst G10 currencies, the Euro and GBP have gained significant value over the USD in recent months. Thanks to surprisingly strong economic developments in both the UK and the Eurozone, sterling and the euro have been amongst the best performing global currencies between March and December. Stay tuned on the British pound, because the UK’s 5.1% current account deficit in Q3 is the 3rd is the worst in UK history (and worse than Indonesia, India and Brazil). This suggests that there is no sign of the UK economy rebalancing and the UK’s economic recovery in its current form is nowhere near as sustainable as the US recovery.

The Japanese Yen has lost significant value (-15.4%) versus the US dollar due to the fresh efforts of the Bank of Japan to create inflation (and nominal growth) in the country. Some emerging market currencies offered strong performance, including the Argentine peso, Chinese Renminbi, Hungarian Forint, Polish Zloty, and Mexican peso, but the majority of EMFX has underperformed the US dollar, notably the Brazilian real, Indonesian Rupiah or South African rand, with the latter being the only currency to return less than the Yen at the time of writing.

Looking back: major currencies performance vs. USD

In conclusion, who would have expected such an interesting ride for fixed income asset classes this year? What is going to happen in 2014? Will next year be a negative or positive one for financial markets, and fixed income specifically? Read our latest Panoramic here and continue to stay tuned to this blog, explore recent posts (here from Ben, here from Mike and here from myself) and read more in the upcoming weeks.

Before saying goodbye, let me ask you something related to the Chinese calendar. The Year of the Snake, which began  on 10 February 2013, will be over at the end of January 2014. In the Chinese zodiac, the snake carries the meanings of cattiness and mystery, as well as acumen, divination and new beginnings. Do you see any fit with 2013? The new year of the Horse will start on 31 January 2014. The horse is considered energetic, bright, warm-hearted, intelligent and able. Any hint? Good luck and happy 2014!

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Panoramic: The effect of globalisation on corporate bond valuations

Corporate bonds have had an incredible run over the past few years. A combination of sub-par growth, the sovereign crisis in Europe and massive amounts of QE on a global scale has driven government bond yields down to historically low levels. At the same time, corporate bond spreads have tightened significantly from the crazy levels we saw in 2009. This has meant double-digit annualised returns from parts of the investment grade market (as you can see from the chart Richard posted yesterday), albeit with some spread volatility in ‘risk-off’ periods.

How do corporate bonds generate similar returns from here? Well, there’s no doubt it’s going to be difficult. Given the duration of the iBoxx £ Corporate index of just under 8 years, we’d need to see yields fall roughly 1% further. So, either 10 year gilt yields would have to rally to less than 1% (from today’s 1.7% level) with spreads staying broadly flat, or spreads would need to tighten significantly with gilt yields stable (or of course any other combination of gilt yield/credit spread moves equivalent to about a 1% fall in overall yield).

Focussing purely on the credit spread and using history as a guide, there certainly is room for further tightening – for example, the spread of the BofA Merrill Lynch BBB Sterling Corporate & Collateralised index was 292bps at the end of March, 191bps wider than the pre-crisis tight of 101bps at the end of May 2007. But what could be the catalyst for such a tightening of spreads?

In the latest version of our Panoramic series we look at what drives the relationship between corporate and government bond pricing, how this has been changing over time and what might ultimately lead to corporates trading at even tighter levels than before the financial crisis.

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Old Lady sells her bonds

Back in 2009 the Bank of England (the Old Lady of Threadneedle Street) began buying a portfolio of investment grade bonds to provide funding to UK corporates, to aid liquidity in the corporate bond market and to supplement their QE purchases of gilts. Last Friday this investor sold its last corporate bonds.

This has been a great success from a profit point of view. The attached chart shows the total return of an index of non-financial corporate bonds over the period of the bank’s purchases and sales as well as an indication of their total holdings.

I believe its actions helped stabilise the corporate bond market in the UK by providing a backstop bid, therefore helping to reduce the cost of funding at the margin for issuers, and would have added to the effects of QE. However, empirically measuring these effects is hard to do – corporate bond markets that experienced no domestic support from their central banks appear to have performed similarly, and the debate on the true effectiveness of QE remains.

What is the primary lesson we have learned? I think it is that state intervention can work where markets are priced inefficiently. This is illustrated by the large profits the bank has made by buying an out of favour asset class from the private sector. It is probably a good base to have the state intervene where markets are inefficient, for example in areas such as healthcare, defence, law and order, and infrastructure. The danger comes when the state interferes to the detriment of an efficient market. From an economic point of view, aggressive trade barriers are the first thing that comes to mind where there would be a great deal of consensus from the left and right side of politics. Other actions may depend on your economic or political view. The best current example of this is the single European currency experiment. Does it aid a free market via price transparency and low transaction costs, or does it hinder efficiency by having one single interest rate and exchange rate for such diverse economies ?

The Old Lady’s portfolio of corporates has served her and the UK well because she bought them at cheap levels from distressed sellers. Unfortunately, this investor has a significantly bigger portfolio of gilts. The carry and mark to market on these looks great. However, turning this unrealised gain into a realised profit still remains a challenge. If she comes to sell, her position is likely to drive the market against her.

old lady blog chart

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Heinz: Beans, Buffett and the return of animal spirits

After years of inactivity, the combination of strong corporate balance sheets and cheap funding has sparked demand for takeover deals. The largest and highest profile deal this year has been the acquisition of H.J.Heinz by 3G Capital and Berkshire Hathaway. It is exactly the type of business that Berkshire Hathaway’s Chairman and CEO Warren Buffett typically goes for: profitable growth; a very recognisable brand; and years of emerging market growth forecast in the future.

Berkshire Hathaway and 3G Capital are buying Heinz for $72.50 per share, a 19 percent premium to the company’s previous record high stock price at the time the deal was announced in mid-February. Including debt assumption, the transaction was valued at $28 billion. Berkshire and 3G will each put up $4.4bn in equity for the deal along with $12.2bn in debt financing. Berkshire is also buying $8bn of preferred equity that pays 9%.

Let’s not beat around the bush. It’s a great company. The business has seen thirty one consecutive quarters of organic growth, stable EBITDA margins, owns a number of globally recognised brands and should be well positioned for future emerging market led growth. Despite this, some are questioning whether Buffett is overpaying for Heinz. So is the price of the deal justified?

The answer, at least in part, lies with cost of debt. The pro-forma capital structure (per the offering memorandum) looks like this:

PF Capital Structure Sources ($m) Net Debt/PF EBITDA
Cash -1,250
1st Lien 10,500 3.87 x
2nd Lien 2,100 4.75 x
Rollover Notes 868 5.11 x
Total debt 12,218 5.11 x
Preferred Equity 8,000 8.46 x
Common Equity 8,240
Total 28,458

Current price talk on the first lien debt sits at $ Libor + 2.75% (floored at 1%) with the second lien at 4.5%. If this is finalised, the company will see an approximate blended interest cost of 3.9% on its new debt securities. Prior to the transaction, Heinz was rated as a solid investment grade business attracting a Baa2/BBB+ rating. Assuming the deal goes through, its new second lien notes are expected to be rated B1/BB-, some five notches lower than Heinz’s current rating, reflecting the much higher financial leverage and structural subordination.

It’s worth noting that through last year Heinz’s 6.25% 2030 bonds traded in a range of 4–5%, despite the much higher rating and lower financial leverage at the time; albeit some term premium is warranted given the longer dated nature of the debt. The bonds have since sold off in recognition of the greater risk – as things stand they will remain in place.

HNZ

Now let’s compare the price action of the proposed debt financing to the preferred equity to be owned by Berkshire Hathaway. Whilst the paper is structurally subordinate to all other debt, it still sits ahead of some $8,240bn of common equity and attracts a cash coupon (which can be deferred) of 9% vs the 3.9% weighted average above. It’s also worth bearing in mind that the transaction has been structured to encourage the preferred equity to be retired, at least in part, ahead of both the first and second lien debt, potentially leaving bondholders with significantly less subordination than at day one. I’d argue that this is by far the most attractive (quasi) debt to invest in within the structure, though that is hardly surprising given that unlike Buffett, few of us can write a cheque of this magnitude.

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As animal spirits return and the leveraged finance community falls over itself to lend to well known companies, the likely winners in the space will be the private equity community. Whilst we are nowhere near the levels of the great private equity binge of 2004-07, the value of takeovers in 2013 is already running well ahead of 2012. After years of corporate deleveraging, we may now be entering into a period of increased M&A activity. Company managers may find that if they aren’t willing to start leveraging up given the environment of extremely low borrowing costs, then investors like Buffett will do it for them.

The Heinz deal has been another recent shot across the bows of the bond market. Rising leverage has a longer term implication for credit markets, in that it is bad for credit quality. Bigger and bigger companies are clearly in play and this is something we will be keeping a very close eye on.

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6 degrees of Kevin Bacon, 5 ways to catch a subscriber – consolidation in cable

I’d been feeling pretty pleased with myself since last Saturday – I managed to get Sky TV, broadband and a landline installed in my flat. That was until earlier today, when after discussing some of the recent activity in this sector with our telecoms and media analyst, I was left feeling something of a technology dinosaur.

These three services sold as a single package is called a “triple play” offer. However, I have since discovered that this is so 2010. These days it’s increasingly about “quad play”, whereby consumers access video, broadband and voice services both inside and outside the home. Inside the home is provided by your cable, copper telephone line and/or satellite dish whilst outside connectivity is provided by a mobile network. The most visible example of this business model in the UK comes from Everything Everywhere (EE), mostly due to their……um……interesting adverts featuring Kevin Bacon. EE allows a subscriber to make voice calls, surf the internet and watch video content either at home or on the move via a combined mobile and fixed line broadband connection. Advances in mobile technology (4G) now mean that seamlessly streaming a film in your house on your iPad as you eat breakfast and then on your journey to work should be possible. This is the direction the industry is moving in the UK, with Vodafone, 3 and O2 expected to launch later in the year once they secure the necessary 4G spectrum that is currently being auctioned. In the US and portions of Western Europe it is already there.

So quad-play has a clear consumer proposition, i.e. ubiquitous and fast media consumption and connectivity from a single service provider. But what benefit do the telecom operators derive from this service? Firstly, they hope to stem the revenue declines and customer churn they have experienced over the past few years as a combination of competition and regulation have ground down prices. Secondly, quad play offers them a cost saving opportunity by shifting data traffic off their mobile networks and on to their fixed line infrastructure as fast as possible, either via an in-home WiFi point or a fibre optic link to the network towers outdoors.

Generally speaking, in each country there is an incumbent telecom operator offering both mobile and fixed line services (the UK is an almost unique exception after BT spun off O2). However, there is also a swathe of mobile-only and fixed line-only operators in each market and hence consolidation in the face of this strong industrial logic seems inevitable.

Last Wednesday, press reports suggested that Vodafone is considering acquiring cable operator assets. Two firms seem to be in their crosshairs for now; Kabel Deutschland and ONO (which operate in Germany and Spain, respectively). Both companies’ bonds rallied on the news that they could be taken over by a company with a much stronger balance sheet – they are both high yield whilst Vodafone is solidly investment grade. We think that Kabel Deutschland would be a better fit but either way Vodafone is clearly interested in fixed line assets across Europe. Last year it bought Cable & Wireless Worldwide in the UK and its interest could also stretch to alternative fixed line network operators like Jazztel (Spain), Versatel (Germany) and Fastweb (Italy).

Similarly, Liberty Global, an international cable operator, recently made a bid for UK cable operator Virgin Media. Virgin’s bonds were weaker on the news as LGI is a lower rated entity than Virgin and plans to leverage the business to a level commensurate with its other European cable investments (UnityMedia, UPC, Telenet). LGI already offers triple play services across its extensive European cable footprint but, along with the usual scale and tax synergies, Virgin brings with it significant experience in mobile as well as providing fibre optic connections to other UK operators’ mobile towers.

What can possibly come after quad-play? Internally we refer to what we believe is the next step as “penta-play”. This involves business models where service providers offer quad play delivery and services complemented by ownership of the content being consumed over those networks. The importance of control over content to a network provider was underlined by the US’s largest cable operator Comcast, with its $17bn purchase of the remaining 49% of NBC Universal it did not already own. If you think this is a US aberration, just think what would happen to Sky if it lost the Premiership contract and why BT has recently decided to park its tanks on Sky’s lawn with its recent expansion into Premiership football and rugby.

And after that? Well the regulators will probably demand these vertically integrated behemoths are broken up but that’s another story…. From a consumer’s point of view we think that consolidation and competition, to provide us with all our communication, entertainment and informational needs under one subscription, will eventually lead to lower prices for services previously purchased separately now being provided as a single service bundle. From a bond holder’s point of view the recent activity suggest M&A risk is on the rise with negative and positive impacts depending own whether you sit in the acquirer or the target, the better rated credit or the company with the weaker balance sheet, and your specific bond covenant protections.

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European autos, stuck in reverse

French auto manufacturers Peugeot and Renault report full year 2012 earnings this week. If Peugeot SA’s write down announced on Friday is anything to go by – when it took a €4.7bn non-cash charge – the outlook for the company and indeed other European focussed auto manufacturers continues to be a bleak one. European market conditions have been described by S&P as ‘dire’. Overcapacity and general economic uncertainty have resulted in utilisation rates below break-even profitability for a number of plants. Cash continues to be burnt and unsurprisingly, share prices don’t make for pleasant reading.

Renault, Peugeot stock price

The need for an overhaul of the likes of Peugeot, Fiat and Renault remains acute.  European light vehicle registrations are headed for a fifth consecutive year of declines (see chart below), Italian and Spanish registrations are at nearly half their pre-crisis levels, profit margins on compact vehicles are slim and Peugeot, Fiat and Renault are losing market share to investment grade rated manufacturers like BMW, VW and Daimler.

Eurozone new light commercial vehicles - monthly registrations

Struggling under a mountain of debt, Peugeot, Fiat and Renault find themselves in a non-too dissimilar position to that of the US auto manufacturers back in 2008/2009. Several years ago GM, Ford and Chrysler were able to successfully restructure, both inside and outside of bankruptcy, allowing them to close capacity, reduce over-indebtedness, renegotiate onerous union contracts and subsequently return to profitability even at levels of production significantly below those pre-crisis. That experience remains in stark contrast to European OEMs (Original Equipment Manufacturers) who continue to labour under many of those same pressures whilst facing ongoing weak domestic demand.

Vehicle registrations in US and Eu-15 (in Million units)

Management continues to struggle to right-size their businesses some 5+ years into the financial crisis in the face of strong political pressure and a determination to avoid job losses. Ironically, the very interference that has hampered change in Europe has now led to Peugeot having to rely on French state support. But these choices cannot be put off into perpetuity and unwelcome decisions are inevitable. Until that point in time, losses will continue to mount, cash will be burnt and creditors will likely favour US over European OEM risk.

Credit default swaps - evolution

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Contingent capital notes – bank equity’s best friend?

As investors, the majority of our time is spent pricing risk with an increasing amount of that spent trying to value optionality. We’ve always had to price the optionality inherent in owning certain bonds. For instance what’s the likelihood of a call option sold to a bond issuer being exercised? What’s the likelihood of an early refinancing, or perhaps a change of control? These and other options are both risks and opportunities that credit investors will regularly have to consider and reconsider.

Some of the more recent options that credit investors have been forced to consider are those embedded within contingent capital notes or CoCos. These aren’t entirely new securities with Lloyds having exchanged bonds for CoCos back in 2009. Simplistically these ‘first generation’ CoCos are designed to behave like a traditional bond until a pre-defined trigger is breached. When triggered, first generation CoCo holders are forcibly converted into equity at pre-determined pricing, aiding the bank with its recapitalisation efforts. These instruments have found favour with the regulator not least because traditional subordinate capital instruments proved themselves almost entirely ineffective in providing loss absorbing capital.

However, since the issuance in 2009 the market has moved on somewhat and a new breed of CoCo has since emerged. Many of these newer instruments (see chart above) are designed to be written off entirely in the event of a trigger without the conversion into equity discussed above. This optionality has two obvious implications. Firstly, given that investors are written down to zero without equity conversion, any prospect of participating in a future recovery becomes null and void. Secondly (with the caveat that the quantum of issuance remains small for now), the prospect of a bond essentially performing the role of a non dilutive emergency rights issue has to be positive for all other stakeholders in the bank, not least common shareholders. And don’t forget that the majority of these instruments will see their coupons paid before tax, further enhancing the relative value of said issuance.

Selling all this optionality does have its price, as do most things in life, but the current exuberance in credit markets may yet see CoCo investors fail to exact an adequate premium.

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