Credit Market Summary 17 October 2014 Portfolio Commentary Punch drunk Henrietta Pacquement Lead Portfolio Manager & Head of Quantitative Analytics It’s not easy weaning oneself off liquidity after years of central bank largess. This week saw global equity markets cave on the back of poor inflation numbers across the globe and reduced global growth expectations. Add to that concerns about Greece, Russia, the Middle East, oil, Ebola and equities were faced with a powerful cocktail that pushed a number of markets into correction territory if not bear market territory in the case of Greece in the space of a few days. This generated a bid for fixed income with quite an extraordinary day on Wednesday where 10 year US rates had a ‘flash rally’ and traded within a 35bps range in the space of a few hours. US 10 year government index on 15 October 2014 2.30 2.25 Top line growth has come under pressure over the last few years in the US and in Europe with European revenues dipping negative and US revenues showing only slight progression recently. Companies are still reluctant, be it in the US or in Europe, to put capital back to work in the form of capex. The re-leveraging that is occurring in the US is predominantly driven by shareholder friendly activity in the form of M&A, dividends or share buybacks. Europe is still working on balance sheet deleveraging and is very conservative in terms of use of capital. European companies are being hampered by poor revenue trends in their efforts. In both the US and Europe this situation doesn’t indicate strong growth prospects. It is also not conducive to high levels of inflation as revenues are not being used to hike salaries to maintain competitiveness. This has been one of the issues highlighted by the Fed or the BoE and one of the reasons central banks have been reluctant to bring forward rate hikes. 2.20 2.15 HY revenue profile Yield 2.10 2.05 2.00 1.95 USGG 10 year index 1.90 8 PM 7 PM 7 PM 6 PM 5 PM 5 PM 4 PM 3 PM 2 PM 1 PM 1 PM 12 PM 9 AM 10 AM 8 AM 6 AM 1.80 4 AM 1.85 15 October 2014 Source: Bloomberg In light of these moves and disappointments about earnings potential, it is worth reviewing corporate trends in recent years to see if these moves are justified in equities and what kind of blowback they may have into credit. ECM Credit Market Summary Source: J.P. Morgan 2 Investment Grade revenue profile turn was also supported by more dovish comments from Fed members given recent inflation trends. On Friday, the European markets were given a boost by ECB comments suggesting asset purchases would start within days. It is worth noting that financial fragmentation remains between Eurozone countries. Aggregate lending rates to non-financial companies are still markedly higher in countries like Italy and Spain compared to Germany or even France. While progress is being made, the ECB is keen to continue to close the gap. Inflation levels are also too low in Europe. The ECB has a clear mandate to keep inflation levels within target. As a result, the markets may be underestimating the ECB’s willingness and ability to act. Source: J.P. Morgan Earnings prospects go some way to explain equity market jitters. So where are we in the credit cycle in Europe? Still in repair mode, with high yield potentially further down the credit cycle than investment grade as growth prospects remain subdued. For high yield, low growth has more potential to put pressure on top lines and make the deleveraging exercise more difficult. As a result, the environment is arguably more supportive for credit spreads in Europe than for equities and suggests credit spreads are likely to remain range bound for now. “…the ECB is still firmly in easing mode and will be taking up the torch of quantitative easing.” While the Fed is further ahead in its cycle and looking to the next step of rate hikes, the ECB is in a different situation. The ECB is still firmly in easing mode and will be taking up the torch of quantitative easing. So the markets are still likely to get their fix in months to come. However, despite fundamentals, we are still clearly in the hands of the central bankers. The markets are hypersensitive to their next decisions. This week’s moves highlight again how dependant markets are on their words and actions. On Thursday, strong US data helped turn sentiment turning the trend on US equities. However, the ECM Credit Market Summary 3 Investment Grade Corporates Duncan Warwick-Champion Co-Head of Global Credit Research It’s been a tough week across many asset classes and for once corporate credit was not immune during the selloff. Our traders reported a notable reduction in corporate liquidity, even for some of the strongest credits across various sectors, as investors stepped back from the market in the face of escalating nervousness and the street refused to step into the breach. Trading, and with it any meaningful price indicators, virtually evaporated. Peripheral credits were particularly impacted by uncertainty, as were higher-beta names and hybrid securities. Overall the EN40 Corporate BBB index was 4bps wider on the week, which felt painful as screen prices gyrated around us, but in reality continues to offer relative stability when compared to other risk assets. Given market anxiety and closed periods ahead of Q3 results, the primary market was virtually closed with SNAM, the Italian utility, being the only issuer this week (€500m 9yr). We are aware that both Areva and Arkema are sitting in the wings with potential issues for next week. Although only early days in the European Q3 reporting season, the vast majority of results have so far been in-line with, if not slightly ahead of, expectations; coupled with affirmations of full year guidance. Interestingly, we have already seen a number of companies pointing towards a softening of operating conditions in Asia, particularly China, offset by stronger operational performance from Latin America. Weakness in European operating conditions is simply a given. Another theme to emerge from early reporting is the pace at which input price deflation, driven by falling oil and food stock prices, is feeding through some business models. We, like many other investors have significantly lowered our oil exposures over recent weeks, but correctly timing the entry point into beneficiary sectors is a far more complicated dynamic to analyse. Interest Rates Alastair Thomas Head of Rates & Treasury Management This week 10 year treasury, bund and gilt yields fell further (currently -10bps, -3bps, -4bps respectively). These relatively small declines mask one of the most volatile weeks in many years. This week’s range in the US 10 year treasury yield was 41.6bps with 36.6bps on Wednesday alone. The markets continued to be concerned about global growth and low inflation, especially with the weak US retail sales and Ebola incidents. Last week I said one should buy treasuries on a break of 2.30% and indeed once that level was breached and the subsequent support of 2.20% the market went into freefall for a couple of hours before starting the recovery. Treasuries continued to outperform bunds and gilts on the back of the weak US data despite Tuesday’s lower than expected UK inflation and weak German and Eurozone ZEW expectations indices. Weak commodity prices fuelled dis-inflation/deflation concerns and Saudi Arabia seems comfortable with oil nearer $80 a barrel compared to their previous $100 level. This will impact economies more dependent on oil revenues such as Russia, Iran and Venezuela and keep global inflation low. Other economic data was not so gloomy: UK ECM Credit Market Summary unemployment fell more than expected to 6.0%, the Fed’s Beige Book reported moderate to modest growth, US initial claims reached a 14 year low (and lowest ever as proportion of the population) and US industrial production rose 1.0% (expected 0.4%) with capacity utilisation back to the highest since June 2008. Central bankers seem to be changing views as rapidly as the markets with the Fed’s Bullard advocating delaying further QE tapering having just 8 days ago recommended removing accommodation and not holding off on rate hikes until the middle of next year. Likewise the BoE’s chief economist Haldane is gloomier about the UK economy having been in favour of sooner rather than later rate hikes in the summer. However, he thinks the UK’s economy remains strong and well-balanced. I expect liquidity, which was already poor, will not recover soon so markets will remain whippy. With CFTC speculative positioning being the longest since 2012, new trapped longs (very high volumes traded at the high prices with open interest collapsing) and a base being put in in stocks I would expect yields to increase at least in the short term. 4 Loans Sam McGairl Lead Portfolio Manager With increasingly wild gyrations in equities, treasuries and high yield, this week has seen some softness creep into the loan market in the previously resilient CLO segment which makes up approximately 25% of the market. The issue is not that CLOs have stopped buying, rather that non CLO investors who hold these names have been more inclined to sell them to re-invest in either USD loans or other parts of the sub-investment grade credit spectrum. There have been two BWICs this week which have traded almost in their entirety. Where bids were not so forthcoming it tended to be at the subordinated level. Well rated Euro denominated names are now trading in a 99.5 to 100.5 range rather than a 100 to 101 range a week ago. Relative volatility is still extremely low compared to other asset classes or the US loan market, where the retail flows (nearly $1bn redeemed this week) continue to drive a repricing of the market. This retail volatility is absent from European loans. The new issue market continues to launch new transactions to European investors. This week saw meetings for refinancings of drug company Amdipharm and roadside assistance provider RAC. Both are solidly performing UK companies which are looking to return some cash to their equity investors. In the case of Amdipharm by a straight dividend to Cinven; whilst Carlyle have sold half of their stake in RAC to the Singaporean investor GIC. Both issuers are looking to place significant GBP tranches with margins of L+475 and an OID in the 99 area. Amdipharm’s EUR denominated tranche is talked at E+425. High Yield Henry Craik-White Senior Investment Analyst The selloff in global risk assets accelerated this week. Spreads on cash bonds in the Merrill Lynch H9PC index widened by 37bps and the iTraxx Xover CDS index outperformed, with spreads widening by 26bps. The Ebola outbreak has added an additional layer of volatility to the market with the travel and leisure sectors particularly impacted. High yield names which have sold off include travel agent, Thomas Cook, airport duty free retailer, Dufry and German airline, Lufthansa, with bond prices falling between two to eight points. As the number of cases continues to rise in West Africa, the risk remains that isolated cases will be seen in the developed countries. Company earnings were dominated by the consumer sector which has seen slightly less volatility this week compared to September, when it significantly underperformed. UK clothing retailer, Matalan, reported better than expected numbers as it bolstered its margins ECM Credit Market Summary through reduced markdowns. Its policy to hold less inventory is paying dividends and despite a very tough September, due to the unseasonably warm weather, it held full year guidance. Its bonds responded well rising three points. France has generally been a difficult territory to operate in as the economy struggles to expand. Despite this, French electrical and furniture retailer, BUT, and food manufacturer, Labeyrie, reported good numbers. BUT saw revenues and profitability grow by 6% and 34% respectively and Labeyrie reported similar revenue growth and 11% improvement in profits. BUT has seen current trading over the summer improve following the disruption caused by the football world cup and Labeyrie is experiencing good revenue growth as it continues to recover input cost inflation. It was a difficult week for various credits in Italy. In the gaming sector, Snai, saw its bonds slide nine points after the government announced proposals to increase 5 taxes and reduce gaming machine payouts. Competitor, Gamenet is likely to be the most impacted and its bonds fell six points. Telco, Wind, has seen its sub bonds fall ten points over the past ten days as local press reports have stated that the near-term consolidation of that market is unlikely. Clearly consolidation would benefit the market but 3 Italia and Wind need to move closer, in terms of a potential deal structure and price. Facility management provider, Manutencoop, announced it was under investigation by the Italian competition authority with respect to a recent contract win. This is in addition to the news over the summer that various members of its senior management team are also being investigated for other alleged improper practices. The market did not take the news well, initially sending its bonds down twenty five points. Its bonds then recovered twenty points after the company hosted a conference call for investors which confirmed the downside was limited and that it had bought back bonds in the open market. On the M&A front, cinema operator, Vue, announced it had agreed a deal with Mediaset to acquire its Italian cinemas for €105m. It is expected that the deal will be part funded with an equity contribution from its owners, OMERS and AIMco, leaving credit metrics broadly unchanged. There were no new issues this week. Sovereigns & Financials Satish Pulle Head of Financials & ABS Sovereigns The Italian and French governments seem to be heading into a confrontation with Germany and the ECB over their budget deficits and further structural reforms. Both governments face political hurdles to reform. The same applies to Greece, where the political dynamics highlight austerity fatigue with the unemployment rate still being extremely high. The ECB’s LTRO programme and OMT announcement provided governments two years’ relief from bond market pressures – unfortunately, this window has only partially been used, and there remains a substantial unfinished agenda of economic reform. Financials The price of Cocos were lower this week, with the Bank of America Merrill Lynch Coco index widening some 144bps, compared with 8.5bps widening last week. By comparison, the EURO STOXX banks equity index was down nearly 4.5% over the same period. Peripheral bank bonds were particularly weak across the capital structure as concerns re-emerged not only about the state of their economies but also about the forthcoming ECB stress test results due in two weeks’ time. Greek bank debt was under pressure as investors took a dim view of the possibility of the Greek government deciding unilaterally to opt out of the IMF ECM Credit Market Summary Robert Montague Senior Investment Analyst programme early. Short-dated Greek bank senior bonds were all 3-4 points lower on the week and now trade with an average yield of 8% compared with a 4% average at issue this summer. Subordinated debt from weak German Landesbanks was under pressure as investors fretted about how they would fare in the stress tests; HSH Nordbank Tier 1 paper fell by 5 points this week to trade in the low thirties range having traded as high as 50 cents in the summer whilst the NDB 6.25 24 Tier 2 bond drifted lower this week to trade around 90 cents having been issued at par in late March. On a more positive note, Bank of China was able to successfully launch its huge inaugural $6.5bn Additional Tier 1 bond. This was the biggest Coco issue to date beating HSBC’s previous $5.6bn dual tranche deal last month. However, the Bank of China issue was very much an Asian affair with 96% of the orders coming from the region despite an extensive road show in Europe. The bonds held up well given the difficult market conditions, trading above par initially, no doubt helped by the 25 cents concession given to private banks, which accounted for 29% of the orders. We feel the 6.75% coupon on the bond was not particularly generous given signs of a significant slowdown in the Chinese economy and signs of a bursting of the property price bubble. 6 Asset-Backed Securities Maddi Rowlatt Asset Class Specialist, ABS The overriding theme in the market continues to be “wait and see, for the ECB”. The difficult week for wider markets did not feed into the entire ABS market immediately, but we have seen some volatile moves in peripheral ABS with senior paper out by up to 20bp. The main players in this paper currently are fast money and the street which appears relatively heavy with this paper given the known exit via ECB purchases, at some point. So, some volatility, with no firm idea of when the ECB will start buying is understandable. The softening did, however, move into core asset classes, with UK prime and Dutch senior widening over the past couple of days. These moves are not large price moves but Dutch AAA are out 5-10bp in spread terms. Mezzanine assets however, seem well supported by the largely firm real money investor base and a better technical market. On a brighter note, the primary market held up well with a number of ABS placed with investors, albeit in core asset classes, UK Credit cards, European Autos ABS, and UK RMBS were all placed with investors this week, with senior and some mezzanine paper sold. Two of those transactions were backed by recently acquired UKAR collateral. Some unusual structural features of these deals led to wider pricing than comparables. Finally, investors in LORDS1 CMBS were left perplexed when, on Friday, S&P unexpectedly withdrew its ratings on the transaction without any apparent communication with the borrower or the issuer. It later transpired that the ratings withdrawal was due to a technical glitch within S&P’s systems and the ratings were duly reinstated later in the day. Emerging Markets Duncan Warwick-Champion Co-Head of Global Credit Research President Vladimir Putin met with European leaders in Milan on 7 October to discuss the ongoing crisis in eastern Ukraine. David Cameron described the talks as positive and stated that Putin had denied that the Russian government wants to see a frozen conflict as the long-term outcome of the current situation in the Donbass. However, a spokesman for the Kremlin later stated that “unfortunately, some participants of [the talks] demonstrated complete unwillingness to understand the reality in south-eastern Ukraine”. The Ukrainian and Russian governments agreed a peace plan in Minsk in September that was supposed to involve a ceasefire between Ukrainian and pro-Russian forces. Clashes nevertheless continue – particularly around Donetsk airport. The economic pressure that Western sanctions are placing on the Russian economy continues to translate into a weaker rouble, with the currency this week hitting new alltime lows against the Bank of Russia’s dollar/euro basket. The central bank’s interventions to protect the currency ECM Credit Market Summary from shaper falls now total US$11bn since the start of October and US$52bn since the start of the year. Recent declines in oil prices certainly provide a further headache for Russian policymakers trying to protect the rouble’s value. The five-year CDS on the Russian sovereign ends slightly weaker on the week at 260bps. Elsewhere in Emerging Europe, Romanian policymakers continue to suggest that the country will seek to sell eurodenominated debt before the 2 November presidential elections. Budget Minister Darius Valcov said that the government aims to sell at least €1bn of Eurobonds in order to pre-finance 2015 – Romania has a €1bn bond maturing next year. Romania should not have any problem in raising new funds from the market, despite recent volatility, given the dramatic change in investor sentiment towards the country that has occurred over recent years. Five-year CDS on the sovereign hit a high of 490bps in 2012, but now trade at just 160bps. 7 ECM Market Monitor As at 16 October 2014 CREDIT MARKETS* 1WK MTD 2014 YTD 2013 Source EURO CORPORATES -0.11% 0.07% 1.95% 2.72% BofA ML ER00 EURO IG FINANCIALS -0.18% 0.04% 1.99% 3.24% BofA ML EB00 EURO HIGH YIELD -1.39% -1.36% 0.17% 9.95% BofA ML HE00 STERLING NONGILTS -0.75% -0.68% 1.17% 4.63% BofA ML UN00 STERLING IG FINANCIALS -0.90% -0.91% 1.35% 7.47% BofA ML UF00 US CORPORATES -0.48% -0.59% 1.12% 2.86% BofA ML C0A0 US IG FINANCIALS -0.43% -0.45% 1.15% 4.07% BofA ML CF00 US HIGH YIELD -1.90% -2.54% -1.05% 9.19% BofA ML H0A0 EURO LOANS -0.54% -0.62% 2.21% 9.63% S&P Euro denominated ELLI* 1WK MTD YTD 2013 Source FTSE 100 -3.66% -6.40% -5.25% 19.05% UKX INDEX S&P 500 -3.37% -5.47% 2.41% 32.37% SPX INDEX NIKKEI 225 -4.78% -8.87% -8.20% 59.37% NKY INDEX 1WK MTD YTD 2013 Source -6.20% -10.77% -23.76% -0.28% CO1 COMDTY 1.19% 2.54% 2.75% -28.04% GOLDS COMDTY 1WK MTD YTD 2013 Source USD 0.93% 1.41% -6.80% 4.17% EURUSD CURNCY GBP 1.12% 2.20% -4.10% 2.26% EURGBP CURNCY JPY -0.47% -1.65% -5.89% 26.45% EURJPY CURNCY 1WK MTD YTD 2013 Source US 10YRS 1.38% 2.93% 8.64% -5.92% ITRR7T10 index GILTS 10YRS 1.52% 2.84% 9.38% -5.08% QX6I index BUNDS 10YRS 0.54% 0.83% 10.94% -1.60% QW3Q index US SWAP 10YRS 1.39% 3.23% 10.12% -7.64% U10C EURO SWAP 10 YRS 0.31% 0.57% 12.84% -2.81% E10C STERLING SWAP 10YRS 1.73% 3.13% 10.58% -6.65% S10C 1WK MTD YTD 2013 Source ITRAXX MAIN -0.52% -0.39% 0.92% 4.04% ERIXITEU index ITRAXX CROSSOVER -2.42% -2.38% 4.41% 17.79% ERIXITXO index EQUITY MARKETS COMMODITY MARKETS BRENT OIL GOLD CURRENCY MARKETS VS EUR Asset-Backed Securities RATES MARKETS CDS MARKETS ECM Credit Market Summary 8 ECM in the Media Recent articles 13 October I should CoCo? Portfolio Institutional 13 October German sub bonds rocked by threat of stress test failures International Financial Review, Reuters 10 September ECM involvement leaves investors grappling with low returns Capital Structure 02 October CLOs: The Comeback Kings International Financing Review (IFR), Hedge Fund Insight 01 October Solvency II drives insurers into sub-bond market Reactions 29 September Junk-Bond rout amplified bt Gross exit as sales expected Bloomberg Click here to view ECM’s press archive ECM Credit Market Summary 9 ECM Asset Management Limited 34 Grosvenor Street, London W1K 4QU Tel: +44 (0) 20 7529 7400 Fax: +44 (0) 20 7529 7411 ECM, Wells Fargo Asset Management and WFAM are trading names of ECM Asset Management Limited which is authorised and regulated by the Financial Conduct Authority This document may be distributed only to persons permitted to receive it under applicable law and may not be distributed or passed to any person in any jurisdiction in which such distribution would violate any applicable law. 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