The initial release on the 26th February saw banks in the Nordic region receive upgrades by as many as four or five notches, some to Moodys’ highest rating of Aaa, ranking them alongside sovereign bond issuers such as the UK, Germany and the US. Moodys’ rationale is predicated upon its new Joint Default Analysis (JDA) approach. Moodys claim that “banks will receive national government support, as well as other major forms of external support such as parental support and support from regional and local governments and cooperative and mutualist groups” which have led to the rethink.
The reaction to the upgrades has been twofold. Firstly as you’d expect, those banks so far benefiting from upgrades have seen the value of their bonds rise in response. Secondly, Moodys have come in for a great deal of criticism. Many investors have questioned the lack of transparency in the new process. It had previously been believed that Moodys were already factoring in state and/or parental support. Investors have questioned for example whether a country such as Iceland (with a population similar in size to Hull, and an economy based around cod) has the ability to support banks which has liabilities three times the nation’s Gross Domestic Product. The new process has also made it far more difficult to distinguish between banks on a credit fundamental basis given the added parental/governmental factor.
The ongoing process is expected to lead to further upgrades, further confusion and no doubt further criticism. One disgruntled bond trader has created this clip. Warning – may only be funny to bond geeks.
PE funds raised $432bn last year globally, according to Private Equity Intelligence, which gives them firepower of around $2 trillion if they used 4 times as much debt to buy companies. And estimates suggest they may raise more in 2007, possibly $500bn. We should expect more Leveraged Buy-Outs (LBOs) in 2007, after all 8 out of the 10 largest LBOs of all time happened in 2006 after less money was raised in 2005.
What does this mean for corporate bond investors? Well bondholders of potential targets, likely to be investment grade, should make sure they are protected with covenants so they can get their money back. There are few places to hide when even Home Depot in the US is talked about as a target. High Yield investors are likely to see more issuance to fund the LBOs but should make sure that the PE fund hasn’t overpaid (multiples are rising as shareholders become less willing to be bought out cheaply).
But the more significant effect may be for corporate Europe to take on more debt and fall down the credit spectrum. Companies such as Portugal Telecom, currently being courted by Sonaecom, are offering special dividends funded by debt to fend off a takeover and so you could see their ratings fall to junk even if they are not taken over. This would bring the ratings of European companies more in line with US companies that have typically had more debt. Maybe one of the reasons for European companies having less debt than their US counterparts was a less established capital market for junk rated companies in Europe, but that fear should have eroded with the maturity of both the European High Yield and Leveraged Loan markets that are more able to finance lower rated companies.
Gilts were marginally damaged by these figures, but why did the bond market not sell off by more? Two answers spring to mind – firstly, complacency; and secondly, the focus on money supply is nowhere near as strong now as it was a couple of decades ago, when the government used to target the money supply in an effort to control inflation.
There is no doubt that in the long run, increases in money growth are more often than not associated with increases in inflation. One of Milton Friedman‘s two most famous quotes was that “inflation is always and everywhere a monetary phenomenon” (the other quote being “there is no such a thing as a free lunch”, which is something I don’t entirely agree with!).
The Bank of England recognises this link between money supply and inflation, since contained within the last inflation report were the words “strong money growth may be associated with greater spending on goods and services, or upward pressure on asset prices, posing an upside risk to inflation. To the extent that people recognise this, strong money growth may also prompt them to raise their expectations of future inflation”.
But the extent to which money supply growth causes inflation is the subject of an economic debate that has been raging for centuries. I don’t want to go into this here, although it is definitely worth mentioning that the money supply clearly plays a role in Mervyn King’s mind. In “No inflation, no money – the role of money in the economy” , a paper he wrote while Deputy Governor of the Bank of England in 2002, he concludes:
“My own belief is that the absence of money in the standard models which economists use will cause problems in future, and that there will be profitable developments from future research into the way in which money affects risk premia and economic behaviour more generally. Money, I conjecture, will regain an important place in the conversation of economists.”
If the Governor of the Bank of England cares about money lending and money supply growth, then so do I. Yesterday’s data releases reinforce my view that the Bank of England will have to hike rates twice more, and possibly by more than that.
Are CCC rated bonds compensating us enough for default risk? Based on historical default rates, the answer is a resounding “no”. Moody’s most recent annual default study looks at global default data from 1920-2005, and on a five year moving average, the historical global default rate for CCC rated bonds is a rather worrying 29.7%. So, if you bought a CCC rated bond now, based on an historical default rate, there is almost a 1 in 3 chance that the bond you bought would default over a five year period.
It’s all very well looking at historical averages, but are we in an “historically average” credit environment right now? Again, definitely not. The global economy had one of its strongest years ever in 2006, which goes a long way to explaining why defaults have remained so low. In Europe, following the default of Schefenacker, only 2 out of 155 companies’ bonds are trading at distressed levels (ie yielding 10% more than government bonds) indicating that they are likely to default soon.
Even though balance sheets are generally very healthy and the credit environment is very supportive, it is difficult to be bullish on something that is the most expensive it has ever been. In my funds I am being cautious on triple-Cs. Where I do hold them it is because they have short maturities or we think that they are likely to be refinanced. I’m not hooked
Defaults are few and far between in the European High Yield market at the moment but we have another today as Schefenacker, a German auto supplier that makes mirrors and lights, has announced a financial restructuring. Holders of the €200m bond issued in February 2004 have been offered 5% of the equity.
This should serve as a reminder to the current jubilant credit market that companies can go bust, although I suspect that it will be seen as part of the auto industry malaise that the rest of the market is insulated from. It should also question recovery rates. Schefenacker bonds are trading at around 10% which is much lower than the “normal” 40% assumption that is the perceived wisdom. With more loans and second lien loans ranking ahead of the bonds, we should expect recovery rates to be lower over the next credit cycle.
No rate hikes from either the Bank of England or the European Central Bank today, in line with the market’s expectations. The MPC will have seen January’s inflation data (out next week), so it’s therefore unlikely (though not impossible) that CPI rose above December’s 3% level and into the territory where Mervyn King has to write a letter to the Chancellor. In fact today’s news that British Gas is cutting both gas (-17%) and electricity (-11%) prices as of March makes the outlook for UK inflation a little more benign. Together these items account for 3% of the Consumer Price Index, and if competitors follow suit, the impact of the price falls will be to take around 0.4% off the inflation rate. In addition, with the IDS wage data for January’s pay settlements having been revised down from the early estimate of 4% to 3.5%, the MPC will be a little more relaxed that a wage inflation spiral in not underway. The ECB however have had no such comfort, with the German metal workers union demanding 6.5%, and the Italian banking union 10%.
In the UK then we’re waiting to see some sustained weakness in housing before we call a peak in rates (mortgage approvals have fallen, but the HBOS house price index rose again today), but it might not be that far away. In the Eurozone however rates will need to go up at least a couple more times – wage growth is a threat, money supply is extremely strong, and economic growth continues to surprise to the upside. So we expect the ECB to be at, or above, 4% later this year.
Friday’s statement from a group of private equity houses that they were “in the preliminary stages of assessing” a possible offer for Sainsbury saw its shares rally 17% and the CDS market jump from spreads in the mid 27 bps out to 75 bps. CDS (credit default swaps) reflect the cost of ‘insuring’ against an issuer defaulting on its debt – the higher the risk of credit deterioration, the higher the premium.
During the first half of 2005 Sainsbury’s CDS contracts traded in a range of 90 bps to 130 bps reflecting the rather poor performance the company was experiencing in a demanding sector. The second half of the year saw a gradual tightening in spreads reflecting an improving credit profile as management began to show signs of turning things around. By the end of the year Sainsbury CDS was trading at around 57 bps, largely in line with its peers.
However, by the end of February 2006 Sainsbury’s CDS had collapsed from the high 50s to the mid 20s and eventually settled in around the high teens a month later. The driver for this move is a technicality in the CDS market. If a credit event takes place, the ‘insured’ party has an obligation to deliver qualifying bonds or loans, and in exchange receives his/her payout from the protection seller (in the same way that if you crash your car, the insurer pays out, but then owns the wreck). The issue in February 2006 was that Sainsbury announced they intended to re-finance their outstanding debt in a move which included buying back their outstanding bonds. This meant that if a credit event was to occur then a protection buyer would be unlikely to be able to fulfil his/her part of the bargain – thus making the value of insurance dramatically lower. (The reason the CDS didn’t trade to zero will become apparent.)
So why is Sainsbury’s CDS currently trading around 90 bps? If private equity were to get their hands on Sainsbury, far from a certainty, then they would be very likely to lever up the balance sheet (by issuing loans and bonds) thus increasing the probability of a default. In theory this should see the CDS trade above the highs of 2005. The reason why the CDS hasn’t yet reached new highs is twofold: firstly we don’t know what the ultimate fate for Sainsbury will be, but crucially we don’t know whether any debt issued would ‘qualify’ as deliverable under the existing CDS contracts. In theory the CDS price should be a function of weighted sum of the various potential outcomes for Sainsbury and that is very much open to interpretation and guesswork. I imagine we will yet see some more volatility in Sainsbury CDS.
Friday’s Wall Street Journal lead on Putin’s response to Iran’s suggestion that the gas-producing nations set up a cartel similar to that run by the oil producing nations. Russia and Iran have the world’s largest proven gas reserves, with a world share of over 40%. Given that Europe gets a quarter of its natural gas from Russia this is a concern for inflation – the natural gas price is already the single biggest contributor to Eurozone inflation. According to the latest Economist however (see here) such a cartel is unlikely to be effective for various reasons – most importantly the long term nature of gas supply contracts. Nevertheless the "protectionism alarm" is ringing more and more frequently here.