Are Europe’s winter prospects warming up?
Monday was the most active day in the primary markets for some time in both Europe and the UK. A number of banks and corporates (including high yield issuers) were out with sizeable deals, resulting in well over €10bn of new bonds being placed with investors. Periods of heavy issuance like this can provide investors with useful information on a number of fronts, and also confirm certain patterns that typically occur when primary markets reopen.
Firstly, banks are usually the first ones to issue in size when primary markets come back to life. By the nature of their business banks are in constant need of funding; they regularly have capital instruments maturing or coming to their call dates, as well as a range of other senior debt instruments to help finance their balance sheets. Therefore they have a vested interest in having an open and buoyant primary market. A total of seven European banks issued bonds on Monday, including senior unsecured, Tier 2 and Additional Tier 1 (AT1) paper. To us, subordinated bond spreads look particularly interesting. For example, Barclays issued a sterling 10-year non-call five Tier 2, rated Baa2/BB+/BBB+, at a spread of 475bp over risk-free. Deutsche Bank issued a euro perpetual non-call five AT1 (Ba2/BB-) at a yield of 10%, which equates to a dollar yield of roughly 12.5%.
Secondly, when new issue markets start reopening, new issue premiums tend to be larger than usual, since investors demand a little extra spread from issuers as a cushion against more turbulent markets. On the aforementioned deals we put the new issue premium at 20-30bp over fair value, which looks attractive when you consider that unlike picking up bonds in secondary, these new bonds are available in good size to investors looking to build more yield into their portfolios.
Thirdly, we learnt that there is significant amount of cash on the side lines. All of these deals were announced and priced within the day, as is often the case for established investment grade issuers. Books were on average 2-3 times oversubscribed which we would deem healthy and reflective of market participants wanting to put at least some money to work at what look like attractive levels. This was probably the most critical lesson we learned when the new issue market reopened at the end of March 2020, and we considered it a strong buy signal at the time after the dash for cash and heavy outflows sparked by the onset of the COVID-19 crisis.
Lastly, we have also seen a slow reopening of the European high yield primary market in recent weeks. The latest deal on Monday came from Faurecia, a large and well-known BB rated auto parts manufacturer. While its sector is cyclical and going through several structural changes, we found it interesting that Faurecia chose to issue a relatively short 3.5-year non-call two deal, which was ultimately priced at 7.25%. Faurecia has a few bonds outstanding, the longest of which is a 2029 bond currently yielding 7.70%, and demand for the new issue was sufficient to increase the deal size to €700m from an initial €400m. So with Faurecia being a well-known issuer and seemingly having to offer so little extra coupon on this new deal, we might wonder why it didn’t opt for a longer bond. In our view, that decision tells us management thinks current yields are temporarily high, but that they will not stay at these levels for long. Given Faurecia’s own fundamentals look in reasonable shape, we think the plan is to issue short dated bonds now with a view to refinancing at a cheaper coupon in a few quarters’ time.
When new issue markets reopen after a period of market stress, there are usually opportunities to be found in the early deals. Later deals tend to be more expensive, with diminishing new issue premium. Early deals also tend to come from higher quality issuers, and we know that historically quality leads the recovery in credit markets. Following periods of stress these early deals can later trade with high price premiums, often quite quickly after reopening, just as we witnessed in the immediate aftermath of the COVID-19 crisis. Our view is that these new deals with high coupons certainly merit the investor attention they are receiving.