The debt market reaction to the biggest takeover bid in the telecommunications sector since the technology bubble burst in 2000 has on the face of it been subdued – but a more detailed look tells a different story.

Telefónica launched its £17.7bn cash takeover for O2, the UK mobile operator, at the beginning of last week. But the market in credit default swaps, which because of their liquidity are now the benchmark for gauging investor sentiment, has shown little reaction.

The big operators such as France Telecom, Deutsche Telekom and Telecom Italia are trading 1-2 basis points wider, which implies the cost of buying default protection has risen about 3 per cent.

That scarcely suggests what some investors labelled a “pivotal” moment of change for the sector.

Even Telefónica itself is trading about 5 basis points wider than before the bid was launched.

But considering at least one rating agency will have downgraded the company by two notches by the time the deal is completed, the reaction has hardly been dramatic.

Reasons for the absence of a sell-off include the fact that the market had already priced in a rising risk of takeovers and that the companies generate sufficient cash flows to handle an increase in overall debt
levels.

But the situation is different in other parts of the market. The telecoms yield curve, or the gap between their short- and long-dated bonds, is at its steepest since a spate of 30-year bonds were issued by the telecoms companies in 2003.

In March, investors demanded a premium of 22-24 basis points for buying the 2033 euro bonds of France Telecom, Deutsche Telekom and Telecom Italia rather than the 2013 bonds.

That premium has now almost trebled to 64bp for the French and German operators and quadrupled to 87bp in Telecom Italia’s case.

The curve steepening is not solely due to investors taking a more downbeat view of the telecoms sector: rising government bond yields and the emergence of hybrid bonds, which have ultra-long or perpetual maturities, have had an impact on demand for existing long-dated corporate bonds.

But the telecoms yield curves have steepened a lot more than other sectors, such as utilities.

CDS and short-dated bond prices have been stable because operators are expected to continue to generate strong cash flows in the next few years, leaving short-term risks relatively low.

But the last two weeks have unveiled a marked shift in the companies’ financial policies, which is why many investors are reducing their exposure at the long end of the yield curve.

When Telefónica an-nounced its takeover bid, Anja King, telecoms credit strategist at CreditSights, said: “A single A-rated European telecoms operator seems to have finally acknowledged that a more aggressive financial policy and efficient capital structure is necessary to drive profitable growth and shareholder value.”

Deutsche Telekom said this week that it would increase capital expenditure by €1.2bn to “develop a more aggressive market approach”.

“In the telecoms sector this was probably as good as it got. It was everyone’s favourite sector for a long time. They were the first to deleverage and are probably going to be the first to releverage,” said Raphael Robelin, portfolio manager at BlueBay Asset Management.

Vivek Tawaday, credit portfolio strategist at BNP Paribas, summed up market sentiment, saying: “After almost three years we have gone to a moderate underweight on telecoms due to a significant increase in idiosyncratic risk, coupled with supply coming to the market in the medium term.”

Much of the supply will come from Telefónica as it refinances the €27.2bn it has borrowed from Citigroup, Goldman Sachs and RBS to buy O2.

Telefónica could bring about €10bn in new deals to the corporate bond market next year, with deals in different maturities and currencies. The company has ruled out an equity issue, which has left the bond market also expecting an equity-like hybrid bond.

Mr Robelin said: “We would prefer to take part in the primary market on an opportunistic basis. If Telefónica is coming with a huge issue, it is going to have to pay up. That will suddenly make its peers look expensive.”

“Spreads are not going to fall off a cliff, but it is hard to see what’s going to take them tighter.”

Excess returns in the telecoms sector have outperformed the wider corporate index every year since 2001 and they were ahead of the index through the first nine months of this year, according to data from Merrill Lynch.

But after a negative return of 0.38 per cent in October, the sector is now slightly behind the corporate index on the year.

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