Corporate credit investors are scrambling to get to grips with sovereign exposure as even apparently healthy companies’ bonds succumb to contagion, finds Lynn Strongin Dodds
In the not too distant past, Europe was divided neatly into the ‘core’ countries and the ‘peripherals’. Today, the distinctions are less clear, as the euro-zone debt crisis infects Europe’s bluest chips, regardless of location. Although the spreads are still wider for those at the rim, investors are advised to look much more carefully at sovereign risk when analysing the corporate fundamentals.
Overall, euro-denominated bonds of European companies in November turned in their worst performance as the crisis intensified. In the derivatives market, the iTraxx Europe Main index of credit default swaps (CDS) on European investment-grade bonds rose to 209 basis points (bps) in November, close to the record 216bps touched in December 2009 (although the Crossover high-yield CDS index is still far from its financial-crisis peaks). Peripherals are only a small contingency of the 125-member iTraxx Europe. It does not contain any Greek, Irish or Portuguese borrowers, while Spain and Italy together account for just 12.8% of its constituents. However, despite their minority position, they are having a disproportionate impact on a corporate world that had been in relatively good health.
“What we are seeing now are signs of weakness in company quarterly earnings and slowing demand, led by the peripheral countries,” says Richard Phelan, head of European credit research at Deutsche Bank. “This has been brought on by the austerity measures taken by these countries and it is causing concern for the credit quality of all companies that issue bonds. The big question is what the impact of the euro-zone crisis will be for default rates, which have been low.”
For now, fund managers are not re-drawing their European investment maps. “[But] it is all getting slightly blurred,” says Bill Street, global head of active fixed income at State Street Global Advisors. “About 18 months ago it was much more clear-cut. We categorised Europe in three tiers. The first was Northern Europe, France and Germany, followed by Spain and Italy in the second tier, as they were seen as being more stable. Greece, Portugal and Ireland were in the third. However, the volatility of the sovereign spreads is being driven up all the way to the core.”
Duncan Sankey, head of credit research at London-based hedge fund manager Cheyne Capital, says: “The corporates that have been beaten up the most are from Italy, Spain and Portugal, because Greece and Ireland do not have many investment grade bonds. However, if you look at government bond yields and CDS sovereign spreads there is definitely peripheral creep into the core. For example, spreads [in France] are definitely coming under pressure and that could have an impact on its companies.”
At the moment, France is battling to hold on to its prized triple-A credit rating, and spreads between French and German government bond yields reached a euro-era record of 200bps in mid-November. Meanwhile, Belgium was downgraded by Standard & Poor’s to AA from AA-plus, while even Germany felt the heat after a disastrous auction on 24 November raised only €3.64bn in 10-year Bunds, out of the targeted €6bn. This was the weakest demand for a German auction since the launch of the single currency, according to data from Danske Bank.
Against this background, spreads have widened in core investment grade bonds, with France being one of the hardest hit as investors reduce their overall exposure to the country. For example, France Telecom’s benchmark 10-year yield jumped more than 100bps to a peak of 4.43% from mid to late November, while Vivendi’s 2021 euro-denominated bond has added 123bps over the same period to yield 5.54%.
The gap, though, is still broader for those in the troubled euro-zone economies. Solid firms including Spanish utility Iberdrola, Italian utility Enel and Telecom Italia have all had to pay extra in recent bond issuance. In October, Enel paid 427bps over Bunds to sell a seven-year deal, compared with 177bps in July for a six-year transaction. In 2007 the spread was just 62bps.
“In every country in Europe, spreads on corporates are reflecting their sovereigns,” says Mirko Santucci, head of credit at Swisscanto. “For example, from the end of June until now, Germany saw spreads [over US Treasuries] widen from 40bps to 95bps while Deutsche Telecom saw a move from 85bps to 135bps. Spain has gone from 262bps to 465bps while Telefonica moved to 412bps from 175bps. As a result, we are looking much more closely at the sovereign risk of corporate credits.”
Santucci is not alone. “There has been a shift in mentality as the problems of France have come more into focus,” says Owen Murfin, fund manager in BlackRock’s global bond portfolio team. “As a result, for the first time we are looking at the exposures of companies to sovereign risk alongside the traditional criteria of ratings, sectors and duration to benchmarks. Some large credit issuers have, however, underperformed unjustly, in our view, as perceived country risk has overwhelmed fundamental quality. A full assessment of some companies would reveal a far more diversified geographical revenue stream than spreads would imply.”
Tomas Lundquist, head of European corporate debt capital markets for Citigroup, adds: “Investors are doing much more granular analysis looking at the impact of the country risk and what percentage of their revenues comes from outside their home market. Investors are much more interested, though, in the downside risk and the factors that are contributing to that, versus the upgrade potential.”
Certain sectors such as financials and utilities - which account for roughly 60% of issuance from the peripheral countries - are most at risk. “Each sector clearly has its own issues but it is no surprise that banks which are heavily interconnected to their sovereigns are experiencing the most stresses and strains,” says Richard Ryan, senior fund manager of institutional portfolios at M&G. “We are doing what we always do: intensive analysis of credits on a case-by-case basis to identify each bond’s breaking points. This includes the issuer’s revenue streams, the locations of their revenue and how discounted their bonds are to the market.”
Sectors such as utilities are exposed to local markets. Julian Marks, a corporate bond fund manager at Neuberger Berman, notes: “As a whole, the utility sector was considered a safe, low-risk group of companies that had a low correlation to the economic cycle. Today, however, they are being impacted by sovereign risk. As for industrials, domestically-focused companies, such as cyclical consumer names, are under greater pressure due to the economic slowdown in these countries than international corporates such as mining and commodities companies that sell into Asia and South America.”
However, as Chris Bullock, credit portfolio manager of Henderson Global Investors points out, with country risk now a key part of credit analysis there is a growing aversion to anything that has a vulnerable sovereign. “We are seeing even international companies such as Telefonica, which generates around 70% of its revenues outside of Spain, performing badly,” he observes. “One of the big questions investors are now asking is what the break-up of the euro-zone will mean for a company. This will depend on the degree of domestic-based sales, defensiveness of its sector and the balance of its currencies between earnings and liabilities.”
Against this uncertain backdrop, investors are either broadening their benchmark horizons or adopting a total-return approach. The negative to the latter is that it leaves the investor heavily reliant on a manager’s acumen, plus many are reluctant to relinquish the transparency and accountability a benchmark provides.
For those sticking with a benchmark, there is a move towards alternatives, such as GDP-weighted, from the traditional market-weighted index. A GDP-weighted benchmark typically favours emerging countries and can lead to large weightings in illiquid and immature markets.
For now, though, investors are mainly sitting on the sidelines, watching, waiting and hoping that European politicians will finally reach a definitive resolution to the ongoing crisis.