March 2017 - Signals from European primary markets
Healthy volume and momentum
The first quarter of 2017 delivered the third-largest quarterly issuance volume ever in European HY markets with more than €25bn across currencies and more than 60 new bonds issued. In comparison, ca. €60bn of HY bonds were issued in 2016 and the record year was above €100bn in 2014. In addition to the current favorable investment backdrop for European credit – credit fundamentals, market technical, investor risk appetite – the high volume of bond redemptions and coupon payments over the quarter almost entirely balanced the volume of new issues. This large proportion of recycled capital within European HY creates a strong support for the refinancing of many idiosyncratic stories and of bonds trading close or above their call prices. That also constitutes a significant buffer against any potential temporary shutdown of primary markets or sudden outflows from credit funds.
Credit quality surprisingly stable in HY while leveraged loans evidence more aggressive features
In terms of credit quality, there was no trend of credit deterioration in new issuance. This is always an important marker to watch as higher leverage, lower ratings and weaker documentation standards often signal the excesses of late credit cycles. With about two thirds of new issuance in the BB category during the first quarter, little CCC issuance and less than €2bn of PIK / Toggle notes, there was no particular sign of credit overstretch in European HY. Average leverage multiple stood at a relatively moderate and stable 3.9x, reflecting the better average rating over the quarter. Even inside the B category, leverage continued to fall to 4.1x from the 4.4x peak reached in 2015. Importantly, it seems that market excesses are more to be found in leveraged loans where average senior secured leverage reached a record 4.8x in Q1 2017 – i.e. above the previous record level of 2007 – with supply greater than in bonds for the first time since the GFC at ca. €30bn.
Looking at the use of proceeds of new issuance can also provide interesting lessons. Traditional refinancing rather than “credit negative” issuance, such as dividend payments, M&A, or other releveraging transactions, accounted for more than 70% of new HY bonds in Q1 2017. Again, this is not a worrying level in light of previous credit cycles, especially in the context of the limited leverage metrics discussed above. With about 50% of new supply driven by such aggressive use of proceeds and a clear trend towards much looser documentation standards, the leveraged loan market currently seems to be the one prone to some excesses. In our view, this is a new space to watch for some overheating signals in European credit markets as new issue loan margins broke the 350 bps average in Q1 2017 for the first time since the GFC.
Staying on the safe side given potential tail events and rich valuations
Although we do not see any clear and present danger of market excess in the European HY primary markets, we believe that some early signs are quite worrying and that current tight valuations offer very little buffer to potential adverse macro and political scenarios playing out going forward. As a result, we maintain our cautious deployment and portfolio positioning – with low gross and net exposures, a focus on short-duration, idiosyncratic and catalyst-driven stories, and a higher tail-hedge budget. We intend to retain significant dry powder at the moment, which could be deployed smartly and profitably in some already-identified positions, in the event of some upcoming market dislocation.