Analysts are recommending that investors protect themselves from possible ratings downgrades in the European telco sector by shifting into step-up coupon bonds. Rick Deutsch, head of European high-grade credit research at BNP Paribas in London, recommends that investors in France Telecom (Baa1/BBB+) and Deutsche Telekom (A3/A-) switch to step-up issues. Both companies are under ratings pressure and Deutsch says that even though 35 to 50 basis points spreads between step-up bonds and plain vanilla bonds are wide, the market tends to undervalue step-ups. Depending on investors' credit view, the step-ups offer value, he argues.
To wit, Jamie Stuttard, London-based portfolio manager at Dresdner RCM Global Investors, says he will only add new issues from France Telecom, if they feature a coupon step-up, because he fears a downgrade. France Telecom's 5.75% of '04 step-up bond, which has outperformed the company's 7.875% of '03 and 4.8% of '05 by about 65 to 75 basis points on a total return basis since Moody's Investors Service and Standard & Poor's put the credit on watch on Sept. 6, says Deutsch.
Simon Surtees, a telco analyst at Bear Stearns in London, says he would definitely opt for the step-ups over the plain vanillas, which are too expensive. "The step-ups are definitely not adequately reflected in the market," he notes. As of last Wednesday, France Telecom's 6.75% of '08, which features a step-up was trading at 155 over swaps, while the company's 6.625% of '10 plain vanilla bond, was at 119 over. Deutsche Telekom's 5.25% of '08, its only bond without the step-up, was trading at 65 over swaps, whereas the 5.75% of '06 was at 115 over. Surtees does not anticipate France Telecom going much below triple-B, while he considers Deutsche Telekom to be more vulnerable to downgrades.
Not all investors are rushing out to buy bonds with step-up coupons. "The last thing you want is to have the coupon ratcheted up on a company that's struggling," says Margo Cook, portfolio manager at BNY Asset Management in New York.