Manager Writes: European Credit

Simon Thorp, founder of The ILEX Credit Fund, analyses Europe's credit markets

Simon Thorp, Founder, The ILEX Credit Fund

The consensus view at the moment within the alternative investment management industry is that credit spreads are historically tight. Consequently ‘credit’ is perceived to be a strategy that’s of no particular interest to many total return investors. ILEX believes the opposite should be the case. In fact, we’re of the opinion that there are now more opportunities to generate long/short performance from a multi-strategy approach than we’ve seen in a long time (ignoring the pure beta trade of 2002-2005). This article lays out our case for why we believe that credit is an area where investors should not fear to tread.

The macro picture

The starting point for our analysis is to make a judgement on where we are in the economic cycle. Our belief is that we are currently in a period of sustained economic expansion with inflation having been kept under control, and with interest rates at historically low levels. The background for corporate profitability remains good (especially in Europe) and barring any unforeseen events this ‘Goldilocks’ scenario is likely to persist for some time. This provides a secure basis for credit and equity markets.

However, we believe that we may be approaching a point where this fine balance is upset, most probably as recent interest rate increases (and possible further increases) begin to affect the consumer in the Western world. If this is the case, then credit markets (which have been the beneficiaries of huge asset allocations and have subsequently traded to record levels) will be vulnerable as the operating environment turns negative. To put this in some sort of perspective, our current calculations are that benchmark ‘B’ high yield credits trade approximately 100bps rich to historic fair value.

At the same time we would point out that data going back over the last 25 years suggests that, unless economies are at a point of recession, it’s unlikely that credit spreadswill widen drastically. Against this backdrop we have examined some of the investment themes that are likely to drive the European credit markets over the next 12-18 months, and see opportunities arising from the following market dynamics:

  1. Sharp rise in M&A activity (including LBOs)
  2. Strong market technicals versus weakening fundamentals
  3. Accelerated growth of the underlying market and new product development has led to pricing inefficiencies
  4. The development of new products to take advantage of opportunities as the credit cycle develops. The development of CDS index and single name products (and options on these products) allows total return funds such as ILEX to exploit opportunities on the short side of the balance sheet considerably more efficiently than in previous cycles. It’s interesting to note that, during the downturns of March through May 2005, it was the credit derivatives markets that provided the transparency and liquidity even at a time when a borrower of GM’s importance was down-graded to ‘junk’.
  5. As always, we continue to believe that the market also offers good opportunities in the form of various different sector themes. Sectors that we favour include Cable (as a result of de-leveraging and ongoing consolidation), Base Materials, Energy & Power, Gaming and Healthcare. On the contrary, we remain bearish on the Consumer Cyclical, Retail, Packaging and Incumbent Telecoms sectors.

In summary, ILEX sees opportunities primarily on the short side of the portfolio, but there are also certain positive trends within European credit that continue to provide opportunities on the long side.

Opportunities on the long side

  1. M&A influence in High Yield
    By definition, most approaches to HY companies will come from better-rated entities producing a positive outcome for the new entity as a whole. In reality most HY bonds have ‘make whole’ language within the bond covenants forcing the acquirer to repay outstanding bondholders at a defined rate over the appropriate Government bond (usually a spread of 50bps which can easilytranslate into an uplift of 10+ bond points).
  2. IPO opportunities
    Recent strength in equities has led to the re-opening of the IPO market. Classically, HY issuers look to take their businesses public approximately 2-3 years after issuing their bonds. The proceeds are often used to pay down debt, and this de-levering – combined with a substantial equity cushion – is regarded as positive event risk for that particular name.
  3. Continued strong demand for fixed income product
    The last three years has witnessed a once-in-a-generation asset allocation shift in favour of fixed income product. Much of this demand has been actuarially-driven as the asset/liability mis-match at insurance companies and pension funds becomes acute. We do not believe that this is a short-term phenomenon. The result of this technical bid is that the credit markets have become a source of cheap funding for corporations. Many companies that borrowed at penal rates in a less friendly environment 4-5 years ago can now refinance at much more favourable levels. Typically this will involve the repurchase of outstanding debt at very attractive levels for bondholders. Thus, the successful identification of such credits can yield exceptional risk-adjusted returns. As an example, in July 2005 Esselte bought back its bonds which had been trading in the low 90s. It paid a bond price of 112, resulting in bondholders picking up a 20 bond point profit.
  4. Corporate balance sheet strength
    Since the credit crunch of 2001-2002, European corporates have significantly improved the health of their balance sheets. After all, it was only a few years ago that the likes of Deutsche Telecom and France Telecom had debt in excess of €70bn, and many questioned whether or not they would survive (currently 5 year France Telecom & Deutsche Telecom CDS trade at 45bps and 41bps respectively). Thesebalance sheet improvements, coupled with the improving operating environment, have led to a significant turnaround in corporate profitability. In fact, at the time of writing this article, European corporates’ cash balances are at record levels. A recent JPMorgan study found that – of the 26 largest corporates – leverage had come down from 1.9x to 1.6x over the last three years, while interest cover has risen from 8.6x to 10.8 times. It’s difficult to get too negative on credit against this backdrop.

Opportunities abound on the short side

  1. LBO Risk
    LBO risk continues to stalk the credit markets (see Chart 2). Private equity buyers are now hunting in packs with the result that no corporation with a market cap of less than $20bn can be deemed safe. The increased debt levels within the capital structure of a successfully targeted LBO can result in spreads blowing out dramatically. In the case of TeleDenmark the five year CDS went from 40 in April 2005 to trade at 300 by the end of the year. Thus the risk/reward of buying 510 year protection on A or BBB paper at spreads often below 100bps is compelling.
  2. Corporate re-levering
    Corporate re-levering is in its early stages. Long gone are the days (in 2002 & 2003 for example) when one could talk confidently about corporate strategies being bondholder friendly, as balance sheets were tidied up and emphasis was placed on the paying-down of debt. Today we see companies in all sectors resuming the quest for growth with many accessing the cheap debt markets to finance acquisitions. This is a clear negative from a credit standpoint. Sectors where this trend is especially prevalent include Telecoms and Media.
  3. Deterioration of credit fundamentals
    It is always difficult to call the exact moment when the credit cycle turns. It is our view, however, (and one that is perhaps shared by the rating agencies), that the outlook for credit is likely to be less positive for 2006 than it was for the last 12 months. Default rates are likely to rise modestly, geo-political risks abound, corporate leverage is on the increase, and inmany sectors profitability appears to be peaking. A recent Deutsche Bank survey of rating activity in BBB and A-rated credits noted that there was only one positive rating change in January and February 2006, versus 13 negative rating changes. Additionally, in a JPMorgan survey taken earlier this year – in which investors were asked about their expectations of credit fundamentals – 55% expected a deterioration, whereas only 25% expected an improvement and 20% expected fundamentals to remain unchanged.
  4. Increased issuance of poor quality credits
    The past 12 months has seen a large jump in the amount of CCC-rated paper on offer to investors. According to JPMorgan figures, in 2004 13% of all high yield issuance was rated CCC. By 2005 this figure had grown to 34%. Furthermore, in 2004, deals carrying leverage of more than 4x were considered to be at the limit of what the market was prepared to countenance. Last year, some of the CCC deals carried leverage multiples of 7x. We also saw the growth of ‘PIK’ deals – a sure sign that equity sponsors are keen to take their money off the table, and often a pre-cursor to a weakening credit market.
  5. Macro economic factors
    The recent inversion of the US yield curve is a warning sign. It doesn’t necessarily mean that a recession follows, but in the past it has been a useful forward indicator (see Chart 3). Recent economic numbers out of the US have reassured investors as to the longevity of the current US expansion, but we – along with other commentators – believe that the Achilles’ heel for the US economy is the housing market, where definite signs of slowing sales and weakening confidence in such an important sector could have grave consequences for the economy as a whole.

The recent inversion of the US yield curve is a warning sign. It doesn’t necessarily mean that a recession follows, but in the past it has been a useful forward indicator (see Chart 3). Recent economic numbers out of the US have reassured investors as to the longevity of the current US expansion, but we – along with other commentators – believe that the Achilles’ heel for the US economy is the housing market, where definite signs of slowing sales and weakening confidence in such an important sector could have grave consequences for the economy as a whole.

Conclusion

Historical analysis would indicate that even though credit spreads are very tight, there’s no reason to believe they will blow out significantly unless world economies are heading for recession (see Chart 4). Even at a time of significant volatility we expect continued strong demand for quality credits. Having said that, ceteris paribus, we do believe that the majority of Alpha generation opportunities will come from the short side of the portfolio as spreads readjust to historic fair value, and the credit cycle moves on to the next stage when deteriorating (credit) fundamentals become more apparent. Perhaps this year investors will be a little less sanguine with credits that fail to deliver?

The ‘ILEX Credit Fund’ was one of the first wave of credit hedge funds in Europe, dating back to 2000 when only a handful of firms were active in what is now an increasingly popular space. ILEX – managed by Simon Thorp (Founder), James Sclater (Partner) and David Meek (who joined the firm as a Senior Partner in 2005 from Citigroup where he was Head of Investment Grade trading) – is a multi-strategy, credit based, long/short fund specialising in the European credit markets.