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."