Fly, fly away

Thomas Cook bonds are trading in the low 30s (from being at 102 a year ago), with the equity off 90%. One broadsheet news outlet cited ‘Brexit is to blame’ – it seems like Brexit gets the blame for every woe at present.

Brexit is most certainly not to blame this time around. Operations have undoubtedly been under pressure because of weak GBP, good weather and an increasingly competitive travel market which is pressuring operations. However, the catalyst for this recent price weakness has been the banks pulling their funding (effectively selling their credit lines at a loss), resulting in a potential near-term liquidity crunch.

Due to the way the operating model works, the business has a large working capital outflow in Q1 of each year, something which requires a large revolving credit facility from which to access liquidity. With the news that banks are exiting their lines of credit at a loss, it creates uncertainty as to how they will fund the working capital outflows given ongoing credit weakness.

Thomas Cook is trying to exit its airlines business to pay down debt, with the business continuing to lose money. The outlook is bleak and so it should be. One quick glance at the financials doesn’t make for happy reading – H1 revenues down 6% YoY and EBIT -£245m from -£170m in the previous year. The new footnotes to the accounts says it all:

The Directors recognise that there is uncertainty surrounding its timing and terms and the associated conditions in the new financing arrangement, which could impact the ability of the Group to access the required liquidity, and they have concluded that this matter represents a material uncertainty. This could cast significant doubt on the ability of the Group to continue as a going concern.”

It is unlikely this business will turn around, and the price of the bonds tell you that. Liquidity concerns aside, Thomas Cook is going to have to slash the price of holidays if they have any hope of clients choosing them as their travel operator – despite management’s best efforts to remind the public their holidays are ATOL protected.

We have a high bar for entrance into our portfolio and when companies don’t make any cash and are no longer in control of their own destiny, we won’t be the ones found lending.

Disclaimer At the time of writing Kames does not hold bonds from Thomas Cook in its fund range.

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ADT – Don’t be alarmed

This week ADT Security Corp, the provider of home security services and alarm systems, came to the market to refinance some of its higher coupon unsecured debt (their 9.25% 2023’s). The company was looking to do this through a mixture of 5-year and 7-year secured and unsecured debt. By way of background, secured debt is secured on the company’s assets and ranks higher in any potential future restructuring than unsecured bonds. For this reason, investors demand a yield premium on unsecured bonds.

Given the recent performance of new issues in the market, the general expectation was that the books would be filled and the company would print paper at their desired price. However, the deal was only partially refinanced with the unsecured leg of the structure dropped due to lack of demand.

So what happened?

It’s unlikely this deal was pulled due to general market fatigue as supply has been shallow this year and cash balances, while shrinking, are still high. Rather, the market appears to have become concerned at what I would describe as very loose covenants within the bond indentures. Based on our own analysis, the covenants have very little room for new debt at the secured level of the capital structure. However, the business has loose debt incurrence limits at the unsecured level, which theoretically could allow the majority shareholder, Apollo, to increase debt in the business in order to pay itself a dividend. However, with only 150 basis points premium for buying the proposed unsecured tranche versus the secured tranche (thereby facilitating the dividend to Apollo), it was no surprise that the deal failed to get over the line. We have no major fundamental concerns with ADT as a business, but we put considerable focus on structures and covenants when making investment decisions and on this occasion the price talk was simply too tight for us (and also the market).

Should we be worried at this development? No, not at all. It tells us we are in a market where investors have been rational enough to push back on a deal where valuations don’t fully compensate for the risk. This is a healthy sign of market conditions, it’s not something to be alarmed about.

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Time for active winners

As QE withdraws and global growth slows down, high yield bond manager, Mark Benbow’ tells us why he thinks this is a great time to generate alpha. Listen to his podcast below.

Don’t blame the Algos

According to a recent report in the Wall Street Journal, “Roughly 85% of all trading is on autopilot—controlled by machines, models, or passive investing formulas, creating an unprecedented trading herd that moves in unison and is blazingly fast.”  Think “Synths” from telly series Humans leading trading decisions rather than, well, the human fund managers at Kames Capital.

The article goes on to blame the recent market weakness on computerised trading algorithms (algos). Just as a reminder, Google summarises an algorithm as “a process or set of rules to be followed in calculations or other problem-solving operations, especially by a computer”. What we find interesting is that while the algos are blamed when it comes to bear markets, they are never blamed when it comes to bull markets. Shouldn’t they be responsible for both?

That eminently non-programmable human, Donald Trump, has come out and blamed the recent market weakness on a “glitch”. We remain a little more sanguine, and view market pricing as trying to tell us something. The Federal Reserve puts a dozen people in a room to deliver a rate decision, but the market rallied to the text of its statement and not to the bearish and mechanical process of a rate rise.

Whilst it is undoubtedly true that the vast majority of trading is now done by computers, this tells you nothing about human choices behind them. Algos execute trades based on a multitude of factors, with flow clearly being a key component.

If you want to blame recent market weakness on outflows that’s fine, but don’t blame the algos per se. There will always be some humans in the process.

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Loans and your liquidity

2018 was not a pretty year for financial markets with most assets classes recording negative returns. Thus, for 2018, ‘smart’ selection meant investors “should” have chosen leveraged loans. The theory goes that rising interest rates will generally hurt (fixed coupon) bond markets, but leveraged loans (as floating rate instruments) would benefit as central banks unwound balance sheets and increased interest rates.

Loans typically rank higher than bonds when borrowers go bankrupt, meaning that the recovery rate is higher. Today however, more than 50% of loans have no junior borrower to take the first hit. As a result, while historic recoveries are typically higher (around 75%), history should not be your guide for future recoveries. Indeed, according to a recent Moody’s report, 2nd lien recoveries are expected to fall from 43% to just 14% as loans are increasingly found at the bottom of capital structures. Given the strength of the economy, many of these facts were either not acknowledged or were deemed something to worry about on a more rainy day. Well, that rainy day could well have arrived as we have seen financial conditions begin to tighten over the last few months and with this there have been outflows within the leveraged loan asset class.

What makes the outflows all the more interesting is the growth in leveraged loan ETFs and mutual funds. At the start of 2000, there were only 15 ETFs or mutual funds dedicated to this part of the market compared to almost 300 today. The main holders of leveraged loans remain CLOs (collateralised loan obligations). Investors in CLOs have their money locked-in and need a secondary buyer of their share of the CLO to redeem their exposure, while ETFs and mutual funds promise instant access to liquidity despite many of the loans rarely trading. As a result, the liquidity mismatch between the vehicle and its asset could quickly transpire into a fire sale.

Recent data suggests we are starting to see signs of the leveraged loans market begin to unwind. Underlying assets and the vehicle in which those assets sit is part of the “dull” plumbing of financial markets, but investors should be mindful of liquidity mismatches.

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Harnessing the Power of the Pull to Par

“Aren’t you limiting your investment universe?”
“Don’t shorter dated bonds have less yield?

It’s common for questions like this to be asked when you’re talking about the short dated high yield asset class. And yes, it’s undeniable that both can be true, but it’s also my belief that within a diversified portfolio there’s merit in including this asset class.

When looking for a return, the profile and composition is better known the closer you are to the bond’s maturity. The nature of a bond, and its final maturity, means that investors know exactly how much money they will make between the start date and the date that the bond matures. The uncertainty lies in how much of that return is achieved from one year to the next – and in my experience it’s rarely a straight line.

I’m only able to estimate the return profile, rather than giving an exact figure, but this assessment is helped by the knowledge that bonds are issued at par (cash price of 100) and redeemed at par, (the exception being if a company defaults before maturity).

And, as with the rest of the high yield team here, I target higher quality companies with recurring cash flows – where the company will continue to exist well beyond the life of the bond. For instance, we currently choose not to hold any CCC-rated credit within the short dated high yield fund. And the result of this choice is that we are able to reduce potential default risk and rely on the ‘pull to par’ effect of the bonds.

The chart below highlights the total returns of the Global High Yield 1 to 5 Year Index. As you can see, while the short dated high yield market may not always generate a positive return from one month to the next, history shows that over any 5 year rolling period (using any start date over the last 20 years) the asset class has generated a positive return almost 100% of the time.

Source: Bloomberg: ICE Bank of America Merrill Lynch.

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Red Flag Indicators

At Kames we study and analyse financial accounts as part of our wide due diligence work when deciding whether to lend our client money to a particular corporate entity or not. While this process is quantitative in nature, our process also encapsulates a more qualitative approach, one that relies on the wealth of experience we have in our high yield team – particularly in instances where something just doesn’t feel quite right. 

While we are paid to view things cynically, one corporate finance decision that caught my eye this week was the refinancing by French telecommunications operator SFR of their 2022 maturity debt. For anyone that follows the European telecommunications sector they will know that SFR has had operational challenges that it is still addressing (in the year to May 2018 the share price of parent company Altice fell 65%, before showing early signs of an operational turnaround in their Q1 results released in the middle of the month). What is particularly striking about this deal is that the bonds being refinanced don’t fall due for another 4 years (2022); the company is having to pay up to take them out (a call premium of 3pts above par); and meanwhile the company is locking in a higher cost of debt (over 2% above the existing coupon on the bonds).

In situations like this we ask ourselves questions such as: “if management truly believe in an operational turnaround, then why not wait another 12 to 18 months, leaving plenty of time to refinance at a presumably much lower cost of debt?” To us, the answer is not clear and serves as a potential warning sign. Time will tell if we are being too cynical with SFR or not, but it certainly serves as a red flag – one we are happy to avoid.

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Paying the price for excitement

A common investment mantra is that high risk equals high returns. Yet, if we look back at history, we see so often this is not the case, for the simple reason that excitement is fundamentally overvalued.

We can of course in hindsight look back on bubbles throughout history and wonder why on earth anyone was willing to get involved. Take for example the Dutch Tulip Bulb Market Bubble in the early 1600s, when speculation and social status drove the value of tulips to extreme levels – the rarest tulips up to 6 times average salaries at the height of the market!

Or indeed the Great Baseball Card Bubble of the 1980s, where collecting went from a niche hobby to big business, as irrational exuberance drove prices to absurd levels.

Rising values created demand in both of these examples but before long, prices reversed as exuberance was swapped for panic selling as the bubble popped.

Yet we see market experts also overpaying for excitement. Whether it was mortgage-backed securities in ’07 or technology stocks in ‘99, it seems that the market easily forgets irrational exuberance from years gone by. Today we have the crypto-currency boom which is drawing investors in, on the hope you are smart enough to ride the boom and get out before the bust, or indeed that ‘this time it’s different.’

As high yield investors, we do not believe that investing is as simple as high risk equals high return – we are firm in our belief that excitement is so often overvalued. Rather, we believe that while quality is boring, boring is fundamentally undervalued. For that simple reason, we enjoy the not-so-secret pleasure of buying undervalued, ‘boring’ bonds.

This means that when the bubbles pop, we are left holding a whole lot more than those investors gripping on to their bit of cardboard with a picture of a baseball player on it.

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Duration risk – a valid concern, but not one of mine

Mark Benbow warns of the growing duration risk in the bond market and how clients should be mindful of facing more risk by default, rather than design

One of the biggest concerns that bond investors face right now is duration risk – the risk that a rise in interest rates creates a fall in bond prices. Considering that the duration of bond benchmarks has been rising for the past 20 years, investors are wise to be mindful of this risk.

Source: Bloomberg as at 30 June 2017

We’ve experienced a long-term trend of falling bond yields, thanks in part to the extremely accommodative monetary policy implemented globally by central banks. As yields have continued to fall, the behaviour of debt issuers has started to change. Debt issuers are taking advantage of this low-rate environment to lock in an all-time low cost of debt for as long as possible, by issuing long-dated bonds. Just last month Argentina issued a bond with a maturity of 100 years, just three years after its last default! Is 8% a tempting enough income to lend to Argentina for 100 years, considering the five defaults it has faced in the last century alone?

The merits of individual issuers aside, the importance of this change in behaviour is that as issuers borrow for longer periods, the level of duration in bond benchmarks rises.

This is at the same time as lower yields are forcing investors into lower-rated or longer-dated bonds to generate income in their portfolios. And certainly the demand for yield in the market is proving insatiable at this stage of the cycle. Factors such as rising pension deficits and the need for retirement liability matching have driven the demand for longer-dated bonds as yields continue to fall.

This is a noteworthy combination: ever-lower yields means more supply (and greater demand) of longer-dated bonds, but for investors’ bond portfolios it can mean more duration risk for less return potential – this is reflected in the chart below.

Source: Bloomberg as at 30 June 2017

Index-based investors in particular face the risk of following this trend and being forced into longer duration than desired in response to the changing characteristics of fixed income markets. Indeed many fixed income portfolio managers are being dragged longer in duration as their underlying benchmark duration has increased, therefore exposing the end investor to additional interest rate risk by default rather than design.

At Kames we do not simply chase benchmark duration as we do not believe debt indices are the basis for a successful investment. In our experience, concentrating our efforts on identifying alpha-generating ideas is the best starting point for building portfolios – not what an index provider tells us.

As a high yield fund manager I take additional comfort in the different characteristics offered by the high yield asset class. Unlike in other markets, duration has been falling over the last 20 years. This offers us significant opportunities to invest in shorter-dated, higher yielding assets and build concentrated, high conviction portfolios to the benefit of our clients.

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