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FIND OCTO ASSET MANAGEMENT
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Growing dichotomy between issuers may signal future credit market upheaval
Politicians and central bankers continue to try to spark recoveries in their respective regions while trying to avoid high visibility currency and trade wars and in doing so create instability in the financial markets. The markets are already perturbed by the approaching end to QE, while companies are anxious to have one last shot at excessively low interest rates to protect themselves from the fact that growth is still weak, uncertain and unevenly distributed.
Monday: Eon announced that it will purchase RWE’s Innogy network for more than €20bn.
Tuesday: ACS and Atlantia agreed to take joint control of Arbertis at a cost of approximately €18bn.
Wednesday: Telefonica issued €2.2bn in new hybrid bonds in order to retire existing ones and to one last time optimize its financing, with lower coupon rates, in advance of what will likely be a gradual increase in rates and spreads. Sanofi issued two bonds for a total of €8bn in six tranches, of which two offered yields of 0% and -0.1%. Investors paying for the privilege of lending is a phenomenon which has come to be accepted in the financial markets, but which remains difficult to explain to the uninitiated without completely losing credibility.
Thursday: Nippon Steel signed an agreement to buy Ovako, which is expected between now and mid-2018 to implement a very early reimbursement of bonds issued last September. On the losing side, for those of which economic transformation has a greater impact than the actions of central banks, earnings season caused some damage:
- Auchan reported profits down 20% despite mostly unchanged revenues
- Fromages Bel was impacted by an increase in the price of dairy raw materials which took operating profits down by 28%
- Astaldi continued to be stuck in the rut that it’s been in for several months and appears to be unable to execute on a satisfactory recapitalization plan. Results in 4Q2017 were again lower and are unlikely to inspire confidence in current or potential investors. It is completely possible that the group is headed for a debt restructuring, if not a default. Astaldi competitors, CMC di Ravenna and Salini are in a better position. But, in this relatively concentrated sector, where there are many joint contracts signed between the large players, contagion risk, at least for stock prices and bond spreads, could be deadly if Astaldi were to meet an inglorious end.
- Bourbon reported revenues down 20% and its net loss increased from -€280mn in 2016 to -€576mn. The group was offside on its covenants at end 2017. Given the amounts involved, the situation is very troubling for the issuer, which must now transform €1.1bn in credit facilities into short term bank debt, for which repayment could be required at any time.
Of course, Bourbon is trying to change the terms of the credit facilities, while the banks, who would prefer not to take a haircut, are expected to postpone exercising their early reimbursement options. For bondholders, who have repeatedly been told by the company that the bonds would be called, the problems are just beginning. With results as they were, it’s not just the reimbursement that has been called into question, but also coupon payments. It is very likely that the banks, given their charitable nature, will demand significant guarantees from the company before accepting to cut it some slack on the covenants.
The group’s hybrid bonds were designed to reinforce the balance sheet and to act as a buffer in the event of a problem. Bourbon will probably be obligated to use them like this. In the absence of: 1/ a spectacular and unlikely turnaround, 2/ a takeover by a party with deep pockets, or 3/ measures that defy classical financial logic, it is very possible that Bourbon will suspend coupon payments for at least several years. With the risk for the bonds so high, their price is sure to continue the slide begun this week and reach 50-60 of nominal at best. In comparison, Bourbon’s situation is different from that of Aryzta. Bourbon may be forced to suspend the coupon payment. Aryzta did so voluntarily, to take advantage of a clause in its prospectus which allowed it to suspend coupon payments and reduce interest expense.
This latest episode serves as a reminder that hybrid bonds are a blend of bonds and shares. Despite all of the marketing that we have seen in recent years which touted them as having high stock performance with low bond volatility, the reality continues to catch up with investors.
While Bourbon is a specific, extreme and, for the moment, isolated case, we note that numerous factors are arising which make it likely that calls will be exercised less often in the future compared to what investors have become dangerously accustomed:
- Higher rates and spreads => paying off the hybrids is less obvious when the coupon is low compared to potential new issues
- Regulatory normalization (especially for the banks) => the end of regulatory disqualifications, which encouraged issuers to replace disqualified bonds with new eligible bonds
- Regulator pressure to provide an economic justification for hybrid calls => end of “reputational” justifications
- Principal of precedent: though rare and penalized in Europe, in the US it is much more frequent because hybrids are considered like preferred shares with a call option exercisable at the issuers’ discretion. While we are currently in the golden age of hybrid bonds, taking advantage of excessively low rates, investors’ obsessive search for yield and changes in regulations which encourage redemption, we believe that the premium is highly underestimated. Today, the relationship between risk and return is inordinately low and investors wishing to buy them must apply drastic selection criteria: issuer quality and dependability, strong incentive to call (very high coupon, sufficient step-up on the coupon after the first call, even in the event of an increase in rates or a deterioration in the issuer’s credit profile, regulatory disqualification almost certain), pricing of the bond in the worst scenarios and not the most favourable, knowledge of how the rating agencies treat the bond on the issuer’s balance sheet, clear and fair coupon suspension or capital reduction clauses.