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Consolidation not always embraced as positive

| October 19, 2018

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Ratings agency assessments of the Invesco acquisition resulted in S&P dropping the company two notches to BBB+ while Fitch affirmed the rating at A-. The divergence in ratings could weaken Invesco debt spreads. Italian banks UniCredit and Intesa have favorable credit metrics, though ratings could come under pressure if the European Commission rejects the government’s proposed budget.

Invesco downgraded two notches by S&P

It appears that S&P was not keen on the terms of the Invesco (IVZ) acquisition announced on October 18th. IVZ was downgraded 2-notches to BBB+/Stable from A/Neg following the announcement that IVZ is buying OppenheimerFunds from MassMututal. The key issue for S&P is the additional leverage for IVZ. The sources of proceeds will be a mix of perpetual preferred securities and common equity, with all but a small piece of the common equity to be issued directly to the seller. That perpetual security is being treated by S&P as debt with zero equity treatment, which elevates IVZ’s leverage a full turn to 2x EBITDA vs S&P’s expectations of 1x leverage. Reading between the lines, this statement effectively says that IVZ management did a poor job keeping S&P aware of the funding sources and structures.  A two-notch rating action sends a very negative credit signal, though S&P left the outlook as stable indicating some expectation of reduced leverage in the future.

By contrast, Fitch affirmed the senior unsecured ratings of IVZ at A-/Stable, and left the IDR ratings at A-/Positive. The difference with S&P is difficult to explain, though perhaps management took more time and effort in conversations with Fitch.

Relative Value: The 2-notch downgrade by S&P puts IVZ on the same ratings level as the one-time high yield credit NEUBER, which we expect will hurt IVZ spreads. The IVZ 3.75% ’26 trade in light volume in the G+108 bp area, vs the NEUBER 4.50% ’27 that also trade in light volume, but nearly 50 bp back of IVZ.

Risk mounts for Italian sovereign bonds on budget concerns

The European Commission (EC) is taking a stand against the proposed budget by the Italian government, which is causing greater concern with Italian sovereign bonds. The risk premium for 10-year Italian sovereign bonds has risen to approximately 326 bp over the German 10-year Bund (see Exhibit 1). The question now is whether the EC will formally reject the Italian budget next week, setting a new precedence among EU nations. The perceived risk in the market has been augmented by the expectation that the new Five-Star government is not likely to back-down from its proposed budget, which could risk approval from the EC. The current form of the Italian budget is below the mandated 3% limit within the EU, but even at 2.1% draws concern from the EC as Italy already has the largest nominal debt in the EU and the second-highest as a proportion of GDP.

Exhibit 1: Spread of 10-year Italian versus German government bond yields

Source: Bloomberg

Impact on Italian banks

We continue to have a favorable credit view of the two primary Italian banks: UniCredit SpA (UCGIM: Baa1/BBB/BBB) WN/S/N and Intesa Sanpaolo (ISPIM: Baa1/BBB/BBB) WN/S/N. The primary constraint on earnings for these two banks continues to be the sovereign ratings and outlooks. However in the past year UCGIM and ISPIM have done well – reducing legacy non-performing assets without significantly impairing capital ratios. The dominant retail and commercial banking franchises for these two banks in Italy also help support the ratings for each. Intesa has the added advantage of a strong asset management business, solid efficiency ratios and management that are credited with steering the bank through difficult markets. UniCredit is more international than Intesa, and has good franchises in Germany, Austria and other central European markets.  The CEO has been on a mission to find a merger partner for the firm, with a particular eye on one of the French banks. Given his prior work experience at SocGen, that name is a regular in the mix. Such a merger may not be well-received by the French, but UniCredit would almost certainly benefit. Deutsche Bank has also been mentioned as a potential merger candidate, but in our view that would benefit UniCredit very little, if at all.

As we go to press, Fitch published a note indicating that the Italian banks’ ratings are under pressure due to credit ratings risk at the sovereign level (as noted above). Fitch cites concerns with capital erosion due to weakening prices in Italian government bonds held, as well as potentially higher costs of funding for the banks in these challenging times.

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