Why I’d rather own a McLaren than a Ferrari in a hard Brexit

We are often asked if there are opportunities in Sterling-denominated high yield bonds. As ever, the answer is nuanced and not black and white. So, in the context of what looks to be an increasingly messy Brexit and sustained weakness in Sterling (down 11% since the peak in April) we thought it worthwhile to explain our logic in some of our preferred Sterling bonds. Indeed, with a global remit there is no shortage of opportunities so why make the case for these issuers?

Our view is that Sterling-denominated high yield bonds “generically” are very cheap at present. What do we mean by this? We see a number of examples where bonds issued by the same company, with the same maturity, and same level of protection for bondholders, are cheaper purely because they are denominated in Sterling. For example, there are currently two bonds issued by the supercar producer McLaren which are identical in every way (covenants, maturity date, etc.) except that one is in Sterling while the other is in US Dollars. The pricing has become so dislocated that, any which way, the Sterling bonds are cheaper.  In absolute yield terms the Sterling bond pays more than the US Dollar bond. This is despite the fact that, in a currency-hedged portfolio investors actually get paid more for owning a Sterling asset than a US Dollar asset. We summarise this incremental return below:

Mclaren GBP bonds McLaren USD bonds
Local Currency yield: 5.94% 5.89%
Effect of Sterling hedge: +1.57%
USD-hedged yield: 7.51% 5.89%

Simply put – for the same fundamental risk an investor can realise a 1.6% higher annual yield by owning the Sterling bonds over the US Dollar. This very pronounced dislocation is an illustration of why we believe unconstrained investors can benefit from investing in Sterling-denominated high yield bonds (and fully hedging their £ exposure).

Of course, a clear concern for UK based companies is the risk that they may be hurt by a further weakening of the Pound. For McLaren, of course, with production based in the UK their costs will be cheaper relative to € or $ based manufacturers. (Good news, the McLaren’s looking cheaper than the Ferrari!)

Similarly, how would a hard Brexit affect other issuers which we believe offer value? We favour companies that would be unaffected or benefit from a weaker £ such as those that compete for sales domestically with foreign imports and/or export globally (such as McLaren). For instance, the UK based holiday operator, Center Parcs benefits from a weaker Sterling as UK customers find they can get more “bang for their buck” (or “power for their pound”?) by staying in the UK rather than traveling abroad.

There are other businesses that have a domestic customer base and have a strong embedded place in the economy. Many of them have traded well throughout the recession following the global financial crisis and we are confident that they should be able to weather any economic weakness that would result from the Brexit process. An example of this is Together Finance which occupies a unique (and very profitable) position in the UK financial ecosystem through its niche mortgage lending. It weathered the 2008-2009 Global Financial Crisis with remarkably little difficulty. Indeed, during the crisis the company’s annual loan losses only got to around 1% – leaving us very comfortable with the issuers risk profile should 2019’s Brexit prove challenging.

Most of the focus in recent months in the Sterling market has been around distressed issuers, especially in the retail arena (i.e. House of Fraser bonds are set to receive a fraction of their face value). This is very far removed from the £ high yield that we are focussed on at Kames, where our team’s approach continues to be to seek the best high yield issuers and remain “unconstrained”. This translates as remaining flexible, being able to identify opportunities and banking profits, depending on where £ high yield credit trades relative to € and $ issuers. This flexibility also means that, should we view Sterling-denominated bonds as no longer providing compelling value, we have the ability to reduce our Sterling exposure to a zero-weight.

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A stock picker’s take on striking gold

Markets are in good shape, and as expected, the new-issue market cranked back into gear last month – an opportunity to find good quality cash flows for our portfolios.

What can be astonishing (and pleasing) in this market is the difference in relative valuations between companies in a sector. Take, for example Equinix versus SoftBank.

Internet storage provider Equinix came to the market last month with a euro new issue. While we are typically cautious about the fast-changing nature of tech companies, we see structural demand for server space and connectivity between different organisations and Equinix benefits from this as a market-leading data centre operator.

As the old saying goes, we would rather sell shovels to prospectors during a gold rush rather than join in the prospecting ourselves – and these bonds offer cash flows, regardless of which online business gains or loses.

Equinix also has a very well-diversified client list (the largest customer is under 3% of revenues) across very different industries and can host its customers’ servers in multiple locations. This increases the stickiness of its customer base.

This high quality story was offered at a spread of almost 3%, which we think compares very favourably against better-known SoftBank. That is despite the lack of fundamental certainty over SoftBank’s long-term cash flows, as it spends huge amounts on highly uncertain early-stage tech investments – in effect trying to join the prospecting herd.

It seems that the yield penalty for choosing quality over quantity is at historic lows, in a market that is more concerned with all-in yield than differentiating between company fundamentals. This is the stock picker’s idea of striking gold.

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Not so (Pet)Smart

Revenues mean nothing if the company in question loses money with every sale made. While this may seem obvious, the high yield market has been reminded of this in a painful way over the last few months.

The company in question is PetSmart – a large American pet store operator. It recently borrowed a grand total of $2bn in order to purchase Chewy, an online pet retailer. Theoretically buying a digital retailer to capture customers moving online makes sense. But PetSmart’s acquisition of Chewy is negative for one very important reason – once all the operating costs are factored in, Chewy doesn’t actually make any money from the sales it generates.

While PetSmart’s physical stores have very healthy profit margins, Chewy’s are negative. In effect what PetSmart is doing in buying Chewy is gaining loss-making online sales as a way to offset the loss of profitable offline sales. While there is a chance that the business can cut costs and restore some of that ever-decreasing pie of profit, the odds are stacked against them.

In contrast one business that we can get excited about is the 100%-online grocer Ocado. Whereas PetSmart’s online acquisition is loss-making, Ocado’s online grocery business is highly profitable, with better margins than all of the listed offline grocers and a very strong structural growth story. On top of its own online success, the business is well-positioned to benefit from other supermarkets attempting to move online through its platform-provision business – which effectively allows other retailers to establish an online business without the huge operational headache that starting from scratch would entail. Morrisons are currently using Ocado for this, which has been successful for both companies.

Overall this is a story of fundamentals. One company is scratching around trying desperately to defend a crumbling offline retail empire by loading up on more debt and buying a loss-making online retailer, while another company has a steady and sensible long-term plan to expand its already highly profitable business even further.

When these two companies came to the debt market earlier this year, the choice was relatively easy for us. As shown below, the subsequent performance has borne out our thesis.

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Holmes moans about loans

As a high yield fund manager it has been interesting to watch leveraged loans become something of an investor darling this year – almost $13bn has flowed into US loans over the year to date. Investors have sought out loans as a place to hide from a Fed that is raising interest rates, and with the perception that they are a “safer” income provider than conventional bonds.

But is this logic sound? How do loans perform in hiking cycles?

US leveraged loans underperformed US high yield by almost 2% per annum over the 2004-2006 hiking cycle. In a hiking cycle, high yield bonds tend to perform well due to their positive exposure to economic growth, while loans offer far less opportunity for capital appreciation.

And how much safer are leveraged loans? The peak-to-trough drawdown was 95% of that seen in high yield during the financial crisis, while high yield has produced 123% more total return over the last 15 years. In other words, investment in leveraged loans over the past decade and a half has resulted in almost as much drawdown while sacrificing the large profits that could have been made by a long-term investment in high yield (a topic my colleague David Ennett has discussed previously http://bondtalk.co.uk/high-yield/carry-me-home-the-source-of-high-yield-returns/).


Source: Bloomberg as at 31 May 2017

Leveraged loans are also more exposed to problem sectors than high yield. Retailers that are mortally threatened by Amazon make up more of the investable universe in loans than in the high yield universe. Leveraged loans are getting riskier too – in Europe the average secured indebtedness for new loans is almost 70% higher than at the end of 2010. In contrast, European high yield leverage has actually fallen over this period.

From my perspective a well-managed high yield portfolio provides a much better way to generate strong sustainable income versus alternatives such as loans. By investing with high yield teams focused on finding defensively-positioned companies with strong business models, attractive risk-adjusted total returns can be generated. Whether the same can be said for loans remains to be seen…



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UK high yield retail – are you being served?

UK retailers are facing significant pressures over the coming years – from the rise in business rates, higher supplier costs due to weaker sterling, and the new national living wage; to the expected continued growth of online retailers like Amazon and Asos. Given all that is facing these companies anyway, investing in the more indebted end of the sector seems to us a costly mistake at present. We would argue that retailers in general tend to have high fixed costs and variable top lines, so adding a large fixed debt service cost generally doesn’t stack up. Interestingly though, the market doesn’t seem to agree with what we would regard as common sense, as the median UK high yield retailer has debt worth almost six times their earnings – significantly above the European high yield average of just over four times.

Despite the fact that UK high yield retailers are facing huge operational headwinds alongside significantly more indebtedness than the wider high yield universe, the bonds on offer do not trade at a discount – in fact when we checked on Friday the median UK high yield retail bond traded with exactly the same spread over government bonds as the wider European high yield market!

In short the bonds of UK high yield retailers offer significant operational risks; large levels of indebtedness; and absolutely no discount to the wider market. We’re quite happy to let the benchmarked funds and ETFs play away in these, and think that our clients are getting far better service by looking at other more attractive parts of the high yield market.