Rising bond yields are not as they might first appear

Cast your mind back to June 2014. King Juan Carlos I of Spain abdicates the throne after a 39-year reign. Uruguay’s Luis Suarez is expelled from the FIFA World Cup for biting Italy’s Giorgio Chiellini. The European Central Bank breaks new ground in monetary policy by cutting its deposit rate to a negative level for the first time. The French air traffic controllers strike over budget cuts (some things never change). Meanwhile, the US high yield bond market hits a record low yield of 4.84%.

Any investors who at that point had perfect foresight would have already known that yields would rise to a level of 6.37% by July 2018, and also a spike in defaults in 2016 due to the impact of declining oil prices on the US onshore oil industry. They would have also known that the Federal Reserve would begin a rate hiking cycle in late 2015. People with such foresight may have been tempted to either disinvest from the US high yield bond market, move to underweight, or go outright short. However, such a decision may not have been as profitable as anticipated.

Despite the steady rise in yields, the US high yield bond market delivered a 17.5% cumulative total return from Jun-14 to Jul-18, or 4.04% on an annualised basis. This was greater than both US investment grade corporate bonds (2.65% annualised) and US Treasury bonds (1.54% annualised). A combination of factors helps high yield bonds in a rising yield environment. These are: relatively high coupons; and quite short duration. For any fixed income instrument, the shorter the duration, and the higher the starting yield, the greater the rise in yields that is needed to create a capital loss large enough to wipe out the yield income. With longer duration and lower starting yields, investment grade corporate bonds and government bonds become much more exposed against a backdrop of rising yields.

Looking at today’s market level, with a yield of 6.37%, the US high yield bond market could sustain a rise in yields to 7.92% over the course of the next 12 months without delivering a negative total return to investors. For those readers that are either cautious or bearish about the high yield bond market, the question to ask yourself is not whether you think yields will rise, but whether yields will rise far enough and fast enough to offset the yield income.

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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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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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Netflix has no time to chill

On this week exactly a year ago, our co-Head of Fixed Income Adrian Hull wrote about Netflix’s debut issuance (Netflix launches Billions) into the euro bond market, when it printed €1bn of 10-year maturity bonds. One year on and Netflix has just priced its first issuance of 2018, this time in US dollars. Having initially targeted raising $1.5bn through senior bond issuance, the company ended up printing almost $2bn. Pricing at 5.875% for a 10.5 year maturity, this bullet bond proved to be another successful bond issue for Netflix. So what has changed for the business in the last year?

Netflix continues to surpass expectations for subscriber and EBITDA (earnings before interest, taxes, depreciation and amortization) growth. Both US and overseas segments saw net additions to subscribers well above company expectations. On top of this, Netflix successfully passed through its planned subscription price increase without significant churn in either its US or overseas base. Last year, US profits meaningfully supported overseas expansion; one year on, international improvements are offsetting margin declines in the US market.

The proceeds for the new bond have been earmarked for ‘general corporate purposes’, which is likely to mean a significant portion will be used to fund Netflix’s anticipated $3-4bn cash flow burn in 2018. We think Netflix will have to keep tapping the debt market in the near term as it burns through its cash pile in its quest to create new content.

On that basis we’re not taking a “Daredevil” approach to this bond issue, and will instead continue to focus our efforts on finding companies with secure and stable cash flows, and of course sustainable returns for our clients.

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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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Ball Tampering

Being the token Aussie within Kames multi-national bond team, I need not have feared a lack of commentary from my colleagues on the topic of the Australian Cricket team’s recent ball-tampering scandal. Regrettably, this format does not allow for a full examination of Scottish, Bulgarian, or even Spanish perspectives on the concept of fair-play or the deep traditions of the great game. Anyone wishing to read more about the scandal, I do commend you to have a look at the Aussie press, who are covering it with their renowned sense of understatement and proportion.

Anyway, looking to the future of the Australian team I encountered an alarming statistic; some 35% of all Australian test cricket runs since 2013 have been scored by Steve Smith and David Warner, the captain and vice-captain who have been side-lined for a year as a result of the scandal. Their absence will place a great deal of pressure on their replacements to be sure, but more pertinently, on the rest of the batting order who have often had their own performances bailed out by their erstwhile teammates. Time will tell, but you do not need to be a cricket tragic to realise this will prove a significant challenge.

In much the same way, global asset markets are facing a similar challenge. Our superstar players – The Fed, ECB, BoE, and BoJ – have all indicated that the glut of central bank liquidity, which has carried the global economy and asset prices along, may be coming to an end sooner rather than later, with the ‘sooner’ part coming into sharp relief on the back of improving economic data. Markets will have to learn to get along without the soothing realisation that evermore central bank support will be there to float all asset prices higher, much as the Aussie top order can’t rely on ‘Smithy’ to bail them out with yet another effortless century. Thank goodness. In my view, the reawakening of volatility in bond and equity markets we have seen in 2018 is the result of participants belatedly rediscovering asset valuation on factors other than central bank largess.

Part of our core view for 2018 had been for the return of dispersion as idiosyncratic risk came to the fore, as the beta-driven QE trade dissipated. The volatility should be seen for what it is – a process of adjustment rather than the beginning of the end. This environment demands a closer examination of business models, cash flow, and financial resilience for the companies you invest in. Assets with flimsy intrinsic valuation will find this being examined, often brutally (hello Tesla). For the rest of us, this volatility presents an opportunity to add to positions in those firms that set to benefit from what is, remember, an improving global growth story. In navigating this environment, we are convinced that selecting an active manager who has been consciously avoiding areas where we see QE-driven excess, and identifying the overlooked and more attractive parts of the high yield market is the right thing to do.

Failing that, I am sure I can find some sand-paper.

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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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2018 – a key year for high yield

2018 is shaping up to be a key year for the high yield bond market. In 2017 the market effortlessly shifted from ‘recovery mode’ (following the 2015/16 shale energy crisis) to rallying in conjunction with the global expansion we see around us. As a result, investors will enter 2018 contending with the offsetting influences of tight valuations against improving macroeconomic – and therefore corporate – fundamentals.

How do we see these competing factors playing out in 2018?

We think the big beta-driven moves of 2016 and early 2017 are behind us. We expect to see a modest amount of yield spread tightening in 2018, but overall we think current valuations are both full and justified.

Investors should remember, however, that the vast majority of returns in the high yield asset class accrue from the compounding effect of high levels of income or carry, through time, and not through the rather more eye-catching beta moves of recent periods.

Furthermore, high yield’s negative correlation with government bond markets leads us to conclude that, in the current improving environment, deriving good levels of income without taking material duration or interest rate risk is very attractive for bond investors.

 

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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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Making Stuff is Hard

The most valuable lessons in high yield investing are usually delivered using a mix of shock, pain and humiliation. A rare exception to this occurred to me a few years ago; however I suspect more recently, similar lessons are visiting Tesla investors, albeit more painfully.

German company Heidelberger Druckmaschinen (HD) is a precision manufacturer of high quality printing presses. In late 2011 it hit a rocky patch where revenues were down, and the high yield market began to seriously worry about its imminent collapse. The timing was lousy. A European high yield market recovering from the Eurozone crisis was in no mood to tolerate any missteps by a CCC rated issuer, and its bonds were duly hammered.

However, taking a closer look, a few things stood out. For one, its lag was entirely predictable as historically orders ALWAYS dipped before the major industry showcase (‘drupa’) which was held every four years, and 2012 was the next one. In addition, there was a view that HD was at the wrong end of the terminal decline of newspapers (what with the internet n’ all), and to make matters worse, Chinese competition was about to take what was left. This nuanced assessment played well to the ‘gut-feel’ view of the world favoured by a certain type of investor. Except it was wrong. HD had actually disposed of its newsprint business many years prior, instead focussing on the growing need for high quality consumer packaging. Chinese threat? Sure, the lower end of the market had been subject to it, however they seemed to struggle to replicate the most advanced presses. Thematic investing is great, but it’s even better when accompanied by some due diligence.

So how does this relate to Tesla? Making ‘stuff’ is hard. The beta version and constant update model of the software industry works well, as their products can be costlessly tweaked after sale. Not unreasonably, software companies are given high valuations based on this high operating leverage. Applying this to the auto industry is more problematic. Tesla is running into problems scaling up production due to the presence of bottlenecks, labour issues, and even difficulty in welding. If this sounds all terribly 19th century, I apologise but it still matters – it is very difficult to sell a car you can’t make. All of this would be manageable except Tesla’s valuation allows for nothing but a non-stop journey to global domination; not a decades-long on-the-job training programme.

Upon visiting HD’s factory I was struck by the huge amount of accumulated skill, knowledge and expertise amongst its many thousands of employees. Not only ‘had’ it accumulated, it was ‘still’ accumulating. I saw first-hand the factory floor work groups that measure absolutely everything and are constantly refining their process to save 12-mins here, reduce 400g of scrap there. To scale up any advanced manufacturing takes this kind of process which simply cannot be replicated – nor should it be dismissed – overnight. Following the visit I invested in HD, confident that it had a significant embedded competitive advantage and that its ability to earn economic profits – and pay our coupon – was intact. I won’t bore you with the details, but it ended very well for the company and the investors who backed it at the time.

Electric cars are certainly the future, but Tesla’s valuation reminds me that the market can sometimes underappreciate the challenges of operating in the physical world, at scale. This can be a great opportunity, as in the case of HD, or it can lead to risks being under-priced by financial markets, as with Tesla’s recent swoon. It’s our job to recognise these factors and it remains a core focus of the way we do things at Kames.

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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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A stock picker’s take on striking gold

Markets are in good shape, and as expected, the new-issue market cranked back into gear last month – an opportunity to find good quality cash flows for our portfolios.

What can be astonishing (and pleasing) in this market is the difference in relative valuations between companies in a sector. Take, for example Equinix versus SoftBank.

Internet storage provider Equinix came to the market last month with a euro new issue. While we are typically cautious about the fast-changing nature of tech companies, we see structural demand for server space and connectivity between different organisations and Equinix benefits from this as a market-leading data centre operator.

As the old saying goes, we would rather sell shovels to prospectors during a gold rush rather than join in the prospecting ourselves – and these bonds offer cash flows, regardless of which online business gains or loses.

Equinix also has a very well-diversified client list (the largest customer is under 3% of revenues) across very different industries and can host its customers’ servers in multiple locations. This increases the stickiness of its customer base.

This high quality story was offered at a spread of almost 3%, which we think compares very favourably against better-known SoftBank. That is despite the lack of fundamental certainty over SoftBank’s long-term cash flows, as it spends huge amounts on highly uncertain early-stage tech investments – in effect trying to join the prospecting herd.

It seems that the yield penalty for choosing quality over quantity is at historic lows, in a market that is more concerned with all-in yield than differentiating between company fundamentals. This is the stock picker’s idea of striking gold.

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Not so (Pet)Smart

Revenues mean nothing if the company in question loses money with every sale made. While this may seem obvious, the high yield market has been reminded of this in a painful way over the last few months.

The company in question is PetSmart – a large American pet store operator. It recently borrowed a grand total of $2bn in order to purchase Chewy, an online pet retailer. Theoretically buying a digital retailer to capture customers moving online makes sense. But PetSmart’s acquisition of Chewy is negative for one very important reason – once all the operating costs are factored in, Chewy doesn’t actually make any money from the sales it generates.

While PetSmart’s physical stores have very healthy profit margins, Chewy’s are negative. In effect what PetSmart is doing in buying Chewy is gaining loss-making online sales as a way to offset the loss of profitable offline sales. While there is a chance that the business can cut costs and restore some of that ever-decreasing pie of profit, the odds are stacked against them.

In contrast one business that we can get excited about is the 100%-online grocer Ocado. Whereas PetSmart’s online acquisition is loss-making, Ocado’s online grocery business is highly profitable, with better margins than all of the listed offline grocers and a very strong structural growth story. On top of its own online success, the business is well-positioned to benefit from other supermarkets attempting to move online through its platform-provision business – which effectively allows other retailers to establish an online business without the huge operational headache that starting from scratch would entail. Morrisons are currently using Ocado for this, which has been successful for both companies.

Overall this is a story of fundamentals. One company is scratching around trying desperately to defend a crumbling offline retail empire by loading up on more debt and buying a loss-making online retailer, while another company has a steady and sensible long-term plan to expand its already highly profitable business even further.

When these two companies came to the debt market earlier this year, the choice was relatively easy for us. As shown below, the subsequent performance has borne out our thesis.

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Boring is good

In our experience, some of the best high yield bonds reflect those of us who invest in them; low-key, reliable, and often profoundly boring. The ‘monotony’ of a business that reliably posts juicy but safe cash flows? Sign me up! Some of our fondest positions are in glamorous industries such as cardboard boxes, funeral care, tin can making, and the gel-like casings your headache tablets come in. Glitz and a good story is more often found in the equity market, and that’s the way we like it.

A test to this rule came recently when US electric car maker, Tesla, issued its maiden, conventional high yield bond. Tesla is unquestionably an impressive company. Their cars are technological marvels that outperform their peers on almost every metric, and to be sure, our friends in the equity market have certainly not been shy in reflecting such wonder. Tesla’s current share price implies an enterprise value (that is the total value of Tesla’s debt and equity) of some 96x its Earnings Before Interest, Tax, Depreciation and Amortisation.EBITDA is the HY market’s imperfect (but convenient) shorthand for cash flow, and illustrates the cash earnings a firm produces from its assets, stripped of as much accounting chicanery as possible. Now, 96x is a lot. A cynic might suggest that all the good things that have ever or could ever happen to this company are currently ‘in the price’.

By way of reference, BMW is a reasonably well-known car maker that has both a very strong position in conventional premium cars, as well as making significant inroads into electrification of cars via the impressive i3 and i8 models. We would be the first to admit that wherever the auto industry is going, Tesla will be part of it, but so too will BMW. In the meantime, they have a significant and highly profitable conventional car business, as well as decades of embedded know-how in the sector and a cash flow profile that can support significant investment in research and development.

Conveniently, BMW ($61 billion) and Tesla ($60.7b) have almost identical equity market valuations. However in terms of cash flow and scale, they are worlds apart. Last year Tesla produced just over 76,000 vehicles to BMW’s 2,360,000; a factor of some 31:1. Cash flow is where the real difference lies however. BMW’s cash flow is such that the company is valued by the market at only 7.5x the EBITDA it can produce today versus the 96x at Tesla. Clearly, the market believes Tesla ‘should’ grow significantly in the future.

Given Tesla’s ambition currently far exceeds its cash flow, it has turned to the high yield market to plug the gap between what it needs to spend to grow into its valuation, and what it can generate currently. For us, this is the antithesis of what a high yield bond is for. By investing in Tesla bonds you are providing growth equity capital with all the potential downside that entails, but with the upside profile of, well, a bond. Regardless of our admiration for Tesla, we don’t like that risk reward profile and we declined to buy the new deal. We prefer businesses that ‘do’ rather than ‘should’ produce the cash flow we need to pay our coupons and principal back. In the good times it can be easy to have one’s head turned by new and dynamic companies; however at Kames we don’t believe that our clients’ interests are served by such an approach, when indeed the opposite is usually far more rewarding for bondholders. If that makes our presentations a little less electric then so be 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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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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Holmes moans about loans

As a high yield fund manager it has been interesting to watch leveraged loans become something of an investor darling this year – almost $13bn has flowed into US loans over the year to date. Investors have sought out loans as a place to hide from a Fed that is raising interest rates, and with the perception that they are a “safer” income provider than conventional bonds.

But is this logic sound? How do loans perform in hiking cycles?

US leveraged loans underperformed US high yield by almost 2% per annum over the 2004-2006 hiking cycle. In a hiking cycle, high yield bonds tend to perform well due to their positive exposure to economic growth, while loans offer far less opportunity for capital appreciation.

And how much safer are leveraged loans? The peak-to-trough drawdown was 95% of that seen in high yield during the financial crisis, while high yield has produced 123% more total return over the last 15 years. In other words, investment in leveraged loans over the past decade and a half has resulted in almost as much drawdown while sacrificing the large profits that could have been made by a long-term investment in high yield (a topic my colleague David Ennett has discussed previously http://bondtalk.co.uk/high-yield/carry-me-home-the-source-of-high-yield-returns/).

 


Source: Bloomberg as at 31 May 2017

Leveraged loans are also more exposed to problem sectors than high yield. Retailers that are mortally threatened by Amazon make up more of the investable universe in loans than in the high yield universe. Leveraged loans are getting riskier too – in Europe the average secured indebtedness for new loans is almost 70% higher than at the end of 2010. In contrast, European high yield leverage has actually fallen over this period.

From my perspective a well-managed high yield portfolio provides a much better way to generate strong sustainable income versus alternatives such as loans. By investing with high yield teams focused on finding defensively-positioned companies with strong business models, attractive risk-adjusted total returns can be generated. Whether the same can be said for loans remains to be seen…

 

 

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Carry me home – the source of high yield returns

To say the past decade has been an eventful one for the high yield market is putting it somewhat mildly. The first half of 2007 was a golden time: markets were in rude health making pre-crisis highs, politicians were for the most part sane, competent, normal human beings, and a eurozone crisis involved accidentally skiing to a Swiss après-ski bar. The following decade has not been quite as smooth, enduring as we have the global financial (2008/9), eurozone (2011), and energy and commodity crises (2014/15) of recent years.

Yes – those were happy days indeed, but with the benefit of hindsight, a seemingly terrible time to buy any risk asset. Within high yield, valuations in 2007 were at their most extreme with the additional yield on offer from high yield bonds (versus similar maturity government bonds) at its all-time low of 2.3%, versus around 4% today.

Taking a closer look at how the asset class has actually performed from this ‘terrible’ entry point illustrates much about the source of returns within high yield.

Global High Yield: 10-year returns

Source: BoAML Global High Yield Index, Bloomberg.  USD. 31/03/2007 to 31/03/2017.

A few things stand out. First is the impressive total return of 110%. To be sure, there were some hugely volatile periods, none more so than the dramatic – albeit brief – near 40% drawdown in early 2009, as well as of course 2011 and 2015. These periods can have a big impact on the short-term price performance of the asset class. But in the context of long-term total returns, we can see that price volatility is dwarfed by one, compelling source of return – carry.

Of the 110% you have made in high yield over the past decade, some 112% of it came from income, and recall that this was from a ‘terrible’ time to buy!

The key to exploiting the carry in high yield is to stay invested – sorry, no carry for day traders – and adopt an active approach to selecting the companies you wish to lend to. Remember, high yield is at its core a mechanism for transforming the real-world cash flows of cash generative companies into coupon flow for investors who provide debt financing. Given we have long known this about the high yield market, it is why we emphasise these very cash flows when selecting companies to invest in.

Perhaps it is asking too much for financial journalists to lead with ‘Massive Coupon Income Hits HY Market’; but we do think investors should keep this in mind when they next read about the ever-present impending doom of the high yield market.

Netflix launches Billions

OK, so “Billions” is actually produced by Netflix competitor Showtime, owned by CBS and broadcast in the UK by Sky Atlantic. However, yesterday, Netflix issued its debut bond into the Euro market with €1bn of 3.625% 10 year bonds using its B1 rating.  What is unusual with Netflix is its vast market capitalisation at $63bn is often associated with materially better rated companies.

Netflix being one of the FANGs (The new tech stock of Facebook – Amazon – Netflix – Google) is still in build-out phase as it aggressively invests overseas to capture market share.  Whilst subscription revenues are evenly divided between the US and the rest of the world, US profits subsidise overseas expansion with top line growth of up to 30% – which is a key ingredient to its huge market capitalisation.  The pricing was fairly aggressive for a B1 issuer, but the halo effect of being a FANG means the deal isn’t breaking bad as it is around ¾ point higher today. The Crown in yesterday’s European high yield market.

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.

UK high yield retail – are you being served?

UK retailers are facing significant pressures over the coming years – from the rise in business rates, higher supplier costs due to weaker sterling, and the new national living wage; to the expected continued growth of online retailers like Amazon and Asos. Given all that is facing these companies anyway, investing in the more indebted end of the sector seems to us a costly mistake at present. We would argue that retailers in general tend to have high fixed costs and variable top lines, so adding a large fixed debt service cost generally doesn’t stack up. Interestingly though, the market doesn’t seem to agree with what we would regard as common sense, as the median UK high yield retailer has debt worth almost six times their earnings – significantly above the European high yield average of just over four times.

Despite the fact that UK high yield retailers are facing huge operational headwinds alongside significantly more indebtedness than the wider high yield universe, the bonds on offer do not trade at a discount – in fact when we checked on Friday the median UK high yield retail bond traded with exactly the same spread over government bonds as the wider European high yield market!

In short the bonds of UK high yield retailers offer significant operational risks; large levels of indebtedness; and absolutely no discount to the wider market. We’re quite happy to let the benchmarked funds and ETFs play away in these, and think that our clients are getting far better service by looking at other more attractive parts of the high yield market.