Shaping a global return profile

The nice thing about a global, high conviction approach is the ability to take advantage of interesting market dislocations. While high yield is certainly an idiosyncratic, stock selection-focused asset class, our global opportunity set helps frame our hunting ground. For example, US BBs are trading almost 100bps wider than European BBs – a reversal of the two-year trend of European BBs offering wider spreads than their American counterparts. For BBs, the US looks like the most interesting place to go.

Source: Bloomberg: ICE Bank of America Merrill Lynch

In single-Bs, the indices are on top of each other in spread terms, despite a long period of wider single-B spreads in Europe. Here we can be agnostic, and an interesting difference between US dollar and European high yield means that we can look for opportunities in different shapes of returns.

US high yield comes with higher coupons, meaning greater cash price stability, price upside potential past par and greater carry from holding a position. Meanwhile, European high yield has typically offered lower coupons. While you have less upside potential past par, a bond’s cash price can fall sharply on spread moves that would affect higher coupon bonds less. So why buy those bonds? Your shape of return is different. If you expect a sharp recovery in an issuer’s bond price after an indiscriminate sell-off, the lower cash price bond will likely outperform over the short-term. An interesting example of this in the period was Ball’s euro 1.5% 2027s versus their US dollar 4.875% 2026s. Ignoring currency effects for simplicity, from the lows to the end of March, the euro 1.5% coupon bonds have outperformed the higher coupon dollar bonds by 8.6%. But, over the longer term, the lower price volatility and greater carry has made the US dollar bond a better investment.

So if you only bought one, you may just own the US dollar bond. But what if you can have both? Adient is a seat supplier to the automotive industry and has its challenges, but we believe it is an interesting company and a good case study for the power of global. Adient’s euro 3.5% 2024s have rallied sharply from their lows of ~62, and are now trading just shy of 80. Last month, the company brought a new, US dollar first lien secured 2025 bond with an attractive 9% coupon.  We can now have exposure to Adient through both high capital price upside potential euro bonds, as well as greater downside protected and attractive carry offering, secured US dollar bonds. By blending these two shapes of return together, and across different parts of the capital structure, we hope to achieve superior risk-adjusted performance versus just owning one of these bonds.

By flexing the global opportunity set, we hope to add material incremental value to our funds in ways that are simply not available to single-region portfolios or to funds that are beholden to benchmark weights.

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Debt and assassinations

Julius Caesar was famously assassinated on the Ides of March and Shakespeare further immortalised it in our memories with ‘Beware the Ides of March’. But, this specific day (March 15) was also a deadline for settling debts in Roman times (Caesar paid the ultimate price).

March 15 isn’t far away. Amidst the current Covid-19 induced volatility, will high yield companies be able to settle their debts? What companies are at risk of ‘assassination’ by a slowing global growth backdrop and a refinancing window that can snap shut for highly risky issuers in times of market stress?

Highly risky companies with debt maturing in the next 12-18 months will currently be assessing the sustainability of their capital structures. It’s hard to say that global growth was on a very positive trajectory before the virus outbreak intensified, and it’s certainly going to be weaker now. Issuers facing structural headwinds who already had rising debt burdens and shrinking margins will suddenly find their problems accelerating. And with the degree of ‘covenant-lite’ documentation (not just in the loan market) recoveries may be lower in restructuring scenarios as the potential for value leakage has increased.

However, despite the virus volatility, the Ides of March for 2020 are likely to be largely uneventful in terms of unexpected restructurings. Companies have been doing a good job in easy financing conditions at pushing out their maturities; in the Bank of America Merrill Lynch US and Euro CCC-rated and lower indices, there are no debt maturities until March 2021. Looking ahead, the 2021 and 2022 maturity walls start to look a little scarier for those invested in companies just limping along. Of course, maturity walls and turnaround runways are key considerations in our credit analysis.

In our all-maturity high yield strategy, the nearest bond maturity is still more than two years away and that certainly isn’t the riskiest credit we own. We typically target issuers who will clearly be able to exist beyond their next bond maturity. We like stable, free-cash-flow-generative businesses that we are comfortable holding through market volatility. No assassinations expected here.

Meanwhile, passive strategies are lending to the highly risky and the less risky alike. They are, of course, just allocating increasing amounts to the most indebted companies. Beware the (next) Ides of March.

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Avoid the sting in the BB’s tail

It’s often said that valuations in high yield bonds are expensive. Yes, this is true to a certain extent. High quality, defensive companies that are BB-rated (the ‘highest of the high’ in high yield) are indeed trading with very tight spreads. This is partly due to yield-starved investment-grade investors dipping down into high yield, pushing valuations up. It is also partly due to some investors feeling nervous about the global outlook, and therefore seeking solace in higher-rated companies. However, for B-rated companies (the middle rung of the high yield universe) credit spreads are more reasonable versus history.

Of course, by definition B-rated companies have a greater degree of credit risk. But right now it could be argued that BB-rated companies have a greater degree of valuation risk. In European high yield, Barclays have shown that 72% of BB-rated bonds are trading at a price above their next call price. This implies that the prices of these bonds cannot rise much further, if at all. High yield is sometimes described as an asset class that can exhibit ‘negatively convex’ behaviour due to the high degree of callable bonds in the universe. A callable bond that rises too far above its call price will eventually reach the point where the yield turns negative, should the bond be called. Few are willing to purchase a high yield bond with a negative implied yield, and as such, the price of that bond reaches a ceiling of sorts. Therefore, thinking in valuation risk terms, at these valuations BB-rated bonds have a very asymmetric risk profile.

Therein lies the opportunity for active managers. For example, in the US, the percentage of B-rated companies trading below par value is 23.5%; compare this to 7.6% for BB-rated companies. There is still significant capital upside for active managers that are able to invest in the credit improvement stories. However, the credit risk inherent in B-rated companies means that these bonds show a much greater degree of dispersion. As such, selecting the right ‘Bs’ is important. As always, careful, high-quality credit research is essential to avoid dispersion to the downside. But we also wield this bottom-up focused approach to capture the upside in B’s. This approach augments the already attractive carry that an investor earns by allocating to the high yield asset class.

An investment process that focuses on high-conviction stock selection can take advantage of the higher degree of dispersion in Bs. And indeed, given the valuation risk in BB-rated companies when compared with the valuation opportunity in B-rated companies, we are currently tilting our portfolio in favour of the Bs and avoiding the potential sting from complacency over the valuations in BBs. The chart below displays the unusually high degree of dispersion in single-B rated bonds; and the unusually high opportunity set for active managers to capture this.

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The myth of the equity cushion

A margin of safety is a wonderful thing for a company. It could be an unassailable market position, an industry-leading level of competitiveness or similar. As investors, we love margins of safety. It gives us confidence that companies can overcome challenges and therefore confidence to buy or hold onto investments when times are tough. Sometimes, bondholders will blithely say that a large ‘equity cushion’ is a margin of safety. An easy way to think of the equity cushion is how much the equity market loves the company in question. Of the total valuation of the company, how much is equity versus debt? The theory goes that if a company has a significant amount of equity value relative to its debt then bondholders are protected – the equity market will support the company. This is dangerous.

An obvious and topical example of this going wrong is WeWork. The company is notoriously lossmaking and much has already been written about its financial position and business model. But the bull case for bondholders has, in our view, an undue reliance on the massive equity valuation of the company, courtesy of SoftBank’s Vision Fund. While the bonds haven’t traded particularly well over their life, they recently looked like a slam dunk as an IPO loomed. When a company is private and the equity cushion can be quite uncertain, an IPO is the Holy Grail; it provides confirmation of the market valuation and typically comes with a debt reduction kicker. But WeWork’s valuation wasn’t what was hoped – investors balked at the price relative to the real fundamentals of the business. The IPO gave them an initial valuation of almost $50bn, but was soon drastically cut to $10bn. This was still not enough to entice investors, and the IPO was withdrawn – and CEO Adam Neumann was forced out. The equity cushion was vaporised, and so has the supposed bondholder margin of safety.

Source: Bloomberg

It isn’t just ‘new economy’ companies like WeWork that can suffer from the vicissitudes of equity markets. Petrobras is the state-owned Brazilian energy company. They supposedly had two ‘equity cushions’, one from a chunky market capitalisation (in 2013 this was $124bn of equity vs $95bn of debt) and one from the protection of state ownership. But in the energy crisis Petrobras’ market capitalisation was destroyed, so much so that in 2015 it was only $22bn versus $124bn of debt. Equity cushions work for as long as the equity market keeps believing in the story, and as long as the market and sector isn’t in meltdown.

The key message here is that we don’t rely on the benevolence of equity owners as a fundamental part of our investment thesis. We lend to companies that we like, based on our bottom-up analysis, and can clearly persist past their next debt maturity whether equity markets are in meltdown or not. A company that thinks it can rely on the equity market to fund it in extremis may find itself in danger if the equity market loses faith in the story.

Equity cushions exist… until they don’t.

Kames Capital does not hold WeWork


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Can ESG help you spot an impending bankruptcy?

Environmental, social and governance factors are no doubt important considerations when analysing a business. But I expect that many would say that when it comes to a business going bankrupt, that’s all down to the cold, hard numbers. While that may be true, independent of the financial health of a business you can certainly spot red flags that may indicate a business is headed for ruin. Most likely, these warning signs will appear in analysis of the ‘G’ in ‘ESG’: governance.

Over the weekend, Weatherford, the international oil and gas services company, announced that it intends to file for Chapter 11 bankruptcy restructuring. The business had to accept that its debt was unsustainable given its weak financial position. Analysis of the financials could have told you this (Weatherford is painfully free cash flow negative), but management had embarked on a grand turnaround scheme that involved asset sales as part of a road to continued solvency. However, even if we believed that the financial position of the company could have been saved, the company has some glaring red governance flags that meant we wouldn’t invest.

Strong governance hasn’t been a highlight for Weatherford. Its past is littered with examples of poor controls, such as charges for violating trade sanctions and also for corruption. It settled with the SEC for material weaknesses in its tax accounting. The company has also re-domesticated itself a few times, moving its domicile from the US to Bermuda, then to Switzerland, and most recently Ireland.

But there are other governance concerns. At the same time as being under extreme financial pressure, the company continually missed its own guidance and Wall Street’s expectations. With demanding turnaround targets that the business was already missing, and looming insolvency, there’s a very strong incentive to manipulate and obscure earnings. And while I am categorically not suggesting that management are cooking the books, disclosure has been progressively reduced. Weatherford’s product lines (at a very broad level) are only disclosed as percentages of sales, while earnings are only disclosed by Western and Eastern Hemisphere! This is as broad as it gets, and makes it impossible to analyse the profitability of the company’s operations. Disclosure used to be better, and this direction of travel is a serious warning sign.

There’s more. A planned joint venture with Schlumberger was abandoned unexpectedly after management U-turned on it and, at least to my eyes, was abandoned for a poorer outcome. Assets are also being sold, but at the nadir of profitability. Weatherford’s land drilling rigs were agreed to be sold just as day rates are rising – the business participated on the way down as day rates collapsed, but captured little of the upside as they rose. And despite management’s ambitious turnaround plan, they remain net sellers of their own stock, a concerning development.

So while the company fell into restructuring due to its financial woes, its significant governance failings certainly didn’t help. We researched Weatherford in August last year and chose not to invest. These warning signs from an ESG perspective only solidified our view that the business was unsustainable in its current form – and analysing whether it could become sustainable was increasingly difficult thanks to decisions made by management.

The ‘G’ in ESG helped confirm that the business was not on an upward trajectory and that bankruptcy was a very real possibility. Here at Kames we encapsulate ESG in our investment research process and this example demonstrates how we endeavour to minimise the potential for credit rating migration, volatility and default.

Disclaimer: At the time of writing, Kames does not hold bonds issued by Weatherford

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McLaren’s road to success

You may have seen, but for those who haven’t, McLaren recently released their full year results. And good for them, the niche supercar-maker is speeding ahead with ambitious growth plans that are now reflected in their results. Compared to the previous year, car shipments increased 45% to nearly 5,000 in 2018. With an average selling price of well over £200,000 per car, this delivered remarkable revenue growth in the automotive division of 76%.

This growth looks set to continue, with a healthy pipeline of new models approaching the start line – the McLaren Senna GTR production run has already sold out. These new models will help inject even more power into McLaren’s earnings. Their new model, the Speedtail, is set to arrive in 2020 with a price of £1.75m (yes million). And like the Senna GTR, even this has also sold out. Never mind the fact they haven’t even announced the planned successor to the McLaren P1 yet…which will presumably cost even more. This success has driven EBITDA margins in the automotive segment of the business from 10% in 2017 to 22% this year.

In our view, over the next few years, McLaren’s automotive division is on a clear road to success. Some may worry that McLaren is the ‘old’ automotive industry, and that companies like Tesla and electric vehicles in general will position McLaren as a dinosaur. We disagree. McLaren has been using electric technology in its cars for years. The P1 was the world’s first hybrid supercar. The Speedtail will also have a petrol-electric powertrain. McLaren is the sole supplier of high-tech batteries for Formula E. This is a company delivering a niche, highly desirable product at the bleeding edge of engineering innovation. And besides, a car like this isn’t just about getting from A to B, it’s an experience and a trophy asset that the super-rich are clearly happy to pay for.

Here at Kames, the fixed income team seek to lend to businesses, such as McLaren, that demonstrate this solid risk-reward profile.

Disclaimer: Kames Capital holds bonds from McLaren within some of its fund portfolios

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The race to the top, but to win what?

Bain & Company recently released their 2019 Global Private Equity Report and within it I found some interesting data points. In particular, the below chart jumped out at me.

What do you anticipate to be the biggest challenges for PE dealmakers in 2018?

Source:Crystal Ball Report 2018, PitchBook Date, Inc

This is the output of a survey of private equity firms at the beginning of 2018*. According to this, the greatest challenge Private Equity (PE) firms believe they are facing is high transaction multiples (i.e. they have to pay more to buy a business), and the second largest challenge is sourcing quality assets. Third is the degree of competition.

So what does this tell us? It tells us that PE firms are having to pay a lot to buy assets, that aren’t necessarily of the highest quality, and that intense competition is making the problem worse.

Competition in private equity isn’t like competition between your local supermarkets – there’s no race to the bottom. The race to buy a business can be an auction process that instead results in a race to the top. The winner, when private equity firms are competing to buy a business, is the one who is willing to pay the highest price. To be able to pay the highest price, the PE firm needs to have access to a significant amount of capital to put to work, or to be able to refinance transactions with forever-higher leverage metrics.

And yet, what does the survey say is of least concern to private equity players? Access to financing.

While PE firms put up some of their own capital to finance an investment, it’ll only be a small portion of the overall invested capital. The rest often comes from the leveraged loan and high yield bond markets. Easy access to financing from these markets allows the PE firms to pay high multiples.

But should financing be so easy when multiples are high enough to cause the private equity firms themselves to worry?

Should it be so easy when they’re concerned over the lack of quality businesses to invest in?

Should it be so easy when high competition for those assets pushes multiples for these businesses even higher?

With all-in yields still relatively low, particularly in Europe, we’re conscious that our investors need an appropriate return on their capital. Careful due diligence in stock selection is absolutely central to our process to ensure our investors are paid for the risk they take on. When we lend money to a business, we’re keenly aware that we are investing assets that have been entrusted to us to manage prudently.

While we would never dismiss a potential investment purely because of private equity involvement, we bear in mind their own concerns about questionable asset quality and high transaction multiples as we conduct our due diligence.

* While this survey relates to expectations for 2018, with continued strong markets (the end of the year was a brief but notable exception) multiples have continued to rise. Indeed, Bain & Company’s report goes on to note that deal values in North America rose 22% in 2018.


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You can’t escape the truth – fundamentals matter

Years of a beta-driven market rally have let some get away with forgetting about corporate fundamentals. But central banks are no longer buying corporate bonds en masse, liquidity is being withdrawn, and interest rates are beginning to rise. It seems that the markets will soon remind those who have forgotten the old lesson: fundamentals really do matter.

Our focus remains on businesses that we are happy to hold throughout the cycle. While calling the exact peak or trough of the cycle is near-impossible, a sense of where we are in the pendulum swing is important. We’re certainly much closer to the end than the beginning, and with quantitative easing being slowly but surely unwound, conditions will be unfavourable to businesses with weak fundamentals.

The chart below demonstrates that when complacency in the market fades away, like in the sell-off we saw at the end of last year, fundamentals matter. Companies with the weakest free cash flow, a key metric for us in credit analysis, were punished much more than those with strong fundamentals.

Chart: Consistent FCF weakness priced in a lot more from November
(Average z-spread of representative bonds for ten weakest and ten strongest ranked issuers in terms of five different FCF measures over several time periods, e.g. FCF/gross debt over five years and LTM FCF/EBITDA)

Source: Company Information, Bloomberg, BofA Merrill Lynch Global Research estimates

Last November, we participated in a new European high yield issue from a company called Intertrust. It’s a great example of the kind of business we like to lend to. They provide administrative services globally to other firms; for example, if a company wants to open a new corporate entity, Intertrust will set it up. Then they can provide ongoing services like legal and tax compliance, accounting etc. If the customer decides to close that entity, Intertrust closes it for them.

While 90% of Intertrust’s revenues are from recurring, non-discretionary services, the ability to open and close corporate entities for their customers helps create an incredibly non-cyclical business. In an economic upswing, businesses expand to operate in new jurisdictions or to undertake M&A, so they open new entities. In a downturn, they might close entities and consolidate their footprint. Intertrust can do these things for them. This creates a very stable revenue profile and a business that is able to weather cyclical storms – regardless of how their customers do.

Intertrust also has high margins, a sensible amount of leverage, very strong interest coverage metrics and significant free cash flow. Combine that with the attractive business profile and you can see why we like this business. It’s possible that rating agencies could upgrade them to investment grade in the future. Furthermore, this operating profile has been rewarded in the recently volatile market. In EUR terms, since new issue-to-date, Intertrust has outperformed the Bloomberg Barclays Pan-European High Yield index by 0.65%.

A key cornerstone of our philosophy is that you can’t day-trade carry. Kames focuses on fundamentally sound businesses that will persist through the cycle, and deliver to our clients a steady income stream with minimal capital losses. So we are cautiously optimistic for 2019, a year that will provide ample opportunity for us to demonstrate our ‘stock picking first’ approach and deliver positive outcomes for our investors.

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Tick Tock Goes the Klöck

Climate change and general concern for the environment, they’re an ever-increasingly important issue for society, so why would it be any different for investors? It isn’t. This is something we’ve been watching for a long time; our ethical franchise will have been running for 30 years next year, so it’s something deeply engrained in our processes.

Lately, plastics and the pollution they cause have faced increasing scrutiny and regulation. This backlash has a fundamental impact on companies in the high yield universe. Take the metal can specialist, Crown Holdings. They suggest that the aluminium can is the world’s most recycled beverage container… and actually it is estimated that 75% of all aluminium ever produced is still in use today. Crown believe that a 1% shift from plastic bottles to metal cans for soft drinks alone could increase demand by billions of cans. This could be an impressive tailwind for positions that produce metal cans – companies like Ball Corp, Crown and Ardagh.

But for every winner, there’s a loser. Klöckner Pentaplast is one of the world’s largest producers of plastic films. This company makes the rigid plastics that cover your food, wraps around batteries, surround gift cards and the packs that your painkillers come in. As such, Klöckner is highly exposed to plastic packaging regulation (and backlash). While regulation isn’t the only problem that this company faces, it certainly hasn’t helped. Operating performance has been deteriorating, with limited revenue growth, falling earnings and negative free cash flow. To its credit, Klöckner has been trying to use more sustainable raw materials, focusing on recycled plastic. But so has everyone else, and the cost of recycled PET has been rising in response – compounding the problem.

Something else that’s interesting about Klöckner Pentaplast is how it has structured its debt. The company has issued a type of bond known as a Toggle PIK. These allow the company to pay interest in cash (like normal) or to elect to ‘pay in kind’ (this means adding more debt to its existing debt!). This toggle option means the company isn’t forced to pay cash away when it can’t afford to. But this extra debt means that the company is becoming increasingly indebted – even as it struggles to pay its existing obligations! This risk means that PIK bonds often come with large coupons, and can be an excellent investment when the business is doing well. This is where stock selection is so important.

We decided not to participate in the Klöckner bond when it was first issued at par (i.e. 100) this time last year. I reviewed the company when the bond was trading in the 50s last month, having lost almost half of its value. We chose to pass again, as the firm’s fundamentals had continued to deteriorate. This week, Klöckner announced it would elect to pay its interest in PIK. Today, the bonds are priced at 35. I can hear the Klöck ticking…

Meanwhile, our can makers in the portfolio continue to hold in very well amidst the recent market volatility. These are fundamentally strong businesses that may also benefit from a helpful regulatory tailwind.

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ReWard your investment not your doctor

A key part of our investment philosophy revolves around whether the cash flows generated by the businesses that we invest in are sustainable. While many factors play into our analysis, ESG considerations are a key component in determining the sustainability of cash flows and indeed, a business.

We recently looked into a new issue to fund the KKR-led buyout of Envision Healthcare, a provider of staffing and other services to the US healthcare industry. For the most part, Envision provides doctors when hospitals choose to outsource their emergency departments. We typically place a great deal of emphasis on the ‘G’ in ESG analysis, Governance. But in this case, the social aspects gave us cause for concern.

Healthcare is a social good. The US healthcare system can, at times, seem to challenge this basic assumption. The system has well-publicised issues with costs and a mind-bogglingly complexity that seems egregious to anyone who hails from a country with a healthcare system like the NHS. Be it rocketing drug prices, or paying for your ambulance journey to the hospital, or even $5,000 ‘discharge’ fees, at least you’re okay if you have health insurance, right?

Possibly not. Health insurers in the US often specify hospitals and services as ‘in-network’ and ‘out-of-network’. If they’re in-network, the insurers will pay a bigger portion of the bill. If not, patients might have to foot the whole bill themselves. So if you have to be rushed to the emergency department, you want to make sure you’re going to an in-network hospital. That way, you get to be “in-network”, treated by a doctor, released and all is well. But then the bill comes. Turns out, you’ve gone to an in-network hospital that outsources its emergency department to Envision Healthcare, and its doctor treats you, and all of a sudden…sorry, you’re out-of-network.

Indeed, the health insurer UnitedHealth is in a very public spat with Envision. UnitedHealth has even dedicated a portion of its website to calling-out Envision Healthcare’s billing practices. They estimate that the average charge for Envision’s doctors is three times higher than what Medicare would be for the same service. There’s also a working paper recently produced by Yale University. This paper suggests that Envision actively ups the number of out-of-network procedures when it takes over an emergency department and that its out-of-network charges are significantly higher than competitors’ out-of-network billing. The New York Times has also published a scathing piece on Envision’s practices that has sparked a US Senate investigation, as well as shareholder lawsuits.

Analysis of the company’s financials demonstrates the outsized profitability of charging individuals directly rather than via insurers. So-called ‘Self-pay’ constitutes just 13% of procedure volume, but contributes towards 46% of revenue. Moreover, the sheer size of these bills means they often aren’t paid in full (or at all), so Envision takes massive provisions for uncollectible charges.

Envision is moving more of its revenues to “in-network”. It argues that insurers are trying to avoid paying providers a reasonable rate and that they are trying to shift costs to the patient. But for us, this business model seems to take advantage of those who either don’t know to, or aren’t able to specify an in-network doctor, at an in-network hospital.

In our view, cash flows that seem to depend on opacity rather than transparency will be inherently less sustainable, and are not what we want in any portfolio.

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