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 client’s 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.

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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.