European credit markets no longer makes any sense
The European Central Bank’s extended quantitative easing programme attracted criticism from the start as many analysts believed such a QE bazooka would distort bond markets. It has become apparent over the past few weeks that this is exactly what is happening.
ECB QE means that 47% of the European area government bond market trades at a negative yield and nearly 25% of the European corporate investment grade credit market trades at a negative yield thanks to the ECB’s Corporate Sector Purchase Programme.
These negative yields are playing havoc with fixed income investors.
The available pool of European government bonds is expected to shrink by close to €600 billion this year, net of redemptions, coupons, and ECB purchases. This is despite the fact that European governments are expecting to issue €844 billion worth of bonds throughout 2016. A further €450 million of negative net supply is expected in 2017 according to Morgan Stanley.
Simply put, the European credit markets sre awash with liquidity, but supply is shrinking. The distorting effects of such a topsy-turvy credit market are, as of yet, unknown. Investors recently paid Henkel and Sanofi to borrow, which is especially interesting because Henkel’s issue is earmarked to fund the acquisition of Sun Products. Credit investors have paid the company to acquire another company. Henkel sold €500 million of two-year debt with a yield-to-maturity of minus 0.05%, while Sanofi sold €1 billion of three-and-a-half year debt, also at a yield of minus 0.05%.
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If the Henkel deal isn’t crazy enough, as Bank of America noted last week if European corporate yields continue to fall at their current rate, negative yielding junk bonds will be a reality in Europe, which could spur a wave of wave of M&A and leveraged buyout deals.
A sudden spike in LBO activity would present a massive 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.
European credit markets failing but equity market remains active
Investors can’t seem to get enough of European credit, yet they can’t sell European equities fast enough. European equities have seen significant net outflows this year. Western European equity funds have seen 31 consecutive weeks of net outflows, totalling $83 billion. On this basis, this makes 2016 the worst year for European equity fund flows since 2008.
However, it may be too early to call the death of the European equity markets just yet. European equity issuance totals $92 billion year-to-date, while buybacks have been close to $46 billion. Dividends paid amount to almost $200 billion and M&A totals $390 billion. Further, according to Morgan Stanley’s research and estimated $90 billion of cash might be returned to European shareholders in the next month alone as the ARM/Softbank and ABI/SAB deals complete.