Read the prospectus, stupid.

A common question I am asked when meeting with investment consultants and prospective clients is: “what is it that you do differently to other investors?” Given the price action of some high yield bonds, it could be argued that reading the documentation is a key factor which separates Kames Capital from our rivals in the business of managing high yield bond portfolios.

In February 2016, Onorato Armatori S.p.A. (also known as Moby), issued €300m of 7.75% senior secured notes due 2023. Moby is an operator of roll-on, roll-off ferry services in Italy, primarily serving Sardinia, but also Sicily, Corsica and the Tuscan archipelago.

The prospectus for every new bond issue includes a section entitled “Risk Factors”, wherein the company highlights potential challenges that the business could face in the future. Two in particular stood out from the Moby prospectus:

  1. “Our revenue is concentrated in certain routes and the loss of any of these routes (or lower sales from these routes) could lead to significantly lower revenue”.
  2.  “The European Commission is investigating [subsidy] payments from Italian public entities to determine whether such payments constitute state aid subject to recovery.  We believe it is more likely than not that the EC will conclude we received incompatible state aid”.

On 14th May 2018, Moody’s downgraded Moby’s corporate family rating to Caa1, citing: (1) “an intense competitive environment, notably in Sardinia”; and (2) “liquidity concerns as the company faces potentially significant cash outflows over the next 12-18 months on the back of an Italian anti-trust fine and an ongoing investigation by the European Commission”. Despite these being issues already disclosed to the market, Moby’s bonds fell in price by 4pts to 86 following the release of the Moody’s report.

Sometimes in portfolio management, investments perform poorly as unexpected turns of events impact companies in ways which couldn’t easily be predicted. However, in this case the causes of the losses were so obvious that even the company wrote about them in advance.

At Kames Capital, our due diligence process includes reading the prospectus in order to understand obvious risks such as these.

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WeWork and the Voodoo Economics of Silicon Valley

Almost every day in my email inbox arrive offering memoranda for new high yield bond issues. Mostly, these come from investment banks that are seeking to arrange financing for a public company or a private equity firm trying to finance a leveraged buyout. Yesterday, something unusual caught my eye. An offering memorandum arrived for a bond issue by WeWork, the operator of fashionable co-working spaces in major cities. The company is hoping to borrow $500m for seven years. The company was founded in 2010 by Adam Neumann in New York and has since expanded to 73 cities. The business model involves the company itself leasing properties in popular commercial locations on a long-term basis and then sub-leasing these on a short-term flexible basis to individuals and small businesses.

This is not a particularly innovative business model: there are already at least two companies doing this that are listed on the London Stock Exchange (Workspace Group plc and IWG plc). Despite this apparent lack of innovation, WeWork has attracted leading Silicon Valley venture capital firms as investors (eg Benchmark) and media reports suggest that the company was valued at $20bn at the time of its last funding round in March 2017.

In its own words, WeWork writes: “We see ourselves as a leader in flexible workspaces as the first company to program real estate and the first global lifestyle brand centered around working and living.” This has certainly led to rapid growth: in 2017 revenue increased ~100% from 2016. Perhaps a co-working lifestyle brand has truly inspired people? Or maybe the company is simply providing its services below cost? A business model of selling £20 notes for £15 would probably also generate rapid revenue growth. A quick review of the financials suggests this is exactly the business model. In 2017 the company earned $886m of revenue. However, “community operating expense” ie. the costs required to operate an open member community location on a day-to-day basis was $814m. This leaves a gross profit of $72m. You’ll have already spotted that $72m is quite a small gross profit for a company that is valued at $20bn. But wait, there are lots of other costs of running a business. These include: the cost of attracting and retaining customers (sales & marketing cost), on which the company spent $143m in 2017; the cost of running the WeWork headquarters and management team (general & administrative cost), on which the company spent $183m in 2017. WeWork also spent a further $131m on pre-opening expenses, $110m on “growth and new market development”, and an additional $295m to compensate its staff by issuing equity.

I don’t need to add these numbers up to show that we’re now quite significantly into negative territory. But wait. WeWork isn’t just growing quickly by leasing office space to customers at loss-making rates, it is first spending heavily to improve those leased buildings in order to help attract those customers. In 2017 the company spent just over $1bn on property and equipment, almost all of which is classified as “leasehold improvements”. In a nutshell, the company spends money to improve properties it doesn’t own, which it then leases to tenants at a loss.

As high yield bond investors, we can clearly identify two different tribes within the broad universe of Silicon Valley darlings: ‘Cash Machines’ and ‘Cash Incinerators’. The first tribe, ‘Cash Machines’, is composed of those companies operating with cutting edge technologies, primarily in the digital world, that have created brand new markets for their products and services. They are growing rapidly, but also generating more cash than they can possibly reinvest. This group includes Apple, Google/Alphabet, and Facebook[1]. Those that have borrowed – Apple and Google – have high quality investment grade credit ratings. Apple is rated Aa1 by Moody’s and Google is rated Aa2.

The second tribe, ‘Cash Incinerators’, is composed of businesses that are trying to apply technology to industries that already exist in the physical world. They too are growing rapidly, but to compete against incumbents they are required to deploy enormous amounts of capital, far in excess of what they can generate internally. This tribe includes Netflix and Tesla, both of which borrow in the high yield bond market in order to finance their cash-burning business models. Netflix is rated Ba3 by Moody’s and Tesla Caa1. A brief review of WeWork’s financials leads us to conclude it is most likely a member of the ‘Cash Incinerator’ tribe. The Voodoo Economics will only work as long as there are speculators willing to fund these losses. This will unlikely be for an indefinite period.

 

[1] You’ll note I’ve not included amazon.com. amazon.com is almost unique in having spent almost exactly its internal cash flow generation on new investments. In recent years the company has become cash generative as Amazon Web Services has grown.

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Where’s the fizz?

“So, where’s the fizz?” asked a colleague recently as we discussed conditions in the global high yield bond market. High yield is often considered a risky segment of the financial market, and so my colleague assumed – that after nearly a decade of quantitative easing, and with signs of aggressive behaviour across a wide range of asset classes – that the high yield bond market might be close to bubbling over.

It is a reasonable assumption. Students of financial history will know that a number of the biggest bubbles of the last few decades have been funded using high yield bonds. These include the leveraged buyout booms of the 1980s and the early 2000s, the telecommunications bubble of the late 1990s, and the US shale energy boom of the 2010s. In each case, investors who passively invested in the broad high yield bond market near the peak subsequently suffered substantial losses.

In which areas can we see financial exuberance today? I would argue that prime suspects include: Cryptocurrencies; certain technology companies; equities valued as “bond proxies”; and real estate in “super-prime” markets. In each of these cases the high yield bond market is neither a primary or even a peripheral source of financing.

A key signal of impending trouble in the high yield bond market is the volume of aggressive issuance. We can identify whether a new issue is aggressive in three key ways:

1) by the credit risk of the borrower – a CCC credit rating is a good proxy for this;
2) the use of proceeds – a debt issue to fund acquisitions or dividends is more aggressive than a refinancing; and
3) the structural quality of new issues – bonds that don’t pay cash interest are particularly aggressive.

So far in 2018, CCC-rated securities make up only 11% of new issuance, which compares to 33% in 2007 (and an average of 19% during the 2004-06 period). Use of proceeds has recently been relatively conservative too, with new issues to finance acquisitions and dividends representing less than 20% of total volume. This is far below the peak of 50% reached in 2007 (and an average of 35% during the 2004-06 period). In addition, in 2007 12% of all new bond issues did not offer coupons in cash. 2018, by contrast, has seen no new issues of non-cash pay bonds.

A key feature of the high yield bond market is its relatively short maturity structure. A consequence of this is that the composition of the market is always changing as different issuers, in various sectors, with evolving credit metrics, are regularly issuing and redeeming bonds. As a result, the risk profile of the market is not constant over time. We would argue that the quality of the high yield bond market is much better than it has been in the past. Therefore, valuation models that use historical risk metrics may be unduly cautious with regard to high yield bond allocations.

 

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Three charts to show why you should consider short-dated high yield bonds

  1. They exhibit negative correlation with government bonds

US high yield weekly return correlation with US Treasury Bond Market (1997-2016)

Source: Bloomberg

 

2. They show resilience to negative events

Transocean: short vs medium maturities

Source: Bloomberg
 

3. They offer a positive real yield with little duration risk

Bond yields versus CPI

Sources: Kames Capital; Bloomberg. Data as at 14 December 2017

 

Worried about rising rates? Like to minimise risk? Like a real yield? Try short-dated high yield bonds.

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Don’t throw the high yield bond babies out with the Brexit bathwater

As we sit at our desks here in Edinburgh, and survey the global high yield bond markets via our computer screens, we can see that GBP-denominated securities trade at much higher credit spreads than their EUR and USD-denominated brethren.

Looking at the chart below, we can see that GBP-denominated corporate bonds rated BB offer a credit spread of 246bps, compared to 212bps for EUR and 220bps for USD. The distinction is much larger for single B rated corporates – GBP-denominated bonds offer a spread of 504bps compared to 376bps for USD and 446bps for EUR. “That’s fair enough”, you might say, “GBP corporate bonds deserve to trade with an additional credit spread because of the risks surrounding the possible economic impact of Brexit”. For many investors that manage money on a top-down basis, the analysis stops here.


Source: Bloomberg

However, if we dig deeper and look at some of the individual credits, we can identify plenty of opportunities for the bottom-up global investor. Although there is indeed a “Brexit premium” required for a number of GBP-denominated bonds, for example those issued by domestic consumer cyclicals, there are also many situations where cross-currency issuers see their GBP-denominated bonds trading at a discount. We can see some examples of this in the table below.

In each case the bonds shown rank pari-passu (a Latin phrase meaning “equal footing”) in the capital structure. Therefore default risk is identical. We have tried to match the maturity dates of each pair as closely as possible, though they are not all exactly the same.


Source: Bloomberg

The table above contains a mix of multinational and domestic businesses which are sufficiently large to have bonds outstanding in multiple currencies. We can see for every issuer shown, the GBP-denominated bonds compensate noteholders with a material extra credit spread. (Note: looking at credit spread rather than yield isolates the compensation for default risk by removing the government bond yield component that compensates investors for the prevailing interest rate environment in each currency). We believe this valuation disparity has occurred because top-down investors, in their desire to avoid Brexit-related risks, have sold down GBP-denominated assets without considering the credit quality of the underlying borrowers or the valuations of the particular bond issues.

For those investors that can operate on a global basis, and are not tied to specific currencies, there are opportunities to be had in lending in GBP to strong individual borrowers, while avoiding the risks associated with Brexit.

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Kames Keeps up with the Kardashians

Reality television production might not immediately appear to be the strongest credit proposition – but appearances can be deceptive. A new bond issue from Banijay Group (responsible for many well-known hits including ‘Keeping up with the Kardashians’ and ‘Location, Location, Location’) actually exemplifies a number of the key business model characteristics that we’re looking for when selecting bonds for our high yield portfolios.

The business model characteristics in question are: diversity, predictability and cash-generation.

Banijay has diversity on a number of measures: by television genre, by television show, by geography and by customer. The value of this from a credit perspective is that problems in any one area are insufficient on their own to undermine the business as a whole.

On predictability, much of Banijay’s revenue is generated from enduring hit shows that run for multiple seasons, meaning that the bulk of this year’s budget is already under contract, and we can be highly confident that the company will continue to deliver in the years to come as big hits are re-commissioned.

Finally, it is cash generative because no large upfront capital investment is required – Banijay pitches to the television networks using scripts, storyboards, trailers and occasionally a full pilot episode. The full cost of producing a television series is not incurred until a television network has committed to broadcasting the show. In an environment where the entry of Netflix and Amazon Prime is forcing the traditional television networks to increase their content spending, we believe Banijay is well-positioned to benefit from this growing demand.

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The Sleepy High Yield New Issue Market

  • The chart shows the proportion of new debt raised in the high yield market that is used to refinance existing borrowings, rather than for more speculative purposes such as capital projects, mergers & acquisitions, and returns to shareholders.
  • Refinancing is the safest kind of high yield bond transaction for an investor to participate in because the company’s operational and financial situation is unchanged by the deal – in all the other cases operational and/or financial fundamental risk is increased as a direct result of the transaction.
  • We can see that as a proportion of total new issuance in the US high yield bond market, refinancing transactions reached over 60% of total issuance in the twelve months to March 2017, the highest level since 2002.
  • We believe that this, combined with the steady upward drift in the average ratings quality of the market, is suggestive that underlying fundamental conditions are much more robust than at many times in the past.

  • The riskiest kind of high yield transactions are dividend (or share buyback) deals. In this case the money raised does not do anything productive – it goes straight out of the door to shareholders. The company is then left with a larger debt burden to service.
  • We can see that the dividend deal boom of 2013 and 2014 has now substantially faded.
  • This is a lead indicator of risk in the high yield bond market and is suggestive that issuers are becoming more conservative in their financing decisions.