European investors use corporate debt as hedge

Continuing uncertainty in the Eurozone is driving investors towards corporate debt as a preferred asset class following firms’ successful refinancing in 2010, ratings agency Standard & Poor’s revealed

Corporates performed better than expected in 2010. “Cashflows have surprised the market, and surprised us in terms of performance,” said Paul Watters, a chartered financial analyst at the ratings agency.

“They are not far off their peak cycle levels of 2008,” he added.

Efforts from management teams to respond vigorously to the financial pressures of 2008, including “aggressive” cost cutting, has enabled corporates to recover quickly, he said. They are also benefiting from stronger growth and inflation.

That is fuelling a trend for investors to reallocate their funds to credit, and it is likely to continue, he said.
Asset of choice

“Corporate debt has become an asset of choice for investors seeking protection from sovereigns and banks,” said Watters.

Blaise Ganguin, chief criteria officer at Standard & Poor’s, said 2009 had seen movement towards B-rated corporate debt issuance, but that went further down the credit curve in 2010, to lower-rated companies.

BBB to BB rated corporate credit is tipped to increase in appeal.

The appeal of corporate debt is driven by investors’ concerns about the lack of visibility in other sectors, said Ganguin.

“Crucially, they are less likely to lose in the corporate sector than elsewhere, giving an appetite for lower-rated bonds,” he added.

Risk appetite meanwhile grew in 2010, and it is rapidly increasing, said Ganguin.

Continually improving performance from corporates is likely to support that appetite. Management is likely to adopt a more positive mindset into 2011, pursuing action to develop and grow their business, said Watters.
More M&A

M&A activity, subdued during the refinancing period, is likely to pick up, predicted Watters.

With stronger balance sheets, corporates are likely to look at mid-sized acquisitions, he said, tipping chemicals and packaging as the most attractive sectors.

Larger acquisitions are “conceivable” as part of corporate consolidation or strategic growth plans, he said. Media and mining are set to benefit from any M&A impulse.

A returning loan market, with banks offering loans of five years plus one or two year extension options, is likely to further fuel M&A activity in Europe, he added.

Underlying bank loans are a typical requirement of corporate acquisitions in the region.

Meanwhile, the recent phenomenon of banks setting a capital markets-funded takeout as a condition for additional financing will spur M&A, he said.

At investment grade, bond market liquidity is likely to be maintained, with the high yield market story for this year [2010] expected to continue [into 2011], said Watters.

Positive rating trends already seen for corporates are expected to continue, with further stabilisation and even upgrades.
Defaults to re-emerge

But beyond 2011, S&P heralded warning signs, particularly from 2013.

“We have a wall of funding requirements awaiting us from 2011 to 2015,” said Ganguin.

“You can’t wait until 2013 to refinance,” said Watters, predicting that a change in perception will emerge out of a tighter monetary environment in 2011 and 2012, amounting to refinancing difficulties.

“Defaults could see a second flip-up,” with corporates finding it increasingly hard to pay lenders to mend their covenants, he said.

He predicted a “significant number of restructurings”, with defaults likely to increase to between 5.5% and 7% in 2012.

Defaults of southern European corporates reduced sharply in 2010, with just 24 in Europe, five of which were public and 19 that were private, S&P confirmed.

That represents a substantial reduction since 2009, said Watters.

The reduction is likely to continue. At the end of 2010, the 12 month default rate is expected to be 4%, and fall further next year, to 3.8% at the end of 2011.

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