By Octo AM

The FED thus cut rates by 50 basis points this week, as market prices had more or less anticipated. For our part, we had no particular expectations on this subject, since the variables in this decision were :

• Extremely volatile, since U.S. economic data is highly heterogeneous and systematically revised the following month.
• For some, outside the realm of pure financial and monetary analysis, the subject of electoral deadlines and the dialectic between the potential future government and the FED could also come into play.

What’s more, what’s the point of trying to speculate in recent weeks on an already very strong market expectation on which there would have been so little to gain?
Indeed, for several weeks now, the markets have been buying into the bond market on a massive scale, as evidenced by the sharp drop in US and European yields (see graph 1), anticipating 2 to 3 yield cuts by the end of the year and 6 to 7 by the end of 2025, as well as a flat yield curve over the next year and key rates of 2% and 3% in the USA (see graph 2).

Graph 1: German and US 10-year yields in 2024

(Sources: Bloomberg, Octo AM)

Graph 2: Summer trends in FED & ECB rate cut expectations

(Sources: Bloomberg, Octo AM)

Speculating in this scenario and continuing to position oneself in the direction of this week’s rate cut would have been tantamount to considering that the markets were too cautious and that the FED, or the ECB since the principle is fairly comparable, would cut its key rates even more aggressively…

Indeed, let’s remember here that since the markets anticipate the future through the principle of discounting, buying or selling an asset systematically amounts to taking a gamble against the market. Thus, buying long sovereign bonds from “core” countries over the past two weeks was tantamount to thinking that the markets were not anticipating enough key rate cuts, and vice versa for a position in shorter bonds, or even money-market bonds, or “short” positions in the fixed-income market.

Let’s not forget that for the past two years, markets have been anticipating too many rate cuts by central banks, for three reasons:

• Institutional purchases linked more to accounting and regulatory issues than to profitability
• Investors seek security in a volatile environment
• Bond yields still high compared with other asset classes
• Recurring biases such as fear of missing out (FOMO), optimism bias and the memory effect of last decade’s very low interest rates.

Thus, between the lack of profitability of long investments compared to short investments and the significantly higher potential volatility, we did not wish to join this generalized movement and even took advantage of it to shorten our portfolios, fearing that the adage “buy the rumor and sell the news” would be repeated once again, as most speculative positions are taken through derivatives with immediate liquidity and extremely rapid flows…

And it looks as though this could be the case when we look at the levels of US and European long-rate futures since each central bank’s decision, as shown in the graph below.

Graph 3: 10-year German Bund since the beginning of September 2024

(Sources: Bloomberg, Octo AM)

In short, we consider that this week’s cut in key rates was already priced in, creating an inverted curve, and that there is no urgent need to massively reallocate positions to lengthen portfolios at the moment – quite the contrary. What’s more, the rally in high-yield credit spreads and equities, which are closely linked to each other, does not seem to us to be enough to urge investors to increase their holdings of risky assets.

On the subject of risky assets, last week we mentioned Ubisoft, a company about which we prefer to warn against investing in bonds. Without offering detailed analyses here, this week we’ll be warning about two issuers: Worldline and Elis.

On Worldline: we might be tempted, simply to make our comments as clear as possible for our readers and without anyone seeing this as a bad omen of any kind, to compare this issuer with Atos and/or Adler. The former for its poor choices and errant strategy, the latter for the massive increase in debt in just a few years for increasingly unprofitable projects, both of which we have already commented on extensively and on which recent events have proved us right.

• Debt growing much faster than sales
• Capitalization divided by 13 from its 2020 highs and by 2 since 2016, when the company had no debt and nearly 4 times less sales
• Intangible assets representing 90% of the company’s long-term assets, including goodwill (i.e. nothing concrete, especially in a company whose results and balance sheets are steadily deteriorating) representing 70% of long-term assets. Bear in mind that, in the event of stress and natural depreciation of this goodwill, the Group’s leverage could quickly become untenable.
• High volatility of cash flows over time, even though the business is not particularly cyclical
• Unreliable management forecasts and frequent downward revisions of results and balance sheet quality
• Weak and volatile governance
• Bonds that are still BBB- with a 4.5% yield to 2028, which doesn’t seem right to us, either in terms of rating or yield.
• The beginning of a yield curve inversion, showing stress on the issuer’s liquidity and/or a marked difference in perception between investors in unrated 2025 and 2026 convertible bonds offering 6.5% and those in conventional 2027 and 2028 bonds, rated BBB- (and therefore eligible in many portfolios and indices) offering only 4%… This hiatus is unlikely to last, and no doubt a rating downgrade or a realization on the part of some investors in conventional strains could cause these bonds to plunge.

On Elis: let’s recall here that the company is currently of good quality and reliable. However, a few days ago it announced the possible acquisition of a competitor that would double the size of the company. If, as a shareholder, the operation may be attractive, the same cannot be said of a creditor, as the latter :

1. No control over the structuring of the operation
2. Could move from an investment in a BBB- company with a conservative risk profile to a company with significant debt and substantial merger operating risk, given the size of the target.

Elis has already carried out relatively aggressive LBOs in the past, which have benefited the company and its shareholders and management. After a few years of caution, particularly post-Covid (Elis operates in industrial laundry and its customers include hotels, restaurants and local authorities), they may be tempted to embark on a more aggressive growth operation. The following chart shows the evolution of Elis’ rating over the long term, demonstrating that the company was more often rated “high yield” than investment grade, benefiting from a business with low cyclicality and profitable economies of scale.

So, while we have no doubts about the quality of the management, the probable coherence of the operation and our confidence in a company that has always been rather reliable for its creditors (which we no longer are), the current yield on this company’s bonds of 3.7% over 6 years and 3.4% over 4 years does not seem to us to sufficiently remunerate the uncertainty of this possible increase in leverage and operational risk, and we prefer companies with higher yields and in the process of deleveraging, having already made acquisitions and increased their leverage. This is more conducive to the performance of our creditors.