The European bond markets have had a good first half, but the rest of 2009 may not be so kind.
First, the good news. Markets have done well as asset managers have pushed more money into corporate credit. They have been drawn by record high yields after Lehman’s failure, and also by the need to hunt down an alternative to low risk-free rates while avoiding volatile equity markets.
In spite of the gloomy outlook for defaults and the continuing drumbeat of rating downgrades, investors have taken progressively more risk as bond prices have risen, moving from defensive companies into more cyclical names, and even high-yield credits. This surge has allowed corporate bond spreads to narrow sharply even as companies have thrown a wall of paper at the markets.
These bond investors, whether intentionally or not, have become key players in global corporate finance. As banks rein in lending, companies need the public debt markets more than ever. With credit and funding in short supply, companies are cutting costs, slashing dividends and raising equity to preserve credit quality and keep their bondholders sweet.
The market has taken further encouragement from a series of better-than-expected company second-quarter results that has helped push spreads on the European investment-grade bond index back to pre-Lehman levels.
But a further leg-up from here looks unlikely, and for some companies, the most likely trajectory for bond prices will be down. While it is true that corporate earnings remain surprisingly strong, to the extent that this is due to restructuring and cost-cutting it is likely to prove finite. Meanwhile revenues, and net income, are falling sharply, eroding and in some cases eliminating free cash flow.
Corporate credit quality is therefore likely to deteriorate from here on in. Even though bond prices rose in the first half, the number of “fallen angels” — companies downgraded from investment-grade to high-yield — has been going up too. Two out of the top three months for downgrades to sub-investment grade on record were last month and in March, according to Standard & Poor’s. The ratings agency has identified a further 75 issuers globally with $255 billion of debt in danger of being consigned to junk status.
This has not been priced in by investors, especially at the high-yield end of the market. CDS prices for companies included in the iTraxx Crossover index of high-yield names suggests that the market expects lower default rates over the next year than the ratings agencies expect.
It could of course be that investors have a better idea of the true credit quality of corporate Europe than rating firms do. But the suspicion is that they are just being optimistic. And bondholders aren’t supposed to do optimism.
Ouch! Moody’s has just downgraded some Italian asset-backed debt parcelling leases made by UniCredit to its clients, called F-E Gold. One of the downgraded bonds took a rather nasty dive from A3 to Ba1, but aside from that the rating cuts aren’t too brutal. Moody’s report does give a quick snapshot of how corporate Italy is faring in the economic downturn. (Leasing is a core source of funding for the small and medium-sized companies that make up the economy’s backbone.)
So far about four percent of the companies that borrowed by leasing real estate or equipment have defaulted since the deal was sold three years ago – the same amount Moody’s was expecting over the life of the deal. The agency has now doubled its default assumption to 8.6 percent — let’s hope it’s just being conservative.
Banks holding European commercial mortgage-backed securities at par on the basis that they stand at the top of the pecking order when it comes to repayment should think again.
Even some of the most senior-ranking bonds backed by commercial property loans will have to be written down as the downturn bites. And with about 120 billion euros of European CMBS outstanding, the numbers are big.
Many of the underlying loans are underwater. But companies who manage the debt have refrained from taking aggressive action and enforcing on the loans on the basis that prices may recover, rents are still being paid and borrowers are still up to date on their interest payments.
Their approach is simple enough. Why risk losses from a fire sale if the market may recover by the time the debt comes due five or so years down the line? In fact, of the 1,100 loans packaged in European CMBS, only 39 are classified as being in “special servicing” — shorthand for having a problem — according to Standard & Poor’s.
One deal where the servicer isn’t taking this wait and see approach is a 487 million pound deal called Epic Industrious by Royal Bank of Scotland for now-defunct property firm Dunedin, which was placed in administrative receivership last year.
Ernst & Young is set to sell the properties to vulture fund Max Property, after a smaller auction last week. This is likely to mean losses for senior creditors — a first for CMBS bondholders in this cycle.
As well as a ridiculous name, Epic Industrious has other peculiarities which suggest a wider fire sale of properties from other transactions isn’t likely in the near term.
Firstly the borrower is in administration, necessitating a more speedy resolution than in situations where a loan is simply in default and can be worked out over time.
Another complexity is the fact that the deal is a so-called synthetic CMBS, in which RBS used credit default swaps to shift the risk of the loan to bondholders. In these deals banks may be incentivised to work out the debt speedily, whatever the losses, and claim on the insurance policy provided by bondholders.
Epic Industrious shows how severe losses will be in some CMBS deals. While some loans are still backed by strong properties worth more than their debt, and generating more than enough cash to service the debt, it is clear that property markets won’t have recovered enough by the time many loans come to be refinanced.
Declining rents will tip more loans into default and many will fail to refinance at maturity.
Moody’s noted in a recent report on a deal created by Credit Suisse that originally parcelled 10 loans that it expects “a very large portion” of the portfolio to default, suggesting that the benefits investors thought they would get by diversifying their risk across a pool of loans is worth little in practice.
Tackling problem loans now, and selling some or all of the assets, may yield better recoveries than simply hoping for a market revival.
Much of this pain is already priced into CMBS, with senior bonds trading at about 70 cents in the euro or less. While some banks will hold at market levels, others may have only partially written them down after last year reclassifying fair value assets into loans and receivables.
Anecdotal evidence suggests some banks are still holding senior tranches at par. This looks hopelessly optimistic. A raft of recent and looming rating agency downgrades will force them to increase capital reserves and prompt them to sell, even if it means taking a loss.
Prepare for a rocky ride in bricks and mortar.
By Neil Unmack
LONDON, July 17 (Reuters) – Guy Hands got famous by working out ways to make pots of money out of the bond markets. Now he appears to be turning to them for a rescue financing for his struggling music company, EMI.
The group, whose acts include Kylie Minogue and Iron Maiden, is struggling under debt taken on from its buyout, and Hands has already had to stump up cash to keep it from breaching covenants. A new high-yield bond could be part of the solution, but only if Hands and his bankers are prepared to take more pain. <For related news click [ID:nLH60373]>.
The resurgence of the high yield market is one of the few examples of markets working well in tough times. Capital-starved banks are reining in lending and shunning leveraged loans, but at the same time low government bond yields are pulling yield-hungry investors into the bond markets. Companies such as Virgin Media <VMED.O> have already gone down the “loan to bond” route, refinancing or extending their debt.
This panacea will only go so far. Leverage multiples for recent high-yield deals for non-cyclical companies have peaked at about five times earnings before interest, tax, depreciation and amortisation (EBITDA).
The more cyclical EMI has approximately 2.4 billion pounds of debt, split between its recorded music and music publishing businesses.
The troubled recorded music business had EBITDA of 163 million pounds in the year to March this year and 950 million pounds of debt. The music publishing business generated EBITDA of about 116 million pounds in the year ending March 2008 — EMI hasn’t released figures for this year.
Put the two together and it’s very hard to see a high yield bond having much appeal without a significant cash injection by Hands and debt writedowns by his lenders, Citigroup Inc <C.N>.
A more tailored restructuring and refinancing of the troubled recorded business section may work, perhaps combined with a sale of part of the music publishing business. While media prices are depressed, the recent partnership between KKR [KKR.UL] and Bertelsmann [BERT.UL] shows there is demand for music assets.
If EMI’s leverage can be sufficiently slashed, however unpleasant that may be, Hands may be able to persuade bond investors to finance the business: loss-making Warner Music Group <WMG.N> recently sold $1.1 billion of secured high-yield notes.
But it won’t be a pain-free process. Bondholders would need to feel they are not being taken for a ride. The high-yield debt market in Europe is still relatively young and fragile. Investors will run for the hills if they sense they are being used as a dumping ground by private equity groups and their lenders.
Sarah Harding, a member of the highly-successful all-female pop act `Girls Aloud’ is to make her acting debut in a UK television drama on the credit crisis tomorrow night (“Freefall”, BBC2). La Harding plays the girlfriend of a dodgy mortgage broker, The BBC website tells us.
This isn’t Harding’s first brush with the world of mortgage securitization and CDOs. In 2006 she performed along with the rest of Girls Aloud for a group of bankers and investors at a plush cocktail party at the annual asset-backed securities industry conference in Barcelona, laid on by one of the leading securitization banks.
The girls did their best to put on a good show, but they never quite got their groove on. Perhaps they were used to a younger, more adulatory crowd. Some bankers danced; many drew back from the cramped dance floor to schmooze clients. The rest of the crowd stood and took photos with their mobile phones. How uncool.
Since then the fortunes of the securitization industry and Girls Aloud have moved in opposite directions. The ABS market is broken, and the heydays of the Barcelona conference won’t return any time soon. Some investors have failed, others have been left nursing losses as their holdings of CDOs and other exotica they bought tanked. Asset-backed debt has proven so volatile in price and unstable in rating that many fund managers simply won’t touch it anymore, despite the crazy-high yields on offer.
Girls Aloud, meanwhile, have gone from strength to strength, largely by knowing their fans, giving them what they want, and making sure they keep coming back for more. Maybe there’s a lesson there somewhere.
Has Bradford and Bingley, a bank under the control of the UK government, defaulted?
In June the UK lender chose not to pay interest on some of its lower-ranking debt, leaving bondholders nursing steep losses. The bank says it isn’t in default because the government changed the terms of the securities after nationalizing the lender in February. So that’s alright then.
Now ISDA, the derivatives industry body, has ruled that the failure to pay interest will trigger the company’s credit-default swaps.
The decision will mean a bloody payout for the unlucky few who were foolhardy enough to sell protection on the bank’s lower-ranking debt. Recoveries on the contract may be very low, if existent.