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.