Salomon bullish on EU corporate credits, says act now

By Ronda Fears

Nashville, Tenn., April 12 - Schroder Salomon Smith Barney credit analysts in Europe are very bullish on EU corporate bonds and in a new report suggest now is the time to act. Indeed, the analysts suggest this is the best time in six months to go long corporate bonds.

"The strategic case for being long corporate bonds is stronger now than at any time in the past six months. Corporate bond markets have only started to price in the recovery of global economic growth and we think that the consensus view on growth is still too low," the credit analysts said in the report.

Salomon economists forecast that first quarter gross domestic product in the EU will be up by an eye-popping 5.2% quarter-on-quarter, the report noted. Stabilization in the labor market, a rise in core durable goods orders and early signs of a profit recovery suggest growth will be sustained in the rest of the year.

The analysts recommend investors raise exposure to BBB and cut allocation to AA credits. Corporate bond spreads tightened slightly in first quarter, the analysts said, but spreads remain cheap on a long-term basis. Economic growth is likely to surprise on the upside in second quarter, he said, adding he believes the trough of the credit cycle has passed.

In general, the analysts said stay very long industrials but take some profit on autos, rely mainly on bond selection to make money in paper, building materials and consumer goods, and keep shorting telecom equipment manufacturers but stay long - albeit only marginally - on telecoms.

Specifically, the analysts recommend selling Unilever to buy Coca-Cola Hellenic Bottling Co. to move slightly down in credit quality in the sector and pick up spread.

In autos, they say sell Ford to buy General Motors and DaimlerChrysler, and add Continental AG.

"We reduce exposure to Ford although we remain long the name because we believe that at current spread levels Ford has less scope to outperform the sector than DaimlerChrysler and General Motors," the analysts said.

"We move some of the money into Continental. The company will soon start to reap the benefits of a restructuring plan and the pricing environment for tires is firming. We think that spreads do not properly discount these positive factors."

Sell British American Tobacco and Gallaher to buy Imperial Tobacco, the analyst said.

"Imperial Tobacco trades cheap because of the recent acquisition of Reemtsma, which caused a rating downgrade and is expected to lead to a new large bond issue," the analysts said.

"However, once the bond issue is out of the way, we think that the bond will outperform the rest of the tobacco sector.

In chemicals, they recommend selling Solvay and buying Syngenta to move slightly lower in credit and pick up spread, while also upping exposure to a more attractive area of the chemicals business.

Among telecom equipment makers, the analysts highlighted the recommendation to underweight Alcatel and Ericsson.

In telecoms, they suggest selling Vodafone and recommend Royal KPN, Telecom Italia, mmO2 and WorldCom with a couple of caveats.

Switch out of the Royal KPN bonds due 2005 into the KPN bonds due 2006, the analysts said, to pick up 45 basis points of yield.

"We remove Vodafone from our model portfolio not because we do not like the credit, but because the bonds are expensive," the analysts said.

"We believe that WorldCom is a high BBB credit with stable outlook, yet the credit is priced at BB levels. We think that current pricing is an overreaction to the announced SEC investigation and that as soon as the situation clarifies the bonds will perform strongly."

For mmO2, the analysts said credit risks are skewed on the positive side. The analysts said mmO2 may not increase its debt as quickly as the market is discounting and in the next 24 months it could be an acquisition target.

"Economic growth is good for credit quality. We stick to the view that 2001 marked the trough of the global credit quality cycle," the analysts said.

But, they added, "Don't wait for credit quality indicators to improve. SSSB corporate analysts believe it could be a long time before rating upgrades start to exceed rating downgrades. For 2002, SSSB analysts forecast that the average credit quality of non-financial corporate borrowers in the EuroBIG index will decline further."

Standard & Poor's credit analyst also think the declining credit quality in the EU will peak in second quarter before getting better. (See related story in this issue)

Thus, the Salomon credit analysts say act now.

"Our research indicates that spreads start to rally once the credit quality cycle has passed the trough. Spreads usually post some of their largest performances in the year past the trough in the credit quality cycle," the analysts said.

"Given the strong contemporaneous relationship between the credit cycle and the economy, these tend to be in the early stages of an economic recovery."

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