Barclays Capital: European Credit Alpha

Barclays Capital: European Credit Alpha

• Strategic Market View: There and back again. Driven by mixed signals from the economic and political front credit spreads see-sawed this week before finally ending up where they started. Risk aversion remains, but largely driven by macroeconomic uncertainties, while strong corporate fundamentals should provide spreads with a buffer if future growth stays anaemic. Sovereign volatility continues to drive valuation dislocations and we highlight a credit-equity normalisation trade on EDP. For investors worried about poor economic growth, we also recommend going long a basket of selected names with counter-cyclical performance while simultaneously shorting the index as a suitable trade for generating counter-cyclical alpha.
• Time to grow: We expect the European distressed debt market to grow as the result of excessive corporate leverage from the past decade. So far, the actual outflow of distressed assets from banks and non-bank investors has been relatively muted compared with the size of lending markets.
• A functioning distressed market is needed to value securities potentially seen as stressed and restructure stressed corporates. For more distressed assets to be released to investors, the institutions that hold them may have to crystallise losses, but this should be balanced against regulatory capital being freed up as well as the prospect of achieving a higher price now and not being part of a restructuring process.
• Distressed debt markets – time to grow: We see the European distressed debt market as growing in size. This will come from weak borrowers who survived on forbearance measures and the low rate of Euribor hitting maturity and amortisation points and European banks continuing with balance sheet shrinkage. Also, with the cost of bailing out Europe’s banking systems via bad banks increasingly interlinked to sovereign funding rates, there is further potential for distressed assets to come from both bad banks and distressed banks.
  • Credit at a glance: Corporates generated just over 50bp of excess returns in September, led by financials and in particular the Tier 1 part of the capital structure. Insurance, which is more heavily weighted towards Tier 1 than banking, was the top performing sector this month – utilities underperformed. Indices were marginally tighter week on week, while investment grade cash was wider. Despite this, our measure of the cash-CDS basis was broadly unchanged as single-name contracts lagged the index tightening.
  • Sourcing distressed debt: We see the shakeout of the European leveraged finance market and forced sale of banking assets as the key contributors to the growth in distressed debt. So far, the distressed asset class has been slow to evolve despite the economic downturn for several reasons:
  • Some countries have created government sponsored frameworks to handle distressed assets in banks. This has allowed banks to either hive off bad loans into a government guaranteed “bad bank” (eg, NAMA in Ireland) or to keep them on balance sheet (eg, RBS benefitting from the APS scheme and Spanish Cajas benefitting from the FROB recapitalisation scheme) to be run off gradually.
  • Banking syndicates have also been generous in forbearance measures (covenant amendments and waivers), with many 2006-07 vintage LBOs also having fewer covenants to breach. This has reduced potential defaults, but if growth remains slow and corporates do not delever further, it remains to be seen if such measures continue.
  • European bankruptcy regimes tend to encourage liquidation of corporate rather than restructuring. This reduces potential recovery rates.
• European distressed debt is much more of a private market compared with the US. If investors want to enter a special situation, they have to sign a confidentiality agreement to access private information and then learn about the situation before being able to build a position. By contrast, the US market is more public with investors being able to obtain public information more easily and start building a position ahead of any restructuring.
• High-yield and leveraged loans. There is a potential catalyst for growth in the distressed debt market as borrowers begin to hit maturity/amortisation points. The 2004-07 boom in lending showed falling underwriting standards, which we would expect to increase the chance of future restructurings. While defaults have increased into 2009, we would argue that decisions taken by banks and investors suppressed the default rate. We believe some defaults and restructurings that should have happened could yet still occur.
• Figure 11 shows covenant deterioration amongst leveraged loan borrowers, with an increasing proportion of deals being struck at leverage above 5x from 2001 to 2007. Similarly, for high yield bonds, CCC issuance also grew (Figure 12) as a proportion of the total. The falling proportion in 2006-07 should be taken in the context of record years for issuance.
• Also, given that banks are under pressure to hold onto more regulatory capital under Basel 3, they may be more incentivised to push names into restructuring and extract a higher recovery rather than seeing them default. European bankruptcy regulations make the default process more complex and generally results in a liquidation, which would lower recoveries. By contrast, the US has chapter 11 bankruptcy laws that keep a business as a going concern and arguably make the bankruptcy process faster than Europe.
• Distressed loans at European banks: We see potentially increased amounts of distressed debt coming from the banks over the medium term. The end result of Basel 3 is that bank assets will have to be better maturity matched with longer-term liabilities. Capital will come from a combination of new capital, increased deposits and, importantly, shedding assets, reducing the need to fund them. We note, however, that the 8-year implementation plan should mean fewer immediate forced sales of assets, thereby enabling more of them to be held to expected maturity if projected recovery prospects improve.
• Not all banks will want to sell given the capital hit they may have to take. Most loan debt is held on the banking book and generally marked at par. If, for example, a senior loan is seen as intrinsically worth €70 and is still paying its coupon, a bank will not force a €30 loss by pushing for a restructuring – they would give a credit time to get a higher recovery or par. Despite this, there are certain circumstances that could force a bank to sell:
  • A bank itself becoming distressed (eg, Anglo Irish)
  • The bank thinks the ultimate recovery could be lower than the current value.

Source: Barclays Capital