Europe’s taper tantrum exposes bond market vulnerability

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By:
Louise Bowman
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Any movement in eurozone policy rates in the near future remains unlikely, but the mini taper tantrum at the end of June shows just how sensitive markets are to central bank signalling.

When European Central Bank (ECB) president Mario Draghi stated that “deflationary forces have been replaced by reflationary ones” at the ECB Forum on Central Banking in Portugal on June 27, he knew exactly how the market would interpret that statement.

He had already declared that “the threat of deflation is gone and reflationary forces are at play” earlier in the same speech. He could have saved his breath and simply said “taper”.

That is what the market heard, and bonds responded accordingly. Between Draghi’s speech and Friday, German 10-year yields blew out 31.7 basis points, France 32bp, Italy 36.9bp, Spain 30.1bp and the UK 30.5bp, while yields on 10-year US treasuries rose by 22.9bp.

Draghi’s comments came in the same month as the ECB published a study of the implementation and impact of its corporate sector purchase programme (CSPP) since its launch a year ago. Its findings will come as little surprise to those in the region’s bond markets.

“Credit premium has been in almost continuous decline since the start of the programme,” the authors of the ECB study point out, reflecting “investor appetite for bonds issued by lower-rated companies”. Another observation is that “investors are rebalancing their portfolios to favour more risky, non-eligible assets.”

The ECB claims that the CSPP has benefited companies that do not rely on capital markets for their financing, particularly small and medium-sized enterprises (SMEs), pointing out that between October and March SMEs had “increased availability of bank loans at lower interest rates than previously”.

A lot of other European corporates have been benefiting as well. Institutional leveraged loan new issuance volumes were up 117% year on year in the first half of 2017.

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Conditions are such that high-yield bond issuance below double-B level is now rare. The standard 10-year non-call five deal has slipped into the loan market, so the bond market has to offer tenor to compete. A recent example of this was UPC’s mid-June €600 million double-B rated issue, which came at a 12-year maturity.

“Investment-grade funds have been very active, particularly in the BB space, which has helped drive the duration discussion,” says Robert Wartchow, head of high-yield syndicate EMEA at Credit Suisse, which led the deal.

Given the eurozone’s mini sell-off in late June, just how those investors will behave when the ECB actually stops buying is a matter of intense debate. The immediate bond market declines after Draghi’s speech revealed the very real risks of duration for bond buyers.

That UPC bond issue was trading at 96% of face value in early July, a mark-to-market capital loss which for many of those investment-grade investors has got to hurt – it is years’ worth of interest income wiped out in a matter of days

In the loan market, the ECB-driven surge in appetite for riskier assets has resulted in a wave of repricings at the senior secured level and surging demand for second lien and PIK deals. Repricings of leveraged loans in the US and Europe hit $178.3 billion in 2016 and the trend shows little sign of slowing down.

In Europe, German gaming operator Tipico recently repriced a €625 million term loan B signed in May 2016 at 550bp over libor. The new deal, signed in March, saw the loan increased to €700 million and pricing cut by 200bp to 350bp – after just nine months.

This is an extreme example of the trend, which typically sees 50bp to 100bp shaved from repriced deals. The terms available are so attractive that loans are repricing very quickly after launch – most have a six-month 101 soft call.

However, as tapering looms, the repricing wave might now start to dry up somewhat.

In the current market, investors have little choice but to participate in repricings, even as they push levels towards what appear to be structural limits. Pricing has pushed towards 275bp for double-B or high single-B, which is unsustainable for legacy collateralized loan obligations (CLOs), which will have an all-in cost of liabilities of 170bp.

These vehicles are, however, less important than they once were.

“CLO vehicles, having been dominant, now represent a reduced proportion of the syndicate, as separately managed accounts have grown,” says Charles Bennett, managing director in the global markets division at Credit Suisse. “Banks have been participating as buyers in the leveraged finance market, but they still constitute only a small slice of demand.”

The push into riskier assets has seen interest in second lien loans surge as well. This is pushing leverage into uncharted – or infrequently charted – territory.

“We are getting into mid-sixes leverage levels on second lien, so it will be interesting to see how this will work with the ECB guidelines,” says Wartchow.

“There is definitely demand for this and we would be comfortable syndicating second lien,” he adds. “We are seeing much more demand from issuers for second lien, which is usually preplaced. Investors are going straight to sponsors, who are more comfortable with this product.”

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Benoît Durteste, ICG
Benoît Durteste, incoming chief executive officer at asset manager ICG, tells Euromoney that the end of quantitative easing (QE) will likely see some investors that have been chasing yield into deeply subordinated territory retrench.

“Investors that look at direct lending as an alternative to fixed income may pull out as interest rates rise,” he says. “That is a good thing because it means less competition.”

Durteste will take over as CEO of ICG, which has €23 billion assets under management, in late July. He emphasizes that for strategies that are higher yielding there is plenty of space in the subordinated debt category.

“In the search for yield, many investors have discovered this [direct lending] asset class,” he says. “That is permanent and we are just starting to scratch the surface. There will always be a place for alternative assets in a sophisticated portfolio.”

Despite Draghi’s comments in Portugal, most investors in Europe believe that any actual rise in rates is still a long way off. That means that any exodus from the riskier assets that they have been pushed into might be some way off as well.

“For some time, we have believed that the ECB is likely to announce in September a reduction in monthly QE bond purchases to €40 billion per month, effective from January next year,” says Mark Dowding, co-head of investment grade at asset manager BlueBay in London.

“As long as inflation remains benign, we believe that a gradual taper will extend purchases to the end-2018 with higher interest rates only likely as we move into 2019.”

He adds: “Nothing that the ECB has recently communicated appears to contradict this view and given that this thinking is relatively consensual, it is somewhat surprising to see how Bund volatility has increased in the past month following Draghi’s comments.”

So, for the time being, it is business as usual.

“A sustained rise in yields much beyond 0.6% seems quite unlikely to us, unless it is part of a more global move with US Treasury yields also rising,” says Dowding. “In this context, we are becoming more inclined to buy euro duration on further weakness.”