The European Central Bank’s ‘bazooka’ QE is causing some very strange movements in the European credit markets. The latest development is the falling yield on European BB rated bonds which could mean JUNK BONDS will soon have Negative yields!
According to research from Bank of America, if the average yield on BB bonds continues on its current trajectory within a few weeks, or possibly a few days negative yielding BBs will be a reality in Europe.
Negative Yields on Junk Debt? Time to Do an LBO
It doesn’t take a top Wall Street analyst to realize that negative yielding junk debt could pose a huge systematic problem to the European credit system. The ECB’s Corporate Sector Purchase Program could quickly become its own worst enemy if this scenario plays if it leads to a rapid rise in re-leveraging. The most aggressive re-leveraging is LBOs in the form of high-grade “take-privates”. In the past, those companies pursuing LBOs have generally had to pay a high rate of interest on the bonds used to finance transactions — a trait that has generally kept the industry under control. However, if negative yielding junk becomes the reality the LBO industry could quickly grow out of hand. Bank of America 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.”
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A sudden spike in LBO activity would present a huge headache for the ECB. Not only would a higher number of LBOs lead to re-leveraging but there would also be a deterioration in credit quality across the European credit universe.
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Indeed, according to the rules of the CSPP debt instruments eligible for purchase must, “have a minimum credit assessment of at least credit quality step 3 (rating of BBB- or equivalent) obtained from an external credit assessment institution.” However, as Bank of America’s credit analysts point out LBO credit generally tends to be downgraded following a highly leveraged deal, which would make it ineligible for the CSPP.
“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).”
It looks as if now’s a great time to be in the European LBO industry but not such a good time to be in the market for high-yield debt.
By Rupert Hargreaves
