Grant's Interest Rate Observer 11/17

More low long term corporate bond rates

World's smallest Veolin

It was only a matter of time, but the first triple-B-rated credit (that’s two notches above junk) in Europe has managed to place debt at a negative yield.  The lucky winner is France’s Veolia Environnement S.A. (VIE on the Euronext), a Paris-based resource/waste management and utility company, which issued €500 million in three year bonds priced to yield negative 0.026%. Even better: Investor demand for the Veolia issue was such that the offering was oversubscribed by more than 4:1.  Said another way, three out of four investors who wished to lose money on a yield-to-maturity basis were left disappointed.

To be sure, Veolia has in recent years made visible progress towards improving its financial footing.  Net debt of €9.3 billion in 2016 is down from €10.7 billion in 2012, lowering the company’s leverage ratio down to 2.8 times from 4.0 times in 2012.  Likewise, 2016 operating income covered interest expense by a bit less than five times, well above the sub-two times of interest coverage garnered in 2012.  Credit analysts from S&P praised the Veolia C-suite for its “prudent and proactive liability management” in a June 2 report, while nevertheless noting that: “We assess Veolia’s risk profile as significant, given the group’s material debt.”

As noted above, Veolia’s placement stands out even in this extraordinary market for European corporate bonds. Consider a trio of other recent issues on the Old Continent:

On Tuesday came the announcement that spirits producer Diageo plc, rated single-A-minus at S&P, is selling €775 million bonds due November 2020 with a coupon of 0.00% and €500 million bonds due June 2024 with a coupon of 0.50%.

Italian luxury sports car manufacturer Ferrari N.V. likewise tapped the EU bond market to the tune of an €700 million senior unsecured offering at a 0.25% coupon due in January 2021.  Ferrari, which is unrated by the bond agencies (the company didn’t get back to us when we asked why), generated free cash flow of €760 million in 2016, equivalent to almost half of its gross long term debt of just under €1.8 billion (the company holds more than €600 million in cash).

Tuesday also brought pricing for €1 billion in junior subordinated perpetual notes from Spanish utility Iberdrola S.A. at a (positive) 1.875% coupon. Iberdrola, unrated at S&P, sports a Baa3 rating at Moody’s, the bottom rung of investment grade. Iberdrola generated €4.51 billion in 2016 operating income, covering its €896 million in interest expense a bit more than five times over.

Helen Durand of Reuters wrote a Nov. 10 piece taking inventory of the evident distortions that have currently gripped the European corporate credit market. It identified as the culprit an actor well known to Grant's readership:

(hint)

 Pricing a new issue is usually straightforward, with a company’s outstanding bonds used as reference points to gauge fair value and a spread is then added to lure investors.

However, corporate spreads have snapped tighter after the ECB [in] late October announced an extension to its asset purchases until at least September 2018 to the tune of €30 billion a month.

“We’ve moved too fast, too quickly on no supply.  Some curves are not curves anymore, they’re lines,” said a senior syndicate banker.

This has made assessing fair value much more difficult, especially for credits that have been squeezed by central bank purchases, which began in June 2016 and now total over €122 billion for corporate paper.

For his part, ECB chairman Mario Draghi remains defiant. Responding to criticism from bank executives over his imposition of a negative 0.40% deposit rate (it’s been less than zero since June of 2014), Draghi offered a sanguine risk-reward proposition for his radical policies:

If there are any negative effects of low rates on net interest income [for the banks] in the future, they should be largely offset by the positive effects of monetary stimulus on the other main components of profitability, such as the quality of loans and therefore on loan-loss provisions.

Needless to say, the chairman’s contention that central bank-imposed negative interest rates and an indiscriminate bid under corporate bonds will help “the quality of loans” is a debatable one.  For now, potential issuers of all stripes are able to finance themselves for virtually nothing.  But a crack has recently appeared in the façade: Amidst the modest selloff in U.S. high yield seen recently, the yield on that Bloomberg Barclays Pan-European High Yield Index jumped to a four month high of 2.88% on Wednesday from 2.19%, a 10 year low, recorded less than two weeks prior.