Junk defence

Well that escalated quickly!  2018 has been a torrid year for most financial assets as they try to adjust to the last decade’s dominant monetary policy regime – Quantitative Easing – reversing direction towards a more “normal” setting.  From the usual suspects of emerging markets and equities, right through to the traditionally more staid investment grade credit and government bond markets, 2018 has set records for being uniquely bad for capital markets.  According to recent research by Deutsche Bank, some 89% of asset classes had posted negative Year-To-Date returns (in USD terms) to the end of October – the highest proportion ever recorded, stretching back to 1901.

To the surprise of many, one area which has performed remarkably well has been the high yield market.  This would seem at odds with most people’s perception of the asset class; with its fixed income and equity-like characteristics coupled with increased market volatility looking like a recipe for disaster in the current climate.  This is not to say that the asset class has not become ‘cheaper’ in the turmoil; indeed the yield on the global high yield index has increased from 5.25% at the start of 2018, to around 6.6% at the end of October.

What has allowed high yield to stay in the black is the often overlooked, and enduring power of carry.  Whilst an equity’s valuation is dominated by the net-present-value of far-off (and often theoretical) cash flows; high yield takes a more certain view of equity-like returns and insists on cash up front via high, contracted, semi-annual coupons.  Similarly, lower yielding fixed income instruments (in government and investment grade markets) have levels of carry often unable to fully compensate for the capital swings that changes in the underlying rate environment entail.  The high yield carry allows the asset class to adjust more quickly to changes in the yield environment, a process further assisted by its relatively low duration of around four years.

High yield is often described as halfway between traditional bond and equity risk, with the negatives of each often emphasised.  In times like the present however, with an uncertain interest rate outlook, low defaults, and moderate but increasing inflation, it offer investors a little of the best of both and we would urge investors to take a closer look.

Sign up to receive our weekly BondTalk email

Ball Tampering

Being the token Aussie within Kames multi-national bond team, I need not have feared a lack of commentary from my colleagues on the topic of the Australian Cricket team’s recent ball-tampering scandal. Regrettably, this format does not allow for a full examination of Scottish, Bulgarian, or even Spanish perspectives on the concept of fair-play or the deep traditions of the great game. Anyone wishing to read more about the scandal, I do commend you to have a look at the Aussie press, who are covering it with their renowned sense of understatement and proportion.

Anyway, looking to the future of the Australian team I encountered an alarming statistic; some 35% of all Australian test cricket runs since 2013 have been scored by Steve Smith and David Warner, the captain and vice-captain who have been side-lined for a year as a result of the scandal. Their absence will place a great deal of pressure on their replacements to be sure, but more pertinently, on the rest of the batting order who have often had their own performances bailed out by their erstwhile teammates. Time will tell, but you do not need to be a cricket tragic to realise this will prove a significant challenge.

In much the same way, global asset markets are facing a similar challenge. Our superstar players – The Fed, ECB, BoE, and BoJ – have all indicated that the glut of central bank liquidity, which has carried the global economy and asset prices along, may be coming to an end sooner rather than later, with the ‘sooner’ part coming into sharp relief on the back of improving economic data. Markets will have to learn to get along without the soothing realisation that evermore central bank support will be there to float all asset prices higher, much as the Aussie top order can’t rely on ‘Smithy’ to bail them out with yet another effortless century. Thank goodness. In my view, the reawakening of volatility in bond and equity markets we have seen in 2018 is the result of participants belatedly rediscovering asset valuation on factors other than central bank largess.

Part of our core view for 2018 had been for the return of dispersion as idiosyncratic risk came to the fore, as the beta-driven QE trade dissipated. The volatility should be seen for what it is – a process of adjustment rather than the beginning of the end. This environment demands a closer examination of business models, cash flow, and financial resilience for the companies you invest in. Assets with flimsy intrinsic valuation will find this being examined, often brutally (hello Tesla). For the rest of us, this volatility presents an opportunity to add to positions in those firms that set to benefit from what is, remember, an improving global growth story. In navigating this environment, we are convinced that selecting an active manager who has been consciously avoiding areas where we see QE-driven excess, and identifying the overlooked and more attractive parts of the high yield market is the right thing to do.

Failing that, I am sure I can find some sand-paper.

Sign up to receive our weekly BondTalk email

2018 – a key year for high yield

2018 is shaping up to be a key year for the high yield bond market. In 2017 the market effortlessly shifted from ‘recovery mode’ (following the 2015/16 shale energy crisis) to rallying in conjunction with the global expansion we see around us. As a result, investors will enter 2018 contending with the offsetting influences of tight valuations against improving macroeconomic – and therefore corporate – fundamentals.

How do we see these competing factors playing out in 2018?

We think the big beta-driven moves of 2016 and early 2017 are behind us. We expect to see a modest amount of yield spread tightening in 2018, but overall we think current valuations are both full and justified.

Investors should remember, however, that the vast majority of returns in the high yield asset class accrue from the compounding effect of high levels of income or carry, through time, and not through the rather more eye-catching beta moves of recent periods.

Furthermore, high yield’s negative correlation with government bond markets leads us to conclude that, in the current improving environment, deriving good levels of income without taking material duration or interest rate risk is very attractive for bond investors.


Sign up to receive our weekly BondTalk email

Making Stuff is Hard

The most valuable lessons in high yield investing are usually delivered using a mix of shock, pain and humiliation. A rare exception to this occurred to me a few years ago; however I suspect more recently, similar lessons are visiting Tesla investors, albeit more painfully.

German company Heidelberger Druckmaschinen (HD) is a precision manufacturer of high quality printing presses. In late 2011 it hit a rocky patch where revenues were down, and the high yield market began to seriously worry about its imminent collapse. The timing was lousy. A European high yield market recovering from the Eurozone crisis was in no mood to tolerate any missteps by a CCC rated issuer, and its bonds were duly hammered.

However, taking a closer look, a few things stood out. For one, its lag was entirely predictable as historically orders ALWAYS dipped before the major industry showcase (‘drupa’) which was held every four years, and 2012 was the next one. In addition, there was a view that HD was at the wrong end of the terminal decline of newspapers (what with the internet n’ all), and to make matters worse, Chinese competition was about to take what was left. This nuanced assessment played well to the ‘gut-feel’ view of the world favoured by a certain type of investor. Except it was wrong. HD had actually disposed of its newsprint business many years prior, instead focussing on the growing need for high quality consumer packaging. Chinese threat? Sure, the lower end of the market had been subject to it, however they seemed to struggle to replicate the most advanced presses. Thematic investing is great, but it’s even better when accompanied by some due diligence.

So how does this relate to Tesla? Making ‘stuff’ is hard. The beta version and constant update model of the software industry works well, as their products can be costlessly tweaked after sale. Not unreasonably, software companies are given high valuations based on this high operating leverage. Applying this to the auto industry is more problematic. Tesla is running into problems scaling up production due to the presence of bottlenecks, labour issues, and even difficulty in welding. If this sounds all terribly 19th century, I apologise but it still matters – it is very difficult to sell a car you can’t make. All of this would be manageable except Tesla’s valuation allows for nothing but a non-stop journey to global domination; not a decades-long on-the-job training programme.

Upon visiting HD’s factory I was struck by the huge amount of accumulated skill, knowledge and expertise amongst its many thousands of employees. Not only ‘had’ it accumulated, it was ‘still’ accumulating. I saw first-hand the factory floor work groups that measure absolutely everything and are constantly refining their process to save 12-mins here, reduce 400g of scrap there. To scale up any advanced manufacturing takes this kind of process which simply cannot be replicated – nor should it be dismissed – overnight. Following the visit I invested in HD, confident that it had a significant embedded competitive advantage and that its ability to earn economic profits – and pay our coupon – was intact. I won’t bore you with the details, but it ended very well for the company and the investors who backed it at the time.

Electric cars are certainly the future, but Tesla’s valuation reminds me that the market can sometimes underappreciate the challenges of operating in the physical world, at scale. This can be a great opportunity, as in the case of HD, or it can lead to risks being under-priced by financial markets, as with Tesla’s recent swoon. It’s our job to recognise these factors and it remains a core focus of the way we do things at Kames.

Sign up to receive our weekly BondTalk email

Boring is good

In our experience, some of the best high yield bonds reflect those of us who invest in them; low-key, reliable, and often profoundly boring. The ‘monotony’ of a business that reliably posts juicy but safe cash flows? Sign me up! Some of our fondest positions are in glamorous industries such as cardboard boxes, funeral care, tin can making, and the gel-like casings your headache tablets come in. Glitz and a good story is more often found in the equity market, and that’s the way we like it.

A test to this rule came recently when US electric car maker, Tesla, issued its maiden, conventional high yield bond. Tesla is unquestionably an impressive company. Their cars are technological marvels that outperform their peers on almost every metric, and to be sure, our friends in the equity market have certainly not been shy in reflecting such wonder. Tesla’s current share price implies an enterprise value (that is the total value of Tesla’s debt and equity) of some 96x its Earnings Before Interest, Tax, Depreciation and Amortisation.EBITDA is the HY market’s imperfect (but convenient) shorthand for cash flow, and illustrates the cash earnings a firm produces from its assets, stripped of as much accounting chicanery as possible. Now, 96x is a lot. A cynic might suggest that all the good things that have ever or could ever happen to this company are currently ‘in the price’.

By way of reference, BMW is a reasonably well-known car maker that has both a very strong position in conventional premium cars, as well as making significant inroads into electrification of cars via the impressive i3 and i8 models. We would be the first to admit that wherever the auto industry is going, Tesla will be part of it, but so too will BMW. In the meantime, they have a significant and highly profitable conventional car business, as well as decades of embedded know-how in the sector and a cash flow profile that can support significant investment in research and development.

Conveniently, BMW ($61 billion) and Tesla ($60.7b) have almost identical equity market valuations. However in terms of cash flow and scale, they are worlds apart. Last year Tesla produced just over 76,000 vehicles to BMW’s 2,360,000; a factor of some 31:1. Cash flow is where the real difference lies however. BMW’s cash flow is such that the company is valued by the market at only 7.5x the EBITDA it can produce today versus the 96x at Tesla. Clearly, the market believes Tesla ‘should’ grow significantly in the future.

Given Tesla’s ambition currently far exceeds its cash flow, it has turned to the high yield market to plug the gap between what it needs to spend to grow into its valuation, and what it can generate currently. For us, this is the antithesis of what a high yield bond is for. By investing in Tesla bonds you are providing growth equity capital with all the potential downside that entails, but with the upside profile of, well, a bond. Regardless of our admiration for Tesla, we don’t like that risk reward profile and we declined to buy the new deal. We prefer businesses that ‘do’ rather than ‘should’ produce the cash flow we need to pay our coupons and principal back. In the good times it can be easy to have one’s head turned by new and dynamic companies; however at Kames we don’t believe that our clients’ interests are served by such an approach, when indeed the opposite is usually far more rewarding for bondholders. If that makes our presentations a little less electric then so be it.

Sign up to receive our weekly BondTalk email

Carry me home – the source of high yield returns

To say the past decade has been an eventful one for the high yield market is putting it somewhat mildly. The first half of 2007 was a golden time: markets were in rude health making pre-crisis highs, politicians were for the most part sane, competent, normal human beings, and a eurozone crisis involved accidentally skiing to a Swiss après-ski bar. The following decade has not been quite as smooth, enduring as we have the global financial (2008/9), eurozone (2011), and energy and commodity crises (2014/15) of recent years.

Yes – those were happy days indeed, but with the benefit of hindsight, a seemingly terrible time to buy any risk asset. Within high yield, valuations in 2007 were at their most extreme with the additional yield on offer from high yield bonds (versus similar maturity government bonds) at its all-time low of 2.3%, versus around 4% today.

Taking a closer look at how the asset class has actually performed from this ‘terrible’ entry point illustrates much about the source of returns within high yield.

Global High Yield: 10-year returns

Source: BoAML Global High Yield Index, Bloomberg.  USD. 31/03/2007 to 31/03/2017.

A few things stand out. First is the impressive total return of 110%. To be sure, there were some hugely volatile periods, none more so than the dramatic – albeit brief – near 40% drawdown in early 2009, as well as of course 2011 and 2015. These periods can have a big impact on the short-term price performance of the asset class. But in the context of long-term total returns, we can see that price volatility is dwarfed by one, compelling source of return – carry.

Of the 110% you have made in high yield over the past decade, some 112% of it came from income, and recall that this was from a ‘terrible’ time to buy!

The key to exploiting the carry in high yield is to stay invested – sorry, no carry for day traders – and adopt an active approach to selecting the companies you wish to lend to. Remember, high yield is at its core a mechanism for transforming the real-world cash flows of cash generative companies into coupon flow for investors who provide debt financing. Given we have long known this about the high yield market, it is why we emphasise these very cash flows when selecting companies to invest in.

Perhaps it is asking too much for financial journalists to lead with ‘Massive Coupon Income Hits HY Market’; but we do think investors should keep this in mind when they next read about the ever-present impending doom of the high yield market.