Bond activity after the American election

Bond activity after the American election

Trump’s victory in November led up to sudden changes in financial markets. Firstly, the fiscal spending he promised has led to higher commodities price as the US government will ask for more commodities to build more facilities. The future tax reduction under Trump’s administration results in repatriation of dollars that strengthens the US currency. The trade tariffs that Trump wants to implement with US commercial partners will have a negative impact on exports of some emerging countries including China and Mexico. Above all, this fiscal stimulus will create inflation that the FED is trying to control by hiking its targeted interest rate from 0.5% to 0.75% knowing that higher interest rates causes lower bond prices. Since the US election in November roughly $3trn have moved from bond markets to stock markets[1].

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Two of the most important factors hurting bond prices right now are then the fact that inflation is picking up in most places and thus major central banks have stopped trying to lower interest rates.

To have a deep understanding of bond activity after American election, one should analyze accurately the FED policy since the election. Indeed, the FED has the power to change interest rates that are largely determining bond prices. Since the election, we have noted that expected inflation is going to be higher than its current level for several reasons. First, Trump’s fiscal and budgetary policies are simulative policies that aims to revitalize the US economy. Moreover, wages are going up in America[2] and that means that people getting jobs in December are more likely to spend money in the following months. This expected high inflation leads the FED to hike its targeted rate in December in order to maintain inflation at the target level of 2%. In a nutshell, the expected high inflation in the following months gave rise to the decision of the FED to hike interest rates. This increase of interest rates led the American bond market to collapse after American election.

Trump has reached the goal of FED: steepen the yield curve which makes banks more willing to lend money, injecting directly real economy. Regarding figure, it should be noted that on the 10-year Treasury bond jumped from 1.73% to 2.36% and reached a peak of 2.60%; the yield on the 2-year bond rose from 0.78% to 1.12% and the 30-year yield curve accounted the steeper curve and the largest changes from 2.56% to a peak of 3.19% in December.

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Source: CNBC – Real Time Quote | Exchange

The 3 most common drivers of decreasing bond prices and increasing yields are faster growth, higher inflation and rising short-term rates because government bonds embed the risk premium of the issuer and expected inflation. Firstly, the rationale behind the shift is the belief that fiscal stimulus will boost economy through tax cuts and infrastructure spending. Consequently, not only the Federal Reserve will be allowed to return monetary policy to more normal levels by pushing up rates by a quarter point on December 14th, but also inflation is expected to raise in the medium term.

“It is something fundamental that has changed”, says Richard Turnill, Global Chief Investment Strategist at BlackRock, “important shifts around real growth, around inflation, around policy all suggest that the move in bond yields we are seeing now can be sustained. I believe we have seen the lower point for yields.” Nevertheless, there is uncertainty on how much of Trump’s program will be implemented, on whether economy will grow due to the president’s aim of pursuing a protectionist agenda and on inflation rebound.

In previous rising rate periods, corporate bonds have tended to outperform government bonds because it has been a combination of a positive return for equities as well since the spread compression and additional interest received from owning corporates can help to provide a return buffer in a portfolio. Under Trump’s presidency, US corporate credit sector should benefit from growth opportunity in a more business-friendly environment and a positive supply-demand dynamic.

The Trump’s tax reform and the interest rate rise in December by the Federal Reserve have positively affected investors’ expectations on faster economic growth and on implementation of a deregulatory regime. According to a report from Financial Times (FT), 11 companies and banks sold a record amount of $19.9 billion in debt in the US on the first trading day of 2017.

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“Expectations around fiscal spending and loan demand, lower taxes, and lighter touch regulation have coupled with actual fundamental improvement to drive the space,” said John Moran, banking analyst at Macquarie. Nevertheless, the uncertainty and concern over Trump’s program has led many companies to postpone their bond issuance in the second quarter if they use their financial statement or delay until the second semester of 2017. Nevertheless, blue-chip high-grade Microsoft, AT&T and Apple raised a total $ 37bn in the first week on February.

Corporate tax reform could play a crucial role, not only in the form of lower rates, but also to the effect on technology and pharmaceutical companies holding sizeable cash balances offshore. This accumulation of cash outside of the US has coincided with high debt issuance from both sectors. Apple has over $ 200bn of cash, yet borrowed around $ 20bn in 2016 and $ 10bn in 2017 to buy back stock and pay higher dividends, if they pay a one-time tax of 8% to 15% then they can bring this money back to the US.

According to Matt Brill, portfolio manager at Invesco Core Plus Bond Fund, technology giants like Cisco (CSCO) , Oracle (ORCL) , as well several big pharma companies, will borrow less in 2017 compared to 2016, if Trump’s tax reforms are enacted. Moreover, he estimates investment-grade bond supply could be reduced from $1.3tn in 2016 to between $1.1tn and $1.2tn in 2017.

Furthermore, 2016 has been the year which has highlighted the political risk also for bond investors in developed countries. After a long period of predictable policies, the rise of Western extremist politicians brings the risk of extreme outcomes with uncertainty of consequences. On one hand, the Brexit vote caused yields decrease, on the other hand, Trump’s election caused was followed by an increase. Consequently, government bond investors may be more aware that most long-dated bonds annual returns are no more secure as they used to be.

Authors:

Ghali Bensouda | Co-Head of Financial Markets Department
Giulia Maccelli | Associate of Financial Markets Department

[1] Blooomberg Finance LP, DB Global Markets Research

[2] https://www.bloomberg.com/news/articles/2016-12-02/america-s-labor-market-gets-tighter-with-wage-drop-seen-as-blip

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The Power of Sight: Essilor Luxottica Merger

The Power of Sight: Essilor Luxottica Merger

Companies Overview

Luxottica:

Global leading Italian Company in design, production and distribution of high-technical quality fashion, luxury, sport and performance eyewear with a brand-names portfolio consisting of Ray-Ban, Oakley, Vogue Eyewear, Persol, Oliver Peoples e Alain Mikli. It also includes prestigious licenses as well as brand like Giorgio Armani, Burberry, Bulgari, Chanel, Dolce&Gabbana, Michael Kors, Prada, Ralph Lauren, Tiffany & Co., Versace and Valentino. The firm was founded in 1961 by the current Chairman Leonardo Del Vecchio in Agordo (VE), Italy. It nowadays employs more than 75.000 people and is headquartered in Milano. Currently Delfin S.a.r.l., controlled by Del Vecchio family, acts as a holding company with a 61.9% stake, having no common managing interest with the subsidiary from an operational perspective.

The business model adopted covers every step of the value-chain production: design, development, production, logistics and distribution. This allowed Luxottica to operate as manufacturer and retailer in more than 150 countries, through more than 7.400 shops. The Company went public on NYSE on 1990 and is publicly listed on FTSE MIB index on the Italian Borsa di Milano since 2000. Luxottica has recently been rumoured about the acquisition of the Brazilian optical franchisor Ótica Carol, which was established in 1997 with approximately 950 locations. The transaction is valued at €110m and remains subject to customary regulatory approvals.

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Essilor:

Headquartered in Charenton-le-Pont, France, Essilor is a leading producer of optical lenses and is led by the French-Canadian chairman and chief executive Hubert Sagnierès. The Firm’s expertise is in the field of designing, manufacturing and distributing ophthalmic lenses and equipment for eye care professionals.While owning different brands such as Varilux, Crizal, Eyezen, Xperio, Transitions, Bolon, Foster Grant and Costa, the Firm distributes its products in more than 100 Countries, through 490 prescription laboratories and 16 distribution centres.

The 90.4% stake of the Company is publicly listed on the Euronext Paris Stock Exchange and is a component of the Euro Stoxx 50 share index. The remaining 9.6% are split within employees, partners and treasury shares. The major shareholders are Harbor Capital Advisors Inc (3.76%), Vanguard Group Inc (1.95%) and BlackRock Fund Advisors (1.13%). Founded in 1972 after the merger of Essel and Silor, the company became the third-largest ophthalmic optical firm in the world. Essel was founded in 1849 in Paris, while Silor started under the name Lissac in 1931 as a retailer of ophthalmic lenses. The Company now employs 61,000 workers worldwide, and it launched more than 250 products in 2015. It also claims to invest €200mln in research and innovation every year.

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Industry Overview

The global eyewear market can be split into contact lenses and spectacles. Further, the spectacles market can be sub-segmented into: spectacle frames, spectacle lenses, and sunglasses. There are different challenges and entry barriers that make this industry hard to penetrate as well as extremely competitive. The last year dynamics are making the eyewear sector an “optimistic” sector, with a compound annual growth rate of 2.5 per cent forecast for 2015 to 2020, according to May Ling Tham, head of personal accessories and eyewear research at Euromonitor.

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Source: Financial Times

The challenges that are increasing the pressure on the $90bln global industry are strictly related to the convergence point of fashion and health trends. This creates a synergy between the ophthalmic lenses and the fashionable eyewear sector, making the demand increase. The key forces which are driving the industry growth are the rising ageing population, the high potential of vision correction, the urbanization process, the under penetration of eyesight correction and the increasing technical and innovation demand in developed markets. 63% of the 7.3bln people are considered to be in need of vision correction, but only 1.9bln can afford it. More than 2.5bln live in Asia, Africa and Latin America. The areas in which demand ramps up are mostly located in Asian markets, where consumers buy most of the products via online channels. The industry is also carving out a niche in the luxury products sector, thanks to the celebrities promotion, who made sunglasses a “must-have”.

Deal drivers: 

The deal intention is to create a company that can produce eyewear in a large scale (lenses and frames) and sell them worldwide. Therefore, EssilorLuxottica would hold a competitive advantage through a comprehensive offering combining a strong brand portfolio, global distribution capabilities and complementary expertise in ophthalmic lenses, prescription frames and sunglasses. Potential revenue and cost synergies between €400mln and €600mln are expected. The combined entity would utilize widespread distribution networks and production capabilities. Through its 32 manufacturing facilities and 16 distribution centers, Essilor will leverage its operating capacity as it moves down in the value chain with an access to Luxottica’s 7.800 retail stores and 10 retail brands. In addition, Essilor will have an access to over 150 countries compared to the 100 pre-merger.

Beyond the production capacity, Essilor will be tied to some of the most valuable brands in the eyewear industry. Also, the Italian frames & sunglasses maker is an established innovative company (top 100 in Forbes’ ranking of the world’s most innovative companies), launching over 2.000 new eyewear styles a year.

Beyond the economics of the deal, succession considerations may have been a key factor for Luxottica’s main shareholder, Delfin. Mr Del Vecchio, Italia’s second richest man (net worth of €20bln) may indeed be implementing succession plans to secure the company’s future. Hence, the all-stock deal shows that the 81 years old founder believes in the upside of the merger, as well as in the management of Essilor. In addition, Luxottica suffered from a massive turnover in its top management, as 90% of its directors jumped ship in the recent years. In a piece published by The Economist (Issue of January 2017), manager painted Del Vecchio’s management style as concentrated, as he “could not foster a strong alternative leader and would not let any of his children become managers”. To overcome such issue, Mr Del Vecchio will be Executive chairman and M. Hubert Sagnières (CEO of Essilor) as Executive Vice-Chairman. Also, the Board of the new entity will be split between the two entities, ensuring a transition of power after M. Del Vecchio’s retirement.

Deal Structure:

On January 15th 2017, Essilor’s Board approved the agreement with the holding company of Leonardo Del Vecchio (Delfin). On the same day, the Board of Luxottica announced that the merger is in the best interest of the company and all its stakeholders. During the calls with the analysts and in various press releases, details of the Merger’s structure where made public and analysed. However, as the deal is still pending conditions may vary. The deal will be a stock-for-stock merger with an exchange of 0.461 Essilor Shares for 1 Luxottica share. The Italian company’s equity is valued at €22.79bln, based on the previous exchange ratio and on the Essilor share price of €102.1 and 484.16 million Luxottica shares outstanding. Such valuation implies a share price of €47.07 representing a -5.03% discount on the price of the day previous to the announcement (€49.56). On the day after the announcement price rose to €53.20, an 11.53% premium on the valuation. Together with the aforementioned equity Luxottica also has €1.13bln of net debt generating a total enterprise value of €23.92bln. Essilor has 218.51 million shares outstanding with market cap of €22.31bln at the initial price. After the announcement, the share price rose by 12.2% to €114.56 by 14:05 GMT of January 16 2017. With a net debt of €2.36bln, the French company had a pre-announcement enterprise value of €24.67bln. The new entity should thus have a combined enterprise value of about €48.6bln. As of the early announcements, newly issued Essilor shares will provide financing of the deal.

Throughout the transaction, with the values provided above, Delfin, majority shareholder of Luxottica, will exchange 62% of its shares retaining majority position in the combined entity. The holding of the Del Vecchio family, indeed, should keep a position of about 38% of the new entity. Most probably, EssilorLuxottica will become a holding company retaining control of Essilor International and Luxottica. Post-merger, the company will remain listed on the Paris stock exchange and becoming its 8th biggest company by market cap. Leonardo Del Vecchio will remain Executive Chairman and Chief Executive for the following years sharing managerial duties with Hubert Sagnières who would become Vice-Chairman and Deputy CEO. EssilorLuxottica’s Board will be made up of sixteen members of whom eight nominated by Essilor and eight by Delfin. The closing is expected in the second half of 2017 and should not face any regulatory constraint.

Advisors:

Essilor was advised by Rothschild’s and Citi’s investment banking teams (respectively ranked 1st and 6th in French M&A advisory), while Luxottica was advised by Mediobanca’s team (ranked 1st in Italian M&A advisory). Tax, corporate & competition due diligence are conducted by Cleary Gottlieb Steen & Hamilton LLP on behalf of Essilor, while Luxottica is advised by BonelliErede and Bredin Prat law firms.

 

Authors:

Guglielmo De Martino
Imad El Ahdi
Filippo Zanini