March 2016 – Credit – Where now?

At the time when most market participants were taking stock of a volatile start of year and of various dislocations across credit markets, the ECB exceeded market expectations by announcing a set of new aggressive non-conventional measures. Among others, the ECB increased the amount of monthly asset purchases to €80bn from €60bn, it expanded the list of eligible assets to IG non-financial corporates and it incepted a new TLTRO program aimed at boosting the credit channel towards the private sector. Although it is impossible to say whether such measures will ultimately succeed in restoring EZ inflation at levels consistent with the ECB mandate, it is pretty clear that they will help stabilize European credit markets for the moment. Importantly, the outlook on the macro side and for credit fundamentals has also improved and provides a more stable backdrop to deploy capital around four investment themes going forward.

HY repricing and decompression
Since the last peak of the European HY market reached about a year ago, the overall market has repriced by about 1% in yield terms to ca. 6%. Importantly, an even more significant decompression has taken place between the best-rated instruments – which continue to trade close to record low yields – and the rest of the names. To our point, the current spread between CCC-rated and BB-rated instruments ranges between 1,100bps and 1,200bps at the moment. In practice, we have been focusing our research effort on long opportunities in junior instruments of the capital structure issued by credits which we like from a fundamental standpoint, as well as on the most senior part of the capital structure of a select number of credits which have started to turn around their business and financial profiles. We have found numerous opportunities in that field where the selloff of H2 2015 and early 2016 has repriced them to an attractive risk-adjusted yield in the 7%-9% range. Symmetrically on the short side, we have been incepting a couple of currently highly-rated positions on names which are vulnerable to a more negative newsflow related to their deteriorating competitive positions or unfavorable secular business trends.

Attractive opportunities in dislocated sectors
After almost two years of huge volatility and often sharp drops in the energy and commodity markets, only now are we starting to see a significant number of investment opportunities. In those sectors, our investment universe does not include many names which were unduly hit by sector-specific concerns and were trading a significant discount to fair value. However, things started to change recently as forced-selling pressures began to create attractive opportunities on resilient credits which can weather the current sector downturn for much longer – especially in busted convertibles and loans. In that space, we focus on situations with diversified business models, favorable cost positions and/or multiple strategic options. Our positioning is still limited at this point, as we want to ramp up our book very gradually to reduce the risk of incorrect market timing for our entry points. That being said, we are excited to have identified and selected half a dozen situations with expected returns in the 15%-30% range in the medium term and that we plan to incept in the next quarter.

Targeted IG shorts post ECB CSPP
The announcement by the ECB that it will include IG non-financial corporate in its list of eligible assets for its QE program has triggered a significant and rather indiscriminate rally for European IG names. Such spread compression generates interesting opportunities – especially on the short side – as some companies remain on our list of potential fallen angel candidates which could de facto kick them out of the ECB’s purchase list and as the exact criteria of eligibility are still unknown at this stage. It is the case of several energy groups, telecom companies and retailers, among others. Although the ECB announcement is reducing the number of such opportunities, we think that the potential upside of those trades has greatly improved in the aftermath of the recent repricing of European IG.

Repricing and confusion in bank subordinated debt
As discussed many times, bank credit investors face a new conundrum in a world of bail-in-able debt instruments. On one hand, European banks have probably never been that safe and well capitalized, carrying lower risk – on and off their balance sheet – while maintaining high liquidity and record-low funding costs. On the other hand, bank debt instruments have become increasingly complex and potentially riskier in the event of a banking crisis. To make it simple, we would argue that the probability of a credit event at a European bank is low but the potential loss upon occurrence of such an event would be high. The inherent complexity of bank credit investing in the new world has now become obvious to many investors. This, combined with some more sector-specific risks, such as Brexit, the resolution of the NPL issue in the Italian banking sector, the lack of clarity around coupon payment language in the AT1 market, or some recent high-profile idiosyncratic stories like CS or DB, have driven a significant repricing of the sector in Q1 2016. With many subordinated instruments issued by large IG-rated European banks trading now in the 7%-10% yield range, greater transparency with regards to the risk of coupon non-payment for most individual institutions, and a regulatory doctrine in the process of being clarified for the benefit of bank creditors, we believe that European bank subordinated bonds have become increasingly investable and attractive.