In recent days, European fund managers in Geneva, London, Paris and even Monaco have had to deal with not only Siberian cold, but also a new wave of searing volatility which took hold of their portfolios. The Italian election and the uncertainty surrounding Angela Merkel’s bid to form a coalition with the SPD did not seem to be the cause of the end-of-week market jitters. Rather, portfolio managers were much more sensitive to the ambiguous words of new Fed chair Powell and to the unambiguous words of President Trump.
So far in 2018, company earnings have been relatively solid, which could be expected to buoy the markets, but once again political risks and the ramblings of central bankers have been the primary determinants of market movements and performance.
After two months of disappointment for the majority of investors, we may finally be about to find out if positions put in place at the beginning of the year will work out as planned. There are two things to consider – interest rates and credit spreads.
Increasing rates: rates have risen across the board since year-end. However, stress levels in risky markets and central banker uncertainty about the durability of resurgent inflation (see the most recent speech from Mr. Powell) have kept a lid on them since the end of January. By the end of February, the spread on German bonds had narrowed from 0.76% to 0.60% and the US 10 yr stabilized at 2.8%-2.9%.
Our view is split: on one hand, we are convinced that the 30-year-old rate-cutting cycle is well and truly over, but on the other hand that doesn’t mean that we will suddenly see a massive uptrend in rates in the short term:
- It can take time before a 30-year trend reverses in a stable and lasting way.
- Western countries (which, despite the banks’ statements to the contrary, are dependent on their central bankers), are not capable of coping with overly high borrowing rates, which would certainly push them into technical bankruptcy. And, the central bankers are very aware of this.
- The current economy is fundamentally deflationist due to the internationalization of exchanges, continual development of emerging countries, disintermediation in numerous sectors, and higher infrastructure spending in Western countries, who have for a long time been making do with rusty equipment.
We think that in the coming month, European rates will fluctuate between 0.5% -1% with a high degree of volatility. It’s possible then to profit from this by gradually putting on hedging strategies between the two levels.
For US rates, it is unlikely that Mr. Powell will stray much from the route chosen by Mrs Yellen, for two reasons: 1/ he has only recently taken control and may prefer to observe for a while, to avoid what happened to Trichet, who raised rates too quickly in Europe, and to Greenspan/Bernanke, who didn’t see the last crisis coming, 2/ when the US President is a source of uncertainty and is known for frequent bouts of bad behaviour, it may be preferable to take the view opposite to his.
Spread widening: as returns from buy-and-hold are currently very low, the slightest spread-widening, even 10 basis points, can have a large impact on a position, but may also appear attractive to a potential buyer. On a relative basis, we hear analysts and salespeople speak of spreads being multiplied by two or three, or spreads between two corporates doubling! But this does not consider that credit spreads are at historic lows, much below those of 2007, just prior to surging to 2008-2009 levels.
With the rate on a 5-year BBB rated corporate at 0.60%, it would be hard to blame a portfolio manager for taking a pass on the opportunity given that his management fees may well be above this yield. However, investors who got in too early, to lock in a few extra basis points on issuers such as Teva, Softbank and Wintre (and these are only three recent examples), have already amassed losses adding up to several years of buy-and-hold returns and may have to hold the bonds to maturity to avoid taking a loss.
Speaking of Teva, this week the group announced a mega-bond issue in Euros and dollars, for up to €3bn. We have studiously avoided this issuer for many months as we consider its debt reduction and operational measures to be too little, too late, BUT, this issue could represent an inflexion point for Teva. It may now have the time and the financial flexibility to optimize its balance sheet, put in place significant asset sales and implement the restructuring which it announced at the beginning of this year.
The problem for existing Teva holders is that the group may be obligated to entice new investors with a significant premium. We saw the spreads on existing bonds widen materially when the new issue was announced. This widening is expected to last until the issue has been finalized. Taking into account the sum involved, the fact that Teva is in a difficult position, and the current bond market climate, it is likely that Teva will offer massive premiums to guarantee the success of the issue and extend its average maturity date. We remember in 2008-2009 when Lafarge and Saint-Gobain, today much more solid, offered premiums of 1%-2% above the secondary market in their primary market issues! Let us not forget that until now, Teva has profited from the ability to borrow easily at low rates. In its last issue done in euros in 2017, prior to the beginning of its troubles, the coupons were between 1.1%-1.8% for 6 and 10-year maturities. Currently, these same bonds trade at yields between 3.6% and 4.3%. To guarantee that the issue goes off without a hitch and to avoid the fiasco that a cancellation of the issue would bring (when Agrokor’s private placement was cancelled, it led to a rapid slide towards bankruptcy) the new issues could be offered at 4%-5% for 5-7 year maturities and represent an excellent opportunity to buy if one is convinced by the proposed restructuring measures. Or, now may be a good time to sell existing positions, even at a discount, as we expect the they will sink further by the time that the primary issue is completed.
The TEVA example could become the norm for a good number of issuers in sectors in difficulty or for issuers which overindulged on the low rate debt buffet, to the point of putting themselves in danger. We give as examples the US retail sector, tech, real estate developers, certain healthcare companies, and special cases such as Altice, which we have discussed at length.