European credit spreads spiked to recessionary levels in March 2020 given concerns surrounding liquidity shortfalls and defaults. Dividends were cut, buybacks halted and acquisitions postponed. More than a year later, the script has changed, with low funding costs, strong balance sheets (European investment grade net leverage is already tracking close to prior cyclical lows) and a positive outlook on cash flows. This backdrop contributed to a sharp rise in European leveraged buyout loan volume in the first half of 2021—a trend we expect to continue.
A key difference from prior cycles in Europe is the size of capital markets and their ability to absorb more deals. The European leveraged credit market is now more than triple its size in early 2007. Recent deals like the Morrison Supermarket “bidding war” seem to indicate increased potential for less conservative financial policies and leverage-related downgrades. However, not all event risk is equal. Vonovia’s recent attempt to acquire Deutsche Wohnen—in what would have been the year’s biggest European takeover and largest ever in the region’s real estate sector—had a material equity component and emphasized maintaining strong credit ratings and balance sheet deleveraging.
In this environment, we believe credit investors need to be diligent of execution, strategy, leverage and agency risk amid accelerating event risk; for corporations, securing growth and adjusting to the secular changes accelerated by the pandemic are both prime motivations and signs of the transition from credit-focused capital allocation to shareholder-friendly policies. At the same time, this is accompanied by the ECB signaling that it will not extend beyond September 2021 its recommendation that all banks limit dividends further. In Europe, historically, corporates have leaned towards dividends over buybacks to reward shareholders, and some have already announced that they will return to their pre-pandemic shareholder-friendly plans.
We believe we’re likely to see more event risk and some companies using cash on their balance sheets to pay extraordinary dividends as a defense mechanism. While credit spreads in Europe could be pushed wider by shareholder-friendly capital allocation policies and debt-fueled takeovers, we still view European corporates as being in a strong position with a supportive backdrop and earnings momentum. As industries emerge from the pandemic in varying stages, along with a spectrum of capital allocation policies, issuer and security selection will become increasingly important.