Kraft Heinz in a pickle

The “57 Varieties” on ketchup bottles mean nothing – Henry Heinz simply thought it was a lucky number…..

Shortly after the Kraft Heinz merger was completed in 2015, the company issued approximately $12bln of new debt in the credit markets to help finance the transaction. At the time, management was very clear with would-be credit investors in stating that the retention of an investment grade rating was not only desirable, but also necessary given the quantum of the company’s debt relative to the size of the high yield market.

However, last Friday, following another set of mediocre operating results and a failure to take remedial action such as cutting the dividend, both S&P and Fitch Ratings finally lost patience and downgraded the company to high yield. With approximately $28bln of debt outstanding, the market reaction was relatively severe, with long-dated dollar bonds as much as 10% lower in price. Such a move confirms that Kraft Heinz is indeed a substantial pill for the high yield market to swallow, particularly given the $10bln or so of debt maturing beyond 10 years. There is low appetite in the market to lend to riskier companies for such long periods.

It also confirms the importance of not only assessing the credibility of a company’s strategy, but also understanding the commitment and incentives of management and stakeholders. Lower interest rates and compressed credit spreads mean that for the company, the incremental cost of operating as a high yield company – rather than an investment grade one – is lower than it was in 2015. This compression in spreads (between the high yield and investment grade markets) has clearly altered management’s priorities.  The company’s ongoing travails in adjusting its offering in a world of rapidly changing consumer tastes will obviously present an ongoing challenge to management although concerns over the strategic direction of the business will no doubt be assuaged in some corners of the equity market by the board’s willingness to maintain a generous dividend.

So what are the lessons for the bond market from this episode? What constituted an efficient balance sheet in 2015 is clearly not the same for some corporate treasurers in 2020. Assessing that changing market dynamic – and by definition how it can influences corporate behaviour – is integral to our ESG analysis and overall investment process at Kames, and one of the main reasons we didn’t have exposure to any of the 57* varieties of this credit.

*there are actually 58 bonds outstanding according to Bloomberg.

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When liquidity dries-up

Suddenly the fund industry is talking about liquidity – or lack of.

Most investors will have read about Woodford Investment Management’s well-publicised challenges around managing redemptions, which led to the suspension of dealing in one of the company’s funds. Then last Tuesday we read about Morningstar suspending the rating on a bond fund managed by H2O, citing concerns over the “liquidity of certain bonds”. H2O have since challenged these concerns, although investors and regulators are increasingly asking questions of their asset managers around liquidity risks.

In my own area – the corporate bond market – liquidity is something we spend a lot of time thinking about. In January I spoke on this topic at a leading bond market conference and published a paper titled Beating the liquidity freeze in bond markets.

To summarise my argument, since the Global Financial Crisis of 2007-2008 we have seen reduced bond market liquidity. There are two main reasons for this:

  1. The greater regulatory scrutiny of banks’ balance sheets following the crisis has had an inverse (and material) impact on the appetite of those institutions to hold bond inventory (and thus provide liquidity for the market); and
  2. Consolidation within the asset management industry has led to a greater concentration of holders (of individual bonds), which has increased the risk of liquidity bottlenecks in times of stress.

I argued in my January paper that central bank QE programmes have to some degree mitigated these risks, and indeed acted to support liquidity. However, the extent to which QE will alleviate the corporate bond liquidity conundrum on any longer-term view is, by definition, limited.

One of the (unintended) consequences of a price-insensitive buyer of corporate bonds (the central banks) has been to compress credit spreads, lower volatility and increasingly push the client base into the arms of a passive industry offering the allure of lower fees. The proliferation of passive bond funds – all seeking to construct essentially identical portfolios that mirror an index of limited size – will ultimately only exacerbate the liquidity problems in the corporate bond market.

So if we accept this is an issue and that it’s here to stay, how should we protect the consumer?

We argue that active management is the answer – with liquidity a key consideration within the investment process.

Quantitative tools can form a valuable part of any liquidity assessment. However, the reality is that liquidity is a fickle beast that does not readily conform to scientific analysis. Mathematical models cannot entirely substitute for experience and market knowledge. A careful assessment of an individual bond (and by extension its impact on an overall portfolio) should form part of every investment decision.

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Electric Dreams

This is an important moment for Volkswagen’s e-mobility drive. Emerging from the wake of the diesel scandal and under pressure to meet stricter EU emissions regulations, the company has an ambition to sell as many as 3 million electric vehicles per year by 2025. To put that into context, VW Group sold approximately 11million vehicles globally last year, 3.7 million of which were under the VW brand.

The UK order books for the first car from its new ID electric range, that will launch at the Frankfurt Motor Show later in the year, are now open. A compact hatchback similar in size to a Golf, the new car will reportedly offer a range of up to 341 miles, although the anticipated £26k entry model is likely to offer only 205 miles. Whether this combination of affordability and range is enough to tempt buyers away from traditional combustion engines in sufficient numbers remains to be seen.

With climate change at the forefront of the public conscience, electric vehicle sales are growing rapidly. The latest figures from the European Automobile Manufacturers Association show that alternatively-powered vehicle sales increased 25.9% in Europe in the first quarter versus 2018. This was largely driven by the electrically-chargeable vehicle segment (ECV), within which pure battery-electric vehicles sales grew 84.4% year-on-year. However, in terms of market share, ECVs still only accounted for 2.5% of all cars sold in the region during the period.

Whilst a step change is required if VW is to monetise the 34 billion Euros it has budgeted to spend on e-mobility to the end of 2022, we believe the company’s scale and strong heritage as a producer of quality, affordable vehicles puts it at the vanguard of the electric vehicle revolution. It is our contention that the market’s focus will ultimately place more emphasis on this and move away from its preoccupation with the historical issues around “Diesel-gate”.

Disclaimer – At the time of writing, Kames holds bonds issued by VW.

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Beating the liquidity freeze in bond markets

Compared to a decade ago there is significantly less liquidity in global bond markets. Last week I presented on this topic at a specialist bond-market conference in London.

I enclose a paper which summarises my presentation. I explain the extent of the liquidity challenges and consider the implications for investor expectations, pricing, capacity management, and the prospects for active investment fixed income strategies.

Download paper

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Renault stalls – do investors need more Va Va Voom?

Renault is a strong BBB credit and a relatively rare issuer in the sterling corporate bond market.  Yet despite last week offering an optically attractive premium to invest in a £250m 5yr transaction, they failed to ‘capture’ sufficient demand and were forced to cancel the deal.  Such events are rare and hence noteworthy.

In recent months the global auto sector has come under increasing pressure from a multitude of headwinds.  US tariffs on steel and aluminium alongside higher oil prices have led to increased input costs and lower margins.  Higher interest rates, particularly in the US, are driving up the cost of finance for consumers and leading to concern about the future trajectory of sales volumes. Emissions related litigation and investigations in the wake of the Volkswagen scandal are ongoing.  New emissions regulations and changing consumer preferences in Europe are increasing costs and depressing sales volumes, particularly of diesel cars.  Evidence of a marked slowdown in the Chinese market, linked to reduced tax incentives and tightening consumer credit conditions, is becoming a cause for concern given that China has long been seen as an engine for growth.

Companies including Daimler, BMW and Ford, as well as auto-parts suppliers Continental and Valeo, have all issued profits warnings in recent months.  Sector credit spreads have reacted accordingly with performance in the past couple of weeks being particularly poor.

Given that backdrop you would be forgiven for wondering why Renault chose to issue a new 5yr sterling bond.  But why not?  Absolute yield levels remain low and so attractive from a borrower’s perspective, even if they have to offer some additional spread to attract investor appetite.  Common practice is for the initial price guidance to be revised tighter (i.e. more expensive from an investor’s perspective) once a solid order book is in place.  Yet in this instance, demand was insufficient and instead the deal was pulled.

Despite choosing not to participate in the deal, it was still a surprise to see it cancelled.  This rare event perhaps reflects not only the cautious stance of many credit investors towards the sector (given the multitude of headwinds highlighted) but also guarded risk appetite in the sterling credit market more broadly as Brexit uncertainty peaks.

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Navigating a sea of M&A

Much has been written about the recent acceleration in global M&A (Mergers & Acquisitions) activity. The $1.4trn worth of deals announced globally year to date is 75% higher than 2017 and the strongest first four months of any year on record according to Dealogic.  

Accelerating M&A is often cited as a late cycle indicator although Citigroup argue this year’s pace is not yet a sell signal for equities, given it is well below previous cycle peaks when considered as a percentage of equity market capitalisation.
Nonetheless, as credit investors increased M&A gives us considerable pause for thought. Despite the recent increase in global rates, companies can still take advantage of historically cheap debt funding to help finance acquisitions through increased corporate leverage. Indeed, the frequency of large, M&A-related debt issuance has increased in recent years (see chart 1).

Chart 1: Large debt issuance deals ($5bn or higher) which includes acquisitions among the use of proceeds

Source: Dealogic, Goldman Sachs Global Investment Research

Such issuance can create headwinds for performance at both the issuer and sector level. However, it can also create opportunity. Empirical analysis by Goldman Sachs suggests the evidence supports a “sell the rumour, buy the news” pattern.

Here at Kames we adopt a similar strategy in trying to avoid issuers and sectors, such as pharmaceuticals, where we see the risk of leverage increasing via M&A as high, and where current valuations do not compensate for the risk. Instead we seek to invest “post-transaction” in newly issued bonds used to help finance an acquisition, when management are able to provide clarity around the trajectory of balance sheet metrics. It is our approach to bottom-up analysis and active investing that helps us navigate the idiosyncrasies of M&A and increase returns for our clients.

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Love me tender…

Despite recent gilt market weakness related to a shift in rhetoric around the prospect of a rate rise from the Bank of England in the near term, sterling credit markets remain well underpinned. Key to this is the strong macro backdrop and generally robust corporate earnings of recent months coupled with the twin technical drivers of inflows into the asset class and ongoing buying of corporates by the European Central Bank.

Another technical that has become more prevalent in recent months as the market has rallied is companies tendering early for their outstanding debt. Tesco and the US communications giant Verizon are the latest companies to join the fray. Motivation to do so at the corporate level is multi-faceted but usually entails a combination of reducing gross debt, reducing interest expense through reissuing lower coupon debt, lengthening the duration of outstanding liabilities or simplifying the company’s capital structure.

Such actions can be beneficial as tenders are typically struck at a premium to the prevailing market and may involve an additional early tender fee. However, investors must balance the benefit of a short-term gain with the ability to replace tendered bonds with attractive alternatives. At Kames we consider each tender on its individual merits, weighing the potential for short-term gain against the credit fundamentals of the company involved and alternative investments available in the market.

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Reports of my death have been greatly exaggerated – the Sterling corporate bond market continues to thrive

More than a year has passed since the Bank of England announced its £10bn Corporate Bond Purchase Scheme (CPBS). While the scheme was completed by April, much more quickly than originally anticipated, its positive impact on the market has been lasting.

Prior to the Bank’s intervention the importance of the sterling corporate bond market was under threat, in part due to poor secondary liquidity and a lack of supply from borrowers drawn to the depth, convenience and competitive pricing of the euro and dollar markets. Even UK-centric borrowers such as Royal Mail favoured the euro market over their home turf.

The backstop bid that the Bank’s scheme provided gave market makers the confidence to increase secondary liquidity through tighter bid/offer and larger size. There was concern as the scheme drew to a close in April that the improved liquidity would diminish but this hasn’t happened. Higher volumes have persisted and market participants are more confident trading larger blocks. A marked increase and greater variety of new issuance over the course of this year (gross issuance year to date has already surpassed full year 2016 volumes) has also helped to define market levels and encourage further secondary activity.

To this end, the Bank’s intervention has been a great success. A more dynamic market presents further opportunities for us as active managers to express views and add value to portfolios for the benefit of our clients.

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The end of sterling corporate QE

The Bank of England is within sight of the end of its corporate bond purchase scheme, a year ahead of schedule, having bought in excess of £9.1bln worth of bonds since the end of September last year.  Given the relatively robust performance of the economy since Brexit, an increase to the £10bln target at this stage is deemed highly unlikely.

Evidence would suggest that the original aims of the programme – reducing the cost of borrowing for companies, encouraging companies to issue more corporate bonds and triggering portfolio rebalancing into riskier assets – have largely been met. Corporate bond supply has increased, spreads are tighter (albeit not uniformly) and lower quality spreads have compressed.

While not an explicit aim, the consistent bid for risk over the past few months has also led to reduced volatility and a marked improvement in liquidity. Going forward, a deterioration in that secondary liquidity following the end of the programme is a concern. As the rate of the Bank’s buying slows, recycling risk becomes more challenging, particularly given relatively tight valuations. Dealer inventories grow and spreads widen. There is evidence this is happening. Sterling credit spreads (libor OAS) are currently c7bps tighter YTD having been as much as 13bps tighter in early March.

The end for sterling corporate QE is not the only factor driving our currently cautious stance towards credit risk.  Brexit uncertainty, the potential for Trump disappointment and European political risk also vex. However as a precursor to the potential end of the ECB buying programme next year, it is certainly worth watching.