Bank of America "Thinks The Unthinkable"

Tyler Durden's picture

Today was a day when not one but two credit analysts, Citi's Hans Lorenzen and BofA's Barnaby Martin, both declared that the ECB was doing "too much" QE.

As Lorenzen showed in one or his slides to the presentation we highlighted previously, the ECB is now officially dominating the secondary € credit market, by purchasing approximately 50% of the traded volume of bonds.  This was part of a presentation which alleged not only that the ECB has injected "too much money & not enough supply", but that the costs of QE in general are now outweighing the benefits.

BofA's Barnaby Martin likewise wrote in a report today that the ECB's "CSPP is simply “too big”, by which he means that it is "Too big – in buying terms – not to remain a consistently bullish tailwind for credit spreads." He further notes that despite a jump in near-term supply, spreads will head tighter into year end and that "European credit can continue to rally. We look for Euro IG spreads to end the year at 95bp, Sterling IG to end at 105bp and Euro HY spreads to end the year at 340bp... the ECB have waited three months for decent primary, and now it is here we believe they are keen to buy in size."

However, with seemingly nothing in the world capable of impairing the relentless grind tighter in spreads as everything trade is now merely frontrunning future ECB purchases, Martin does point out something worth contemplating, namely "that CSPP could quickly become its own worst enemy if it leads to a rapid rise in releveraging." Specifically, Martin believes that an outbreak of the most extreme form of "animal spirits" , i.e., LBOs is imminent, to which he then adds:

And lo and behold, over the last few weeks TDC has confirmed that it has received private equity interest (which the company later rejected), and last week Bloomberg reported that KKR was one of the bidders for Repsol’s stake in Gas Natural.

 

The last European LBO cycle in 2005 and 2006 was relatively light in deals compared to the US LBO cycle. Many of the obstacles then to European take-privates – such as the prevalence of government shareholdings (chart 4) – are still relevant today. But there were enough big European LBOs a decade ago (TDC, VNU, ISS, Boots) for the risk to become a systemic one for spreads. And the LBO rumour mill was often enough to drive credit spreads of a highlighted company much wider.

A surge in LBOs in itself, is not a problem; what Martin is far more concerned about is a thought experiment in which "the unthinkable" happens, namely  BB yields going negative. As we explains, "such has been Draghi's influence across the whole credit market that we are close to seeing our first negative yielding BB-rated bond. But if debt costs for speculative grade companies become "inverted", then the economics of LBOs will be transformed, and the quality of the assets they are buying will become secondary. We see a growing risk that another private equity cycle emerges in Europe now, and the severe rating deterioration that LBOs pose would become the greatest challenge to central banks' credit buying."

To emphasize this point, the BofA strategist, in Chart 5, shows the most negative yielding corporate bond (or the
smallest if positive) over time in each rating category. He notes that we
are very close to having our first negative yielding BB-rated bullet
bond (HeidelbergCement €18s yield 18bp and Peugeot €18s yield 20bp).
Moreover, the lowest-yielding single-B (bullet) bond is now just above 1%.

Why are BB-yields turning negative considered an unthinkable outcome? He explains:

The concept of negative debt-costs for high-yield companies will transform the traditional economics of LBOs. Take interest coverage, for instance, as chart 6 shows. Private equity pushed the envelope with interest coverage during the last LBO cycle. Interest coverage fell to just over 2x for European LBOs in 2007. But now, with the rapid decline in non-IG yields, note that interest coverage of European LBOs has begun to rise this year. Cheap debt can suddenly make unviable candidates appear “viable” for private equity.

Which brings us again to the TDC case study, a "very telling" example of what may be about to happen, according to Martin: "TDC was a previous large take-private in late 2005. With the cost cutting that has been implemented since, profit margins for the company are now high, so news of a second LBO seems strange. Low debt costs can alter the equation, however. Recall that in 2006, the high-yield debt  financing that accompanied the TDC LBO had coupons of 8%+ (second lien debt). But today we stand close to the reality of negatively yielding speculative grade bonds, and private equity firms will realise that using debt to go “long” the European equity market has never been easier."

In other words, we are about to enter a world in which the debt tranche may actually pay itself down, an outcome even more perverse than the recently reported deal where the ECB was directly funding the acquisition of Krispy Kreme by JAB Holdings.

Putting it all together, Martin's conclusion is that the inevitable surge in LBOs may prove to be the catalyst that forces the ECB to step back from its frenzied corporate bond-buying pace:

LBOs would be the biggest headache for Draghi: The point about a take-private is that it rapidly deteriorates credit quality. When TDC was LBOd, the rating on the senior bonds went from BBB1 to BB2 within three months (and eventually fell further). This, in our mind, would be a very challenging type of event risk for the ECB to manage and could sap their enthusiasm for continuing with CSPP. LBOs would mean CSPP bonds going from eligible to non-eligible. As we have seen recently with K+S, the risk of non-eligibility can have a profoundly negative impact on spreads (chart 7). While K+S bonds are already in our high-yield bond index, the recent negative watch on S&P’s BBB- rating has seen spreads jump wider (a loss of this rating would render the name ineligible for CSPP). We know from the CSPP ISIN disclosure that the ECB hold three K+S bonds (the €18s, €21s, and €22s).

Martin is probably right, which means that eventually the ECB will back off (much to the delight of Citigroup too, as noted above). However, before that happens, Europe is about to see an unprecedented LBO frenzy as double-Bs go negative. Which also means that it may once again be time to start buying CDS on some of the most popular LBO candidates, as no matter the ECB jawboning, unless Draghi assures the market that the ECB will monetize everything through D(efaulted) bonds, event risk such as a major chunk in new leverage will inevitably lead to a spike in default risk, especially if and when names fall out of eligibility.

It also means that the bubble frenzy to purchase Europe's assets with lots of margin, this time by PE shops, is about to get a whole lot more "exciting."

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Lonesome Crow's picture

Quantitative Easing is evil.

Quislings Exclamation is evil.

How about some analysis?

maskone909's picture

If it takes 7 years of emergency central bank intervention to garner "full employemnt"(bus boys) then what happens when the music stops?

Father ¢hristmas's picture

Corporate Fascism or Communism.

"When there's nothing left, when you can't borrow another buck from the bank or buy another case of booze, you bust the joint out.  You light a match."

Bilderberg Member's picture

Library of security analysis books for sale...Will trade for mercury dime

sonya55's picture

Time to buy 10 cases of Vodka.

tarsubil's picture

I guess you are talking about when the music stops in musical chairs, but it makes me think more of the Titanic and how the band played on until the very end.

But this isn't like the Titanic. They realized something was very wrong early on with the Titanic. They just weren't prepared for what happened. With just a little bit of basic preparation at a tiny fractional cost, they could have been fine with 99% survivors. 

This isn't like that. It is like if the captain had been in total denial about the flooding of the ship and the engines were left to run until the boilers exploded from being doused with icy ocean water and no life boats were prepared. When this ship sinks, only those that prepared themselves will have any chance.

larz's picture

QE  is theory central planning is evil

UncleChopChop's picture

and noone raised a hackle over central bank buying private-sector assets? I guess the cb's have managed everyone like frogs in boiling water with their sovereign purchases, where they could claim they were targeting 'interest rates' to manage macro policy. aw shucks, it just so happens that the 'risk free rate' (cue laugh track) happen to be government bonds. ah well.

but corporates? corporate equity? they are running dangerously closer to central banks overtly (as opposed to implicity) owning everything.. and then people will begin to ask "and who owns the central banks again?"

it's fascinating watching tptb do everything they can to maintain control.. and yet have all their attempts continually backfire on them.

 

 

dimwitted economist's picture

or Rather NOTHING 

is UNTHINKABLE to those Bitches at BOA!!!!!

Toonces Feline's picture

Let Draghi fund your LBO and take all European companies private.  What could possibly go wrong?

Japan is doing something similar, with the JCB buying up all the publicly traded companies and making them central bank-owned entities.

Front-running central banks only works until all the assets have been bought by them.

This is crazy.

Toonces

 

 

 

 

Seasmoke's picture

TILT. Game over.

cognitive dissident's picture

the Piper is beginning to tire, and everybody has heard ALL of his tunes now... at some point, sooner than most here believe, he will expect payment for his perfomance.

BabaLooey's picture

FUCK Bank of America

Lousy fuckers. Go fuck right off.

Zeusky Babarusky's picture

I agree. Bank of America sucks. I will not do business with them ever again.

luri's picture
luri (not verified) Sep 5, 2016 7:20 PM

QE IS A TAX ON THE PEOPLE - PLAIN AND SIMPLE.

HELICOPTER MONEY IS A TAX.

NIRP IS A TAX

ZIRP IS A TAX.

AND AS WITH ALL TAX MONIES, IT IS TAKEN FROM THE MANY, AND GIVEN TO THE RICH!

THIS IS CLASSIC "TAXATION WITHOUT REPRESENTATION"!

thefinn's picture

Shhh didn't you get your payment this month or something ?

buzzsaw99's picture

nobody says the "dee" word. [/beetlejuice]

Porous Horace's picture

No... they can't end QE. I'm counting on hyper-inflation to allow me to pay off my fixed-rate debt (mortgage, cars and motorcycle) with only a couple days' pay. I don't know what my creditors are counting on, but then again, I don't really care.

sonya55's picture

I to will join in your Fantasy. 

DontWorry's picture

In the weimar hyperinflation they adjusted mortgage contracts to account for the new value of the mark

The house always wins.

shamus001's picture

Really!? Did they really adjust the contracts? Can that be done legally here on a fixed 30yr?

I was thinking in hyperinflation with no ability to get any money, thus things cost exponentially more, and your job earnings are deflationary, so there is no money to buy anything (or pay anything off)?

hongdo's picture

I was going to bust your chops on your first para:

Obviously legal means nothing anymore.  Why do you think Soros is funding the election of liberal prosecutors who have the power to chose prosecution or not based on their discretion.

but then I read your second para:

Hyperinflation of things you need and deflation of job earnings is what we currently have, so your prediction is correct already.

UnschooledAustrianEconomist's picture

You bet, before or during hyperinflation they'll run some scheme to prevent suckers like you to profit from it.

Get rid of the debt if you can, don't be a debt slave.

hedgiex's picture

LBOs will not be catalysts to ECB's trips, unless they become mini-ponzis within the debt peak EC economy. Another concotion of snake oils that is not going to impress global markets except for the naive investors. Try harder...BOA .

michelp's picture

"LBOs would be the biggest headache for Draghi"

Seriously now, do you really think Draghi is even capable of having headaches?

m.