Credit markets: Mid-cycle or fashionably late?
One of the main macro debates within LGIM’s investment team at the moment has been about where we currently find ourselves in both the economic and business cycles. There’s broad agreement that it’s somewhere between mid and late, but they carry very different implications for global asset classes.
One of the clearest signals that we are moving into a late-cycle environment is headline-grabbing M&A activity. This is typically great news for equity investors, but less so for credit investors who have to provide the debt finance for a potentially high-leveraged entity.
We have harboured concerns for some time that from a stage-of-the-cycle perspective, investment-grade credit hasn’t been in a great place – risk premiums are very low and a lot of other indicators are already mid-cycle.
History tells us that in normal cycles, credit spreads can remain at the tight end of their valuation ranges for a lot longer than you might expect. But if you believe that the impact of the pandemic may be accelerating the cycle, this could be the period when credit swings from out- to under-performing.
Late cycle, large scale and heavily debt-funded M&A has regularly signalled in the past that we’ve entered the final throes of the bull market. Daimler-Benz* and Chrysler* in 1998, RBS* and ABN Amro* in 2007, and the spectacular AOL* and Time Warner* in 2001 all occupy a special place in investors’ memories.
While M&A levels are already at historic highs, the headline-grabbing, large-cap private equity deals have so far been conspicuous by their absence. It therefore raised a few eyebrows to read of KKR’s* €33 billion buyout offer for Telecom Italia*. We think this trend continues in earnest from here, as a big bid is sure to attract attention. There is a herd-like element to these deals, as pressure builds for others to follow.
With yields and spreads this low, debt is incredibly attractive in this context. As we head into 2022, this could get much more interesting. Markets will have to decide whether they believe inflation is transitory or not. If the latter, then yields will start rising next year. This could force dealmakers to accelerate their plans, worried that low yields are not going to be around forever and they need to move fast!
Private equity finally comes to the party
A Telecom Italia takeover would be one of the biggest ever private equity transactions in Europe. Although we see several hurdles to this deal, if successful, it raises the bar for the size of potential future European leveraged buy-outs (LBOs). This precedent would be concerning for credit investors across Europe, but particularly for those in the telecom sector as we think the logic behind this bid applies across the industry.
Telecom equities have significantly underperformed over the past five years, with the sector lagging the European average by over 60%. However, telecom infrastructure – mobile towers and broadband networks – has seen an enormous growth in M&A interest over this time period, with their predictable cash flows attracting bids from infrastructure funds, as well as listed ‘tower companies’. The chart below shows the disparity between underperforming operators and outperforming ‘tower companies’, such as Cellnex*.
The divergence in valuations between telecom operators and their underlying infrastructure could theoretically present opportunities for telecom companies, with many considering the sale of stakes in their infrastructure assets. However, the major operators have yet to convincingly re-rate their share prices, and we believe that those which fail to monetise their infrastructure effectively may be vulnerable to private equity taking advantage of this disparity.
Most telecom companies have some takeover defences – broadband networks are strategically important national infrastructure, so any LBO will face intense scrutiny from the relevant government. However, we don’t think it is fair to assume that all countries would be inherently opposed to takeovers of their national telecom operators (Denmark, for example, has allowed this to happen twice).
We think traditional LBOs – where a company is piled high with debt and cash is stripped out of the business – would generally not be palatable, but deals structured to include appropriate investment promises and protections could arguably be allowed to proceed. In the case of Telecom Italia, Italy has initially responded positively to the approach by KKR, though press reports suggest that any deal will require the telecom network to remain in Italian hands, indicating that this would not be a traditional LBO structure.
One swallow does not make a summer, and a private equity bid for Telecom Italia in isolation is not enough to convince us that we are definitively late cycle. However, the rise in LBO interest across sectors – UK retail being a notable example – certainly gives pause for thought for bondholders. Whether we are late cycle or not, current spreads do not leave much room for error, so anticipating the next big deal is more important than ever.
*For illustrative purposes only. Reference to a particular security is on a historical basis and does not mean that the security is currently held or will be held within an LGIM portfolio. The above information does not constitute a recommendation to buy or sell any security.