Takeaways: As negative yields spread, the divergence between Euro and dollar borrowing costs becomes more marked. Add the Euro at an 11-year low and it’s no wonder Mr Buffet – and a growing number of his US compatriots – are not only shopping in the European aisles, but borrowing in the Euromarket. Of course there’s a flipside. The ECB’s bond buying driving much of this yield decline comes from a position of weakness. However, there are brighter spots emerging across Europe and transactions aren’t just a bet on recovery; they can help to build resilience through increased market share, diversification, lower costs and innovation. Good reasons why the deal appetites we saw return in 2014 should continue to improve in 2015.
Negative yields…worryingly rational
In the last seven years, there have been some pretty unusual sights in financial markets; but seeing around half of all Eurozone sovereign bonds trade with negative yields is right up there. Investors are now paying for the privilege of holding around $3tn of debt worldwide. It sounds nuts, but there is some rationale.
If you’re a Eurozone bank, a small negative yield offers a better return paying 0.2% keep money in the ECB’s ‘vaults’ or 0.75% at Denmark’s Nationalbanken and Swiss National Bank. Analysts at Commonwealth Bank of Australia believe almost a quarter of worldwide central-bank reserves now carry a negative yield. Other investors will offset negative yield against deflation expectations and some are required or choose to hold safe assets. And this is where we get to the crux of the issue. The pool of ‘safe’ assets has shrunk considerably since the financial crisis. Hence why Mario Draghi’s ‘whatever it takes’ mantra – combined with promised QE demand – sounds so attractive. There is a good chance once QE buying begins next week that prices will go even higher – and yields lower. The ECB has set a -0.2% limit on its negative yield buying – which may set a floor – but only if investors can see alternatives.
There is an obvious opportunity for borrowers here – see below – but negative yields also ring alarm bells. Returns expected by investors generally reflect the health of the economy. There are those mitigating factors around asset supply discussed above and the Eurozone growth outlook is improving, but painfully slowly compared with the region’s debt. Meanwhile, Greece, like a niggling toothache, threatens to come back at some point and require more drastic treatment – perhaps extraction.
There is also an inherent instability in negative yields. Investors can only generate returns by selling at a higher price or benefiting from an advantageous currency move – leaving little incentive to hold if the narrative changes….if there isn’t a ‘greater fool’. On the other hand, the longer this goes on, the greater the potential for asset bubbles to form – again. Like deflation, negative yields are only beneficial in small, controlled doses.
Time to borrow…
Caveat emptor, but this environment obviously creates a significant opportunity for borrowers. The ECB isn’t buying corporate bonds, but high demand for a limited number of sovereign bonds has already pushed buyers into other euro markets to companies’ benefit. This week GDF Suez launched a zero-coupon two-year bond. New issues in the European high-yield bond market have hit €14.6 billion so far in 2015 – a 52% increase year-on-year, ahead of any other comparable period.
The US divergence opportunity we’ve been highlighting is also gathering more proponents. Warren Buffet had already signalled his intent to buy in Northern Europe, this week he announced his intention to borrow in Euros too. US companies have issued €18.6bn of debt in Europe in 2015, according to Thomson Reuters, a record for the first two months of the year, and 160% higher the total for same period in 2014. The increasing popularity is obviously helped by rising demand and falling yields, but also by a growing convergence in US and European debt markets across terms and structures.
Companies who’ve taken advantage include Coca Cola, whose recent €8.5bn issue was significantly oversubscribed, on 1.125% on 12-year debt and 1.65% on 20-year bonds. Then again, investors in Europe are looking at companies like Nestle trading with negative yields, whilst in the US similarly rated AA-rate Merck recently issued US$ debt with yields of 2.75% on its 10-year and 3.7% on its 30-year bond. Value for everyone.
Meanwhile, the sterling market has come out from its post Phones 4U slump. Sterling denominated high-yield bonds currently average 5.69%, well above the Eurozone’s equivalent 4.19%. As, the FT highlighted this week, Jaguar, Virgin Media, Macquarie and Wagamama have come back into the market in 2015. However, this isn’t an easy ride for all. Barclays CCC Euro bond index has risen to 9.3% from 7.3% six months ago, in contrast to a fall from just over 3% to 2.5% at BB. And the high yield market remains an area to watch closely if confidence wavers. The exits are still small.
Time to buy….
Unsurprising, given this backdrop, companies are indicating an interest in transacting. Our analysis shows a year-on-year fall in global announced deals in February; but it’s tough to match a month with a US$70bn Time Warner-Comcast acquisition. This kind of mega deal isn’t back, but we’re seeing plenty of single digit billion dollar deals fill the pipeline.
Europe could still be a significant driver of M&A volumes, although the region is somewhat of an enigma. We expect stronger volumes in 2015, should the region avoid a further breakdown in confidence; however economic lethargy could encourage European players to look overseas….unless the Euro falls much further. Although, conversely a weak Euro is encouraging US companies to look selectively across the region. The Eurozone as a whole still looks somewhat troubled. However, there are pocket of growth and strength and undervalued businesses, especially in Northern Europe.
Our latest edition of Capital Insights explores a number of sectors likely to be the focus of M&A activity in 2015. Last year saw record deal values of over $200bn in life sciences and we expect activity to remain high in 2015. Companies in the sector still have prodigious firepower and strategic imperatives to add focus, scale and – for ‘big pharma’ – a need to meet tough growth expectations. In European telecoms, the drive to consolidate and fill the content pipeline saw deal activity in 2014 surpass 2013’s total by the end of the third quarter. Mega deals have continued into 2015. Size matters in this space. Without scale, companies cannot compete for content and telecoms markets in France, Italy and the UK all look ripe for further consolidation.
Across all sectors, but especially those under pressure, like oil & gas, the focus is on building resilience to changes in sector dynamics and a more volatile world. In the absence of growth and with significant pressure on margins, consumer facing companies are focused on portfolio optimization. Recent profit warnings highlight sustained pressure on UK consumer products and retail companies, even as disposable incomes rise back above pre-crisis levels. During a recent EY panel discussion, 45% of attendees stated that the ability to maintain and improve margin would be the key challenge for UK retailers in 2015, with 56% believing this pressure would come from ‘everyday pressure on pricing’.
Building a resilient enterprise goes beyond deal making. The October 2014 edition of EY’s Global Capital Confidence Barometer revealed that 52% of companies regard corporate optimization as a pressing issue for their business, up from 29% at the same point in 2013. Businesses can achieve significant benefits from rationalising their legal entities, which can help cut costs, save on technology infrastructure and reduce liability risk. There are obvious challenges around licences, systems and occasionally lending agreements, but the rewards can be significant. A near-halving of the number of legal entities within the insurance group Aviva helped it to reduce its operating costs by 11% (US$565m) over three years to the end of 2013.