(VIDEO) Fixed income outlook 2nd half 2020

Adrian Hull, Head of Fixed Income UK, is joined by Sandra Holdsworth (Rates), Iain Buckle (IG), and Tom Hanson (HY) to discuss the outlook for the fixed income markets in the second half of 2020.

Click here to download a copy of the slides used in the video.

Sign up to receive our weekly BondTalk email

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

Sign up to receive our weekly BondTalk email

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.

Sign up to receive our weekly BondTalk email

Shaping a global return profile

The nice thing about a global, high conviction approach is the ability to take advantage of interesting market dislocations. While high yield is certainly an idiosyncratic, stock selection-focused asset class, our global opportunity set helps frame our hunting ground. For example, US BBs are trading almost 100bps wider than European BBs – a reversal of the two-year trend of European BBs offering wider spreads than their American counterparts. For BBs, the US looks like the most interesting place to go.

Source: Bloomberg: ICE Bank of America Merrill Lynch

In single-Bs, the indices are on top of each other in spread terms, despite a long period of wider single-B spreads in Europe. Here we can be agnostic, and an interesting difference between US dollar and European high yield means that we can look for opportunities in different shapes of returns.

US high yield comes with higher coupons, meaning greater cash price stability, price upside potential past par and greater carry from holding a position. Meanwhile, European high yield has typically offered lower coupons. While you have less upside potential past par, a bond’s cash price can fall sharply on spread moves that would affect higher coupon bonds less. So why buy those bonds? Your shape of return is different. If you expect a sharp recovery in an issuer’s bond price after an indiscriminate sell-off, the lower cash price bond will likely outperform over the short-term. An interesting example of this in the period was Ball’s euro 1.5% 2027s versus their US dollar 4.875% 2026s. Ignoring currency effects for simplicity, from the lows to the end of March, the euro 1.5% coupon bonds have outperformed the higher coupon dollar bonds by 8.6%. But, over the longer term, the lower price volatility and greater carry has made the US dollar bond a better investment.

So if you only bought one, you may just own the US dollar bond. But what if you can have both? Adient is a seat supplier to the automotive industry and has its challenges, but we believe it is an interesting company and a good case study for the power of global. Adient’s euro 3.5% 2024s have rallied sharply from their lows of ~62, and are now trading just shy of 80. Last month, the company brought a new, US dollar first lien secured 2025 bond with an attractive 9% coupon.  We can now have exposure to Adient through both high capital price upside potential euro bonds, as well as greater downside protected and attractive carry offering, secured US dollar bonds. By blending these two shapes of return together, and across different parts of the capital structure, we hope to achieve superior risk-adjusted performance versus just owning one of these bonds.

By flexing the global opportunity set, we hope to add material incremental value to our funds in ways that are simply not available to single-region portfolios or to funds that are beholden to benchmark weights.

Sign up to receive our weekly BondTalk email

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.

Sign up to receive our weekly BondTalk email

BondTalk Podcast: The high yield reaction to coronavirus

“Most thought the Fed were going to take some action like this. I think what came as a surprise was the magnitude and the timing of the move. The Fed has gone reasonably large and reasonably early and their aim is to shore up sentiment in the market…”


In this Podcast edition of BondTalk, Head of European High Yield Tom Hanson discusses how the big shift in risk sentiment caused by the coronavirus is affecting the high yield markets. He also discusses what he makes of the Fed’s reaction and how this changes his team’s positioning during the ongoing situation. The podcast is presented Investment Specialist Stewart Duncan.

Sign up to receive our weekly BondTalk email

Debt and assassinations

Julius Caesar was famously assassinated on the Ides of March and Shakespeare further immortalised it in our memories with ‘Beware the Ides of March’. But, this specific day (March 15) was also a deadline for settling debts in Roman times (Caesar paid the ultimate price).

March 15 isn’t far away. Amidst the current Covid-19 induced volatility, will high yield companies be able to settle their debts? What companies are at risk of ‘assassination’ by a slowing global growth backdrop and a refinancing window that can snap shut for highly risky issuers in times of market stress?

Highly risky companies with debt maturing in the next 12-18 months will currently be assessing the sustainability of their capital structures. It’s hard to say that global growth was on a very positive trajectory before the virus outbreak intensified, and it’s certainly going to be weaker now. Issuers facing structural headwinds who already had rising debt burdens and shrinking margins will suddenly find their problems accelerating. And with the degree of ‘covenant-lite’ documentation (not just in the loan market) recoveries may be lower in restructuring scenarios as the potential for value leakage has increased.

However, despite the virus volatility, the Ides of March for 2020 are likely to be largely uneventful in terms of unexpected restructurings. Companies have been doing a good job in easy financing conditions at pushing out their maturities; in the Bank of America Merrill Lynch US and Euro CCC-rated and lower indices, there are no debt maturities until March 2021. Looking ahead, the 2021 and 2022 maturity walls start to look a little scarier for those invested in companies just limping along. Of course, maturity walls and turnaround runways are key considerations in our credit analysis.

In our all-maturity high yield strategy, the nearest bond maturity is still more than two years away and that certainly isn’t the riskiest credit we own. We typically target issuers who will clearly be able to exist beyond their next bond maturity. We like stable, free-cash-flow-generative businesses that we are comfortable holding through market volatility. No assassinations expected here.

Meanwhile, passive strategies are lending to the highly risky and the less risky alike. They are, of course, just allocating increasing amounts to the most indebted companies. Beware the (next) Ides of March.

Sign up to receive our weekly BondTalk email

High yield outlook 2020

Given how 2019 started, and how different the world felt back then, few people backed high yield, and even fewer would have predicted that the year would turn out to be one of the best on record in terms of returns delivered by the high yield market.  Global high yield (as measured by the ICE BofAML Global High Yield index) returned 12.32% in sterling terms (14.52% in US dollars) in 2019. So the natural question is what can it do in 2020?

Let’s get the bad news out of the way first; in 2020 it is extremely unlikely that high yield will generate anything like the returns we have seen in 2019. The bond mathematics simply aren’t on the sector’s side in this regard. The valuation picture within global high yield remains one of the most challenging parts of the market.  The government option-adjusted spread (OAS) on the ICE BofAML Global High Yield index currently stands at about 425 basis points (bps), with an effective yield of 5.5%. If one compares either of these metrics to the long-term averages for the asset class, they are clearly expensive versus history. In other words, it doesn’t seem plausible to rely on a further significant tightening of credit spreads to drive total returns in 2020, and although we note spreads have traded at significantly tighter levels over this cycle, it feels hard to make a compelling valuation argument, given the asymmetric potential return profile. So what are the upsides?

Firstly, high yield does still offer you an attractive income based return in a world that is largely bereft of yield, particularly when compared to that on offer from investment grade corporate bonds or governments. There are still pockets of value too; higher quality BB-rated bonds trade tight, but there are still plenty of opportunities in the lower rated space that can be unlocked by careful credit analysis. The recent trend of dispersion here plays into our hands as active, fundamentally driven investors. A more volatile world offers us more opportunity to deliver value through our rigorous investment process. Furthermore, this frequently misunderstood asset class does offer some defensive characteristics too; it has a high breakeven level (the amount by which spreads need to widen in order to deliver a negative total return), it has a low interest rate sensitivity, and a low correlation to other asset classes.  Global high yield rarely has a down year (just two out of the last ten have delivered a negative total return), and when it does, it tends to recover those losses extremely quickly.

From a corporate fundamental perspective, the backdrop has continued to deteriorate at the margin, with key credit metrics such as leverage and coverage worsening, albeit from very strong levels and at a very slow pace. This is clearly not a favourable trend for credit investors, however defaults do remain low, and are generally contained to idiosyncratic stories, which is why an active management approach to the asset class is imperative. Without a sharp and sustained growth slowdown it is hard to see where a significant pick-up in defaults comes from, and given there are tentative signs of a bottoming-out of some of the macroeconomic data, a slightly more benign 2020 growth outlook will be supportive for the asset class.

Last, but most certainly not least, central banks continue to deliver sustained supportive policy to markets, effectively providing an underlying bid for risk. Our approach this year is to favour a more beta-neutral position overall, and to use security selection, particularly within lower rated bonds, to drive returns. In summary, whilst we can’t expect more of the same in terms of the stellar returns seen this year, we can expect high yield to go back to doing what it does best: deliver a solid carry-driven year, providing investors an attractive, risk-adjusted total return, and act as a good portfolio diversification tool.

In January 2020 we held a webinar with our high yield portfolio management team, where they discussed their outlook for the high yield market in 2020 and the four themes that will shape the year ahead. Listen to the webinar here >

Sign up to receive our weekly BondTalk email

Avoid the sting in the BB’s tail

It’s often said that valuations in high yield bonds are expensive. Yes, this is true to a certain extent. High quality, defensive companies that are BB-rated (the ‘highest of the high’ in high yield) are indeed trading with very tight spreads. This is partly due to yield-starved investment-grade investors dipping down into high yield, pushing valuations up. It is also partly due to some investors feeling nervous about the global outlook, and therefore seeking solace in higher-rated companies. However, for B-rated companies (the middle rung of the high yield universe) credit spreads are more reasonable versus history.

Of course, by definition B-rated companies have a greater degree of credit risk. But right now it could be argued that BB-rated companies have a greater degree of valuation risk. In European high yield, Barclays have shown that 72% of BB-rated bonds are trading at a price above their next call price. This implies that the prices of these bonds cannot rise much further, if at all. High yield is sometimes described as an asset class that can exhibit ‘negatively convex’ behaviour due to the high degree of callable bonds in the universe. A callable bond that rises too far above its call price will eventually reach the point where the yield turns negative, should the bond be called. Few are willing to purchase a high yield bond with a negative implied yield, and as such, the price of that bond reaches a ceiling of sorts. Therefore, thinking in valuation risk terms, at these valuations BB-rated bonds have a very asymmetric risk profile.

Therein lies the opportunity for active managers. For example, in the US, the percentage of B-rated companies trading below par value is 23.5%; compare this to 7.6% for BB-rated companies. There is still significant capital upside for active managers that are able to invest in the credit improvement stories. However, the credit risk inherent in B-rated companies means that these bonds show a much greater degree of dispersion. As such, selecting the right ‘Bs’ is important. As always, careful, high-quality credit research is essential to avoid dispersion to the downside. But we also wield this bottom-up focused approach to capture the upside in B’s. This approach augments the already attractive carry that an investor earns by allocating to the high yield asset class.

An investment process that focuses on high-conviction stock selection can take advantage of the higher degree of dispersion in Bs. And indeed, given the valuation risk in BB-rated companies when compared with the valuation opportunity in B-rated companies, we are currently tilting our portfolio in favour of the Bs and avoiding the potential sting from complacency over the valuations in BBs. The chart below displays the unusually high degree of dispersion in single-B rated bonds; and the unusually high opportunity set for active managers to capture this.

Sign up to receive our weekly BondTalk email

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

Sign up to receive our weekly BondTalk email

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.

Sign up to receive our weekly BondTalk email

Can ESG help you spot an impending bankruptcy?

Environmental, social and governance factors are no doubt important considerations when analysing a business. But I expect that many would say that when it comes to a business going bankrupt, that’s all down to the cold, hard numbers. While that may be true, independent of the financial health of a business you can certainly spot red flags that may indicate a business is headed for ruin. Most likely, these warning signs will appear in analysis of the ‘G’ in ‘ESG’: governance.

Over the weekend, Weatherford, the international oil and gas services company, announced that it intends to file for Chapter 11 bankruptcy restructuring. The business had to accept that its debt was unsustainable given its weak financial position. Analysis of the financials could have told you this (Weatherford is painfully free cash flow negative), but management had embarked on a grand turnaround scheme that involved asset sales as part of a road to continued solvency. However, even if we believed that the financial position of the company could have been saved, the company has some glaring red governance flags that meant we wouldn’t invest.

Strong governance hasn’t been a highlight for Weatherford. Its past is littered with examples of poor controls, such as charges for violating trade sanctions and also for corruption. It settled with the SEC for material weaknesses in its tax accounting. The company has also re-domesticated itself a few times, moving its domicile from the US to Bermuda, then to Switzerland, and most recently Ireland.

But there are other governance concerns. At the same time as being under extreme financial pressure, the company continually missed its own guidance and Wall Street’s expectations. With demanding turnaround targets that the business was already missing, and looming insolvency, there’s a very strong incentive to manipulate and obscure earnings. And while I am categorically not suggesting that management are cooking the books, disclosure has been progressively reduced. Weatherford’s product lines (at a very broad level) are only disclosed as percentages of sales, while earnings are only disclosed by Western and Eastern Hemisphere! This is as broad as it gets, and makes it impossible to analyse the profitability of the company’s operations. Disclosure used to be better, and this direction of travel is a serious warning sign.

There’s more. A planned joint venture with Schlumberger was abandoned unexpectedly after management U-turned on it and, at least to my eyes, was abandoned for a poorer outcome. Assets are also being sold, but at the nadir of profitability. Weatherford’s land drilling rigs were agreed to be sold just as day rates are rising – the business participated on the way down as day rates collapsed, but captured little of the upside as they rose. And despite management’s ambitious turnaround plan, they remain net sellers of their own stock, a concerning development.

So while the company fell into restructuring due to its financial woes, its significant governance failings certainly didn’t help. We researched Weatherford in August last year and chose not to invest. These warning signs from an ESG perspective only solidified our view that the business was unsustainable in its current form – and analysing whether it could become sustainable was increasingly difficult thanks to decisions made by management.

The ‘G’ in ESG helped confirm that the business was not on an upward trajectory and that bankruptcy was a very real possibility. Here at Kames we encapsulate ESG in our investment research process and this example demonstrates how we endeavour to minimise the potential for credit rating migration, volatility and default.

Disclaimer: At the time of writing, Kames does not hold bonds issued by Weatherford

Sign up to receive our weekly BondTalk email

McLaren’s road to success

You may have seen, but for those who haven’t, McLaren recently released their full year results. And good for them, the niche supercar-maker is speeding ahead with ambitious growth plans that are now reflected in their results. Compared to the previous year, car shipments increased 45% to nearly 5,000 in 2018. With an average selling price of well over £200,000 per car, this delivered remarkable revenue growth in the automotive division of 76%.

This growth looks set to continue, with a healthy pipeline of new models approaching the start line – the McLaren Senna GTR production run has already sold out. These new models will help inject even more power into McLaren’s earnings. Their new model, the Speedtail, is set to arrive in 2020 with a price of £1.75m (yes million). And like the Senna GTR, even this has also sold out. Never mind the fact they haven’t even announced the planned successor to the McLaren P1 yet…which will presumably cost even more. This success has driven EBITDA margins in the automotive segment of the business from 10% in 2017 to 22% this year.

In our view, over the next few years, McLaren’s automotive division is on a clear road to success. Some may worry that McLaren is the ‘old’ automotive industry, and that companies like Tesla and electric vehicles in general will position McLaren as a dinosaur. We disagree. McLaren has been using electric technology in its cars for years. The P1 was the world’s first hybrid supercar. The Speedtail will also have a petrol-electric powertrain. McLaren is the sole supplier of high-tech batteries for Formula E. This is a company delivering a niche, highly desirable product at the bleeding edge of engineering innovation. And besides, a car like this isn’t just about getting from A to B, it’s an experience and a trophy asset that the super-rich are clearly happy to pay for.

Here at Kames, the fixed income team seek to lend to businesses, such as McLaren, that demonstrate this solid risk-reward profile.

Disclaimer: Kames Capital holds bonds from McLaren within some of its fund portfolios

Sign up to receive our weekly BondTalk email

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.

Sign up to receive our weekly BondTalk email

The race to the top, but to win what?

Bain & Company recently released their 2019 Global Private Equity Report and within it I found some interesting data points. In particular, the below chart jumped out at me.

What do you anticipate to be the biggest challenges for PE dealmakers in 2018?

Source:Crystal Ball Report 2018, PitchBook Date, Inc

This is the output of a survey of private equity firms at the beginning of 2018*. According to this, the greatest challenge Private Equity (PE) firms believe they are facing is high transaction multiples (i.e. they have to pay more to buy a business), and the second largest challenge is sourcing quality assets. Third is the degree of competition.

So what does this tell us? It tells us that PE firms are having to pay a lot to buy assets, that aren’t necessarily of the highest quality, and that intense competition is making the problem worse.

Competition in private equity isn’t like competition between your local supermarkets – there’s no race to the bottom. The race to buy a business can be an auction process that instead results in a race to the top. The winner, when private equity firms are competing to buy a business, is the one who is willing to pay the highest price. To be able to pay the highest price, the PE firm needs to have access to a significant amount of capital to put to work, or to be able to refinance transactions with forever-higher leverage metrics.

And yet, what does the survey say is of least concern to private equity players? Access to financing.

While PE firms put up some of their own capital to finance an investment, it’ll only be a small portion of the overall invested capital. The rest often comes from the leveraged loan and high yield bond markets. Easy access to financing from these markets allows the PE firms to pay high multiples.

But should financing be so easy when multiples are high enough to cause the private equity firms themselves to worry?

Should it be so easy when they’re concerned over the lack of quality businesses to invest in?

Should it be so easy when high competition for those assets pushes multiples for these businesses even higher?

With all-in yields still relatively low, particularly in Europe, we’re conscious that our investors need an appropriate return on their capital. Careful due diligence in stock selection is absolutely central to our process to ensure our investors are paid for the risk they take on. When we lend money to a business, we’re keenly aware that we are investing assets that have been entrusted to us to manage prudently.

While we would never dismiss a potential investment purely because of private equity involvement, we bear in mind their own concerns about questionable asset quality and high transaction multiples as we conduct our due diligence.

* While this survey relates to expectations for 2018, with continued strong markets (the end of the year was a brief but notable exception) multiples have continued to rise. Indeed, Bain & Company’s report goes on to note that deal values in North America rose 22% in 2018.


Sign up to receive our weekly BondTalk email

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.

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.

Sign up to receive our weekly BondTalk email

Tick Tock Goes the Klöck

Climate change and general concern for the environment, they’re an ever-increasingly important issue for society, so why would it be any different for investors? It isn’t. This is something we’ve been watching for a long time; our ethical franchise will have been running for 30 years next year, so it’s something deeply engrained in our processes.

Lately, plastics and the pollution they cause have faced increasing scrutiny and regulation. This backlash has a fundamental impact on companies in the high yield universe. Take the metal can specialist, Crown Holdings. They suggest that the aluminium can is the world’s most recycled beverage container… and actually it is estimated that 75% of all aluminium ever produced is still in use today. Crown believe that a 1% shift from plastic bottles to metal cans for soft drinks alone could increase demand by billions of cans. This could be an impressive tailwind for positions that produce metal cans – companies like Ball Corp, Crown and Ardagh.

But for every winner, there’s a loser. Klöckner Pentaplast is one of the world’s largest producers of plastic films. This company makes the rigid plastics that cover your food, wraps around batteries, surround gift cards and the packs that your painkillers come in. As such, Klöckner is highly exposed to plastic packaging regulation (and backlash). While regulation isn’t the only problem that this company faces, it certainly hasn’t helped. Operating performance has been deteriorating, with limited revenue growth, falling earnings and negative free cash flow. To its credit, Klöckner has been trying to use more sustainable raw materials, focusing on recycled plastic. But so has everyone else, and the cost of recycled PET has been rising in response – compounding the problem.

Something else that’s interesting about Klöckner Pentaplast is how it has structured its debt. The company has issued a type of bond known as a Toggle PIK. These allow the company to pay interest in cash (like normal) or to elect to ‘pay in kind’ (this means adding more debt to its existing debt!). This toggle option means the company isn’t forced to pay cash away when it can’t afford to. But this extra debt means that the company is becoming increasingly indebted – even as it struggles to pay its existing obligations! This risk means that PIK bonds often come with large coupons, and can be an excellent investment when the business is doing well. This is where stock selection is so important.

We decided not to participate in the Klöckner bond when it was first issued at par (i.e. 100) this time last year. I reviewed the company when the bond was trading in the 50s last month, having lost almost half of its value. We chose to pass again, as the firm’s fundamentals had continued to deteriorate. This week, Klöckner announced it would elect to pay its interest in PIK. Today, the bonds are priced at 35. I can hear the Klöck ticking…

Meanwhile, our can makers in the portfolio continue to hold in very well amidst the recent market volatility. These are fundamentally strong businesses that may also benefit from a helpful regulatory tailwind.

Sign up to receive our weekly BondTalk email

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.

Sign up to receive our weekly BondTalk email

Junk defence

Well that escalated quickly!  2018 has been a torrid year for most financial assets as they try to adjust to the last decade’s dominant monetary policy regime – Quantitative Easing – reversing direction towards a more “normal” setting.  From the usual suspects of emerging markets and equities, right through to the traditionally more staid investment grade credit and government bond markets, 2018 has set records for being uniquely bad for capital markets.  According to recent research by Deutsche Bank, some 89% of asset classes had posted negative Year-To-Date returns (in USD terms) to the end of October – the highest proportion ever recorded, stretching back to 1901.

To the surprise of many, one area which has performed remarkably well has been the high yield market.  This would seem at odds with most people’s perception of the asset class; with its fixed income and equity-like characteristics coupled with increased market volatility looking like a recipe for disaster in the current climate.  This is not to say that the asset class has not become ‘cheaper’ in the turmoil; indeed the yield on the global high yield index has increased from 5.25% at the start of 2018, to around 6.6% at the end of October.

What has allowed high yield to stay in the black is the often overlooked, and enduring power of carry.  Whilst an equity’s valuation is dominated by the net-present-value of far-off (and often theoretical) cash flows; high yield takes a more certain view of equity-like returns and insists on cash up front via high, contracted, semi-annual coupons.  Similarly, lower yielding fixed income instruments (in government and investment grade markets) have levels of carry often unable to fully compensate for the capital swings that changes in the underlying rate environment entail.  The high yield carry allows the asset class to adjust more quickly to changes in the yield environment, a process further assisted by its relatively low duration of around four years.

High yield is often described as halfway between traditional bond and equity risk, with the negatives of each often emphasised.  In times like the present however, with an uncertain interest rate outlook, low defaults, and moderate but increasing inflation, it offer investors a little of the best of both and we would urge investors to take a closer look.

Sign up to receive our weekly BondTalk email

Why I’d rather own a McLaren than a Ferrari in a hard Brexit

We are often asked if there are opportunities in Sterling-denominated high yield bonds. As ever, the answer is nuanced and not black and white. So, in the context of what looks to be an increasingly messy Brexit and sustained weakness in Sterling (down 11% since the peak in April) we thought it worthwhile to explain our logic in some of our preferred Sterling bonds. Indeed, with a global remit there is no shortage of opportunities so why make the case for these issuers?

Our view is that Sterling-denominated high yield bonds “generically” are very cheap at present. What do we mean by this? We see a number of examples where bonds issued by the same company, with the same maturity, and same level of protection for bondholders, are cheaper purely because they are denominated in Sterling. For example, there are currently two bonds issued by the supercar producer McLaren which are identical in every way (covenants, maturity date, etc.) except that one is in Sterling while the other is in US Dollars. The pricing has become so dislocated that, any which way, the Sterling bonds are cheaper.  In absolute yield terms the Sterling bond pays more than the US Dollar bond. This is despite the fact that, in a currency-hedged portfolio investors actually get paid more for owning a Sterling asset than a US Dollar asset. We summarise this incremental return below:

Mclaren GBP bonds McLaren USD bonds
Local Currency yield: 5.94% 5.89%
Effect of Sterling hedge: +1.57%
USD-hedged yield: 7.51% 5.89%

Simply put – for the same fundamental risk an investor can realise a 1.6% higher annual yield by owning the Sterling bonds over the US Dollar. This very pronounced dislocation is an illustration of why we believe unconstrained investors can benefit from investing in Sterling-denominated high yield bonds (and fully hedging their £ exposure).

Of course, a clear concern for UK based companies is the risk that they may be hurt by a further weakening of the Pound. For McLaren, of course, with production based in the UK their costs will be cheaper relative to € or $ based manufacturers. (Good news, the McLaren’s looking cheaper than the Ferrari!)

Similarly, how would a hard Brexit affect other issuers which we believe offer value? We favour companies that would be unaffected or benefit from a weaker £ such as those that compete for sales domestically with foreign imports and/or export globally (such as McLaren). For instance, the UK based holiday operator, Center Parcs benefits from a weaker Sterling as UK customers find they can get more “bang for their buck” (or “power for their pound”?) by staying in the UK rather than traveling abroad.

There are other businesses that have a domestic customer base and have a strong embedded place in the economy. Many of them have traded well throughout the recession following the global financial crisis and we are confident that they should be able to weather any economic weakness that would result from the Brexit process. An example of this is Together Finance which occupies a unique (and very profitable) position in the UK financial ecosystem through its niche mortgage lending. It weathered the 2008-2009 Global Financial Crisis with remarkably little difficulty. Indeed, during the crisis the company’s annual loan losses only got to around 1% – leaving us very comfortable with the issuers risk profile should 2019’s Brexit prove challenging.

Most of the focus in recent months in the Sterling market has been around distressed issuers, especially in the retail arena (i.e. House of Fraser bonds are set to receive a fraction of their face value). This is very far removed from the £ high yield that we are focussed on at Kames, where our team’s approach continues to be to seek the best high yield issuers and remain “unconstrained”. This translates as remaining flexible, being able to identify opportunities and banking profits, depending on where £ high yield credit trades relative to € and $ issuers. This flexibility also means that, should we view Sterling-denominated bonds as no longer providing compelling value, we have the ability to reduce our Sterling exposure to a zero-weight.

Sign up to receive our weekly BondTalk email

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.

Sign up to receive our weekly BondTalk email

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.

Sign up to receive our weekly BondTalk email

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.

Sign up to receive our weekly BondTalk email

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.

Sign up to receive our weekly BondTalk email

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.

Sign up to receive our weekly BondTalk email

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.


Sign up to receive our weekly BondTalk email

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.

Sign up to receive our weekly BondTalk email

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.

Sign up to receive our weekly BondTalk email

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.


Sign up to receive our weekly BondTalk email

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.

Sign up to receive our weekly BondTalk email

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.

Sign up to receive our weekly BondTalk email

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.

Sign up to receive our weekly BondTalk email

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.

Sign up to receive our weekly BondTalk email

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.

Sign up to receive our weekly BondTalk email

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.

Sign up to receive our weekly BondTalk email

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.

Sign up to receive our weekly BondTalk email

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.

Sign up to receive our weekly BondTalk email

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…



Sign up to receive our weekly BondTalk email

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.