Always something to worry about

There is plenty to worry about in the world right now, whether that be the global pandemic, the uncertain economic impacts of this recession, the normalisation of interest rates, or what nobody seems to talk about anymore….Brexit!

But if we are completely honest with ourselves, we always have a tendency to worry about something. Bank of America publishes a credit investor survey every month and it always surprises us that the market can come up with such a broad range of things to worry about (as can be seen in the chart below). Now, that is not to say we should disregard these concerns; indeed we should be aware of them within our investment decisions. But we should always be mindful to give them the proper risk weights within our thought and investment processes.

Back in February, we asked the question – “Why do we panic?” The answer is uncertainty. Uncertainty will always be there – after all we are trying to predict the future and anyone that tells you they know what is going to happen is either a liar or a lunatic. We base our decisions on probability and risk-adjusted outcomes. The famous investor, Howard Marks, talks about the market being a pendulum that swings from greed to fear. It’s not always easy to tell where you are.

Expensive markets get more expensive and cheap markets get cheaper, but following a proven, robust investment process and taking a long-term approach (without getting too caught up in the day-to-day noise of headlines) is always a sensible strategy.

Source: Bank of America

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No longer at the coal face

11th June 2020 marks the first time that the UK has ever gone two months without burning any coal.

To put this into perspective, ten years ago 40% of the UK’s energy came from coal. At the centre of this problem was Drax. However, over the last decade Drax have moved from a pure coal power generation business (and one of the UK’s biggest polluters) to being an integral part of the UK’s net zero carbon infrastructure. In fact, such is their progress in sustainability, in February 2020 the Norges Fund removed Drax from their coal exclusion list as the company now fits within their ESG parameters.

We own Drax bonds within the Kames high yield suite and like the business not just for its steady and regulated cash generation, but also for its strong ESG story – Drax is a core part of the UK’s decarbonisation strategy. They own and operate six power generation units in the UK and with the help of both the regulator (Ofgem) and the UK government they have now converted four of their six plants in the UK from coal to biomass. They are in talks with National Grid, Ofgem and the UK government to upgrade the remaining two as they seek to become even more sustainable.

As bondholders, we want to make investments which not only generate good returns for our clients, but also make a difference to society. Drax has been one of those names that has helped create a more sustainable environment for all of us.

Let us now hope that next time we can write about not only a two month break from coal burning, but a permanent one. 

* At the time of writing Kames held Drax bonds

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Things are bad, but what’s priced in?

It’s easy to say things are bad right now, whether that be socially or economically. It’s also easy to say things look set to stay that way for quite a while.

However, as portfolio managers, we are paid to be a little more insightful. It is our job to determine what is priced in and seek out where the best opportunities lie.

What is priced in?

The default rate topped 15% in the Global Financial Crisis, however, the actual loss given default was just above 7%. At this moment in time high yield spreads are around 750bps and taking the historic recovery rate of 40% gets you to a default rate of 12.5%. Although spreads on global high yield actually blew out to around 2,150bps during the GFC, which implied a default rate of 36%, we know the high yield market typically overcompensates for defaults. So in short, we have a lot of default risk priced in to the asset class right now versus historic realised default cycles.

Where are the interesting opportunities?

The secured deals of some unloved credits such as Viking Cruises and Sally Beauty, is an area where opportunities are arising. As more and more businesses seek rescue financing, the investment decision as a bondholder should not be viewed as one that is similar to an equity holder’s thesis.

Clearly we are paid to make judgements on the value of the underlying security being offered in these deals, and it is often the case that we will still elect to demur on the opportunities presented to us. However, it can certainly be argued that the increased prevalence of high yield bondholders being offered this additional improved security has been one of the (small number) of positives to have emerged from the crisis.

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Even Angels Fall

The European high yield market currently has €221bn of debt outstanding in the BB-rated space, representing 70% of the BofAML European High Yield index. If you look at the amount of debt that has fallen into the European high yield space on any 12-month rolling period historically, there was close to €100bn over the 2008 global financial crisis, €80bn during the European peripheral crisis in 2011 and just over €60bn in the 2015 market sell-off. It is therefore not unreasonable to expect anything from a 25% to 75% increase in the size of the Euro high yield market over the next 12 months; some investment banks have even estimated a doubling in size! Some of the largest constituents in the BBB-rated space are Volkswagen, Deutsche Bank, Bayer and Renault. Due to the large volume of bonds these companies have in circulation, a drop in credit rating could trigger a big impact in the market and composition of indices.

Where a company does see a drop in credit rating to high yield, it’s valuable to think about what this does for its funding costs (expenditure associated with raising capital in the market). It’s not quite as simple as saying they will rise dramatically; there are a number of moving parts to consider. A vast number of companies at risk of downgrade require their investment grade ratings to receive government support in times of crisis. But in some instances, we have seen governments still lending a helping hand. The German government provided a €2bn loan to BB-rated travel operator TUI this week, the proceeds of which will be used to increase the company’s existing credit lines. We have also observed some companies split their capital structures across both investment grade (bonds are secured on collateral) and high yield (bonds are unsecured, repayment relying on the full faith and credit of the issuer) such as T-Mobile/Sprint and Charter Communications. Nevertheless, while higher quality issuers will be welcomed in the high yield space (as we have most recently seen with Kraft Heinz and Ford), it is worth reminding ourselves that not all companies will see such strong marginal buyer support.

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Funding to stay afloat

Carnival Cruise Line is in the market looking for $4bn of funding to shore up their balance sheet. With the current restrictions in place regarding sailing, the business is in desperate need of liquidity to stay afloat. The company initially came to market with a multi-tranche deal, selling notes in both US dollars and euros, making this the first euro high yield new issue since the market downturn at the beginning of March. The euro leg of the deal was dropped before books were set to close and the dollar bond sale was bumped up from $3 billion to $4 billion. This move highlights the continued weakness in European high yield and the hesitance from companies to issue debt in this market.

Just one month ago Carnival was rated A- but has since been downgraded to BBB- as the coronavirus restricts the business from operating. Subsequent to this new deal the business will have enough liquidity to survive until November. However, this funding comes at a cost. Despite the investment grade rating, investors are expecting an attractive compensation on the notes, of over 11%. The new bonds which are only three years in length are secured on the majority of the company’s fleet as well as other assets, with a combined book value of $28bn. Optically this suggests that that debt is extremely well covered should the business run of out of liquidity. With only 0.6x turns of leverage through these notes, should the business not navigate out of these choppy waters, we believe bond holders would be well covered on any emergence from Chapter 11.

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De-risking from equities into high yield

Clients often push back on allocating to high yield as they deem it the highest risk part of the fixed income asset class and don’t give it much more thought. It’s a question I get in almost every client meeting – why high yield, and why now?

There are a couple of characteristics of the high yield asset class that make it stand out. One is duration. At a headline level, the average duration of the asset class is low at just 3.4 years, but dig a little deeper and you will find that the asset class actually has very little correlation to interest rate risk. This makes sense given the low level of duration that the asset class has, but it also highlights the fact that high yield portfolios are constructed of sub-investment grade corporates that should behave more in line with their business fundamentals as opposed to the direction of the risk free rate.

With this in mind, high yield has a greater level of correlation to equities than it does to traditional fixed income, but the returns between the two may surprise you. As you will see below, US High Yield has delivered over 80% of the returns of the S&P 500 over the last 30 years with less than half the volatility. In fact, it has returned the same over 20 years with once again less than half the volatility. So why exactly does high yield offer such strong risk adjusted returns over time?

Part of the reason is quite simple: bonds mature, equities don’t. As a result, bonds, particularly ones with low amounts of duration, can only deviate so far from par before the price ‘snaps back’ thanks to simple bond mathematics. As a result, in times of weakness, while high yield will be highly correlated to equity markets, it snaps back a lot quicker – it is not reliant on multiple expansion or mean reversion of equity multiples. Investors, therefore, should be less concerned about how cheap or expensive the asset class looks when almost all your return is made from income. High yield is an asset class with strong foundations; it doesn’t really experience much of a ‘dip’ to buy into.

Indeed, a move to ‘fair value’ in high yield (as measured by the asset class moving to average 20-year spreads), would result in 2% capital loss whereas, if you do the same for the S&P 500 (taking the average 20-year P/E multiple), it would be around a 14% loss. This is why in the last 30 years, there has never been two consecutive years of negative returns for US high yield – a remarkable statistic.

As we look towards 2020, the compounding returns of high yield, which offer compelling risk-adjusted returns through the cycle, will likely be a key consideration from an equity de-risking perspective.

Source: Bloomberg June 2019

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Thomas Cook fallout

The loss of Thomas Cook from the high street should see TUI the marginal winner, the sole remaining tourism company with any significant retail store base. In the UK, Thomas Cook had an 8% market share compared to TUI which has 19%; in Germany, Thomas Cook had a 10% market share versus TUI with 17%. Following the demise of Thomas Cook a significant portion of market share will go to TUI in both countries.

While the public may be worried about the collapse of Thomas Cook being repeated at TUI, they should be mindful that both companies have materially different balance sheets. For starters, the TUI credit rating is 10 notches higher at BB (versus D for Thomas Cook). TUI also has more than double the amount of equity in its capital structure when compared to debt. In comparison, Thomas Cook had zero equity with its debt trading below face value, resulting in an inability to perform any type of rights issue. TUI has larger scale with €19bn of revenues (versus £9bn), but crucially has access to liquidity.

What ultimately caused Thomas Cook’s decline was not Brexit, not margin pressure, and not a hot British summer – it was ultimately banks pulling their funding lines as the proposed rescue plan left them still worrying about the company’s liquidity position. With TUI having almost €1.6bn of cash on hand, it is an entirely different story to Thomas Cook.

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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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