TwentyFour Asset Management

Margin For Error in Credit Selection Narrows

TwentyFour Blog

We have seen overwhelming evidence of strong technical pressure on European credit markets in the early days of 2020, with the euro region’s largest ever week of debt issuance (just over €100bn of securities) being met with huge demand for new paper despite spreads having tightened considerably from the same point a year ago.

A combination of easing tensions between Iran and the US, and expectations for the conclusion of ‘phase one’ of the US-China trade talks, led issuers to launch new deals while the market was feeling buoyant and investor cash was sitting on the sidelines looking to be put to work.

Activity has been across a variety of sectors including industrials, supranationals, chemical groups, consumables and even cross-border transactions by Chinese real estate issuers, but the standout volume has come in the financials space.

It is here where we have been most surprised at the ease with which some opportunistic issuers have been able to get deals not just over the line, but comprehensively well done. Banco BPM, the entity formed from the 2017 merger of two regional Italian banks, Banco Popolare and Banco Popolare di Milano, has a considerable gross non-performing loan (NPL) ratio and a relatively skinny common equity Tier 1 (CET1) ratio to support its balance sheet at this mature stage of the cycle, in our view. And yet it was able to issue a €400m Additional Tier 1 (AT1) bond on Tuesday 50bp tighter than initial price talk, with books oversubscribed by 10x at €4.1bn.

Also notable was Wednesday’s €400m CCC+ rated tier two deal from Banca Monte dei Paschi di Siena, which drew a 2.3x oversubscription and was priced with a coupon of 8%. Remarkably, in the 2016 stress tests that led to the European Central Bank declaring Banco Popular was “likely to fail” (and was subsequently acquired for €1 by Santander in 2017), Monte Dei Paschi performed significantly worse and was saved only by a capital injection from the Italian state.

We have talked regularly about avoiding ‘next year’s skeletons’, and this is now more pertinent given the strength of the current technical backdrop, combined with spread levels that are significantly tighter relative to this time last year. We came into 2019 with starting yields for European high yield some 210bp higher than where they are now, so the margin for error has decreased at a time when supply from opportunistic issuers is higher than it has been for some time.

This reinforces our view that the best way to protect ourselves is continuing with a bias towards the shorter end of the credit curve, particularly given the flatness of the credit curve, and avoiding the temptation of additional yield associated with more speculative credits, despite the current market demand.