AT&T and the Justice League

AT&T has hit a roadblock in its merger with Time Warner Inc. in the form of a law suit from the Justice Department to prevent the deal. This may offer an opportunity for investors to benefit.

Special Mandatory Redemption Provisions

When undertaking a large acquisition, bonds can be issued to pre-fund the deal before the final legal closure occurs. Often this requires shareholder or regulatory approval and there may be doubts over whether the deal will actually be consummated. For some of this pre-finance, they may include SMR language – Special Mandatory Redemptions. Essentially if the deal fails to materialise (usually by a back-stop date) then the bonds are redeemed at 101 (plus accrued interest to that date).

This can be both a positive and a negative for holders of the bonds. If the price has moved above 101, then there can be a painful loss of value. However, with a bond price below 101, there is scope for some capital appreciation. With yields rising, however, a number of bonds with this language sit with prices below 101. This gives the potential for a capital gain if the acquisition process fails.

AT&T, the US telephony company, is in the process of acquiring Time Warner Inc., owner of a number of media brands and assets such as CNN, Warner Bros. films, HBO and Turner Sports. This would fit well with AT&T’s purchase of satellite broadcaster DirecTV and diversify revenues from its reliance on telephony.

At the end of July, AT&T issued $22.5 billion — ranking as the third-largest corporate bond sale on record. Issuance consisted of seven series, all subject to a special mandatory redemption at “101 percent of the principal amount of the notes plus accrued but unpaid interest if the merger agreement with Time Warner is terminated or the acquisition of Time Warner does not close by April 22, 2018”. It also issued two euro tranches and a sterling bond in June with the same clause.

The market was expecting the deal to close this quarter well before the back-stop date but, as they say in America, in “a left-field move” the Justice Department (taking a leaf out of the Warner film franchise “Justice League”, possibly) has instigated a lawsuit to block the merger. The Justice Department’s argument is that the deal is anti-competitive and therefore unlawful. AT&T is seeking to argue against this but there is a political element hanging over the deal as President Trump has in the past said the merger should be blocked and dislikes CNN.

A deal could be struck, like the one for Comcast when it merged with NBC in 2011, which imposes conditions on AT&T to improve its “behaviour” post a merger. However, the Judge appointed, Richard J. Leon is viewed as conservative and unlikely to move for a settlement, and looks to be sceptical of behavioural remedies given his negative views on the Comcast/NBC consent decree.

The clock is now ticking and AT&T has four months to close the deal. It could seek to extend the deadline with bondholders but it may need to offer an incentive to do so. Currently all the dollar bonds are trading below 101 in price and therefore offer some upside to investors. The euro issuance is above 101 and therefore could see a price drop. In the sterling market, the 2037 bond also sits below par, offering the chance for a capital gain.

Note: Since we published this article, the court date has been set later than AT&T and Time Warner had hoped. It is now set for March and it looks like the SMR provisions are likely to be triggered. AT&T have a few months to decide and it is possible they will seek to extend the deadline for the provisions. This would require a ‘consent solicitation’, which usually involves them paying a fee to bondholders or they could redeem and re-issue the bonds. Either way, bondholders should benefit.

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Eat, Drink and be Merry

The food retailers will be trying hard to tempt you over the coming festive season with their irresistible products, as UK food remains highly competitive. However the British Retail Consortium (BRC) has warned that Christmas dinner could be an expensive affair this year.

Data from the ONS shows food prices last month were up by 4.2% on 12 months earlier. Rising food prices can be negative for volumes and typically results in down-trading. Brexit may result in further food price hikes, labour shortages in the food industry and the loss of farmer subsidies.

Comparing the Consumer Price Index (CPI) to the Producer Price Index (PPI) shows that food CPI has increased less than food PPI – suggesting that supermarkets have not passed all the inflation on to customers and have absorbed part of it. Indeed Tesco and Waitrose have noted this, which is positive for volumes but hurts profitability.

The discounters are not immune to this either. Aldi has felt the margin squeeze as a result of its efforts to keep its prices lower than the Big Four and improve product quality, as the larger grocers have tried to become more price competitive.

We have seen many proactive strategies to improve brand, price position and customer in-store experience from the Big Four. Sainsbury’s acquired Home Retail Group while Morrisons has created alliances with both Amazon and McColl’s. The CMA (the Competition and Markets Authority, the UK’s competition watchdog) has perhaps given Tesco some seasonal cheer unveiling its provisional findings on the potential merger between Tesco and Booker, stating that it does not see any significant obstacles to competition. The merger of Tesco and Booker would create a group with a market share of close to 30% in the UK convenience segment (Booker runs more than 5,000 stores) – a segment that is likely to gain importance in the next few years as changes in consumer habits indicate huge potential in this area.

Tesco remains the leader in the UK, with a market share of 28%, but has faced fierce competition from discounters as well as the other major players. There will be no relief over the important festive period. The discounters continue to grow, Asda is recovering from its underperformance, and Amazon is increasing competition online. Increased competition means that it is unlikely that UK grocery retailers’ margins will return to the levels of 2013 and earlier.

In early January we will find out just how much goodwill has been shown to the sector.

Winter is coming

UK clothing and sales volume growth has been robust year-to-date. Latest data from Kantar Worldpanel (to 24 Sept 2017) shows the market has improved marginally year-on-year (yoy) for the fourth year in a row. 12-week yoy growth at +1.5% is the strongest seen for around 2-years, although this is likely to have been boosted by favourable weather and previously weak same-store sales.

The year-to-date yoy growth in clothing retail sales has been highly dependent on the weakness of sales last year, when the weather was extremely unfavourable. Although it seems likely that weather conditions will be more befitting to the season for the start of the Autumn/Winter clothing-retailing season than last year, clothing retail sales weren’t all that weak in early autumn last year so the year-on-year comparison will not be as easy as it has been for Spring/Summer.

The Autumn/Winter season has appeared to be off to a strong start with the likes of M&S, Debenhams and Primark seeing better market share trends. Encouragingly, the data has shown improved sales of products at their full price, most notably at Next and M&S. However, this relatively positive backdrop looks to be fully reflected in bond prices. Pressure on disposable income appears to have returned in the near term (The Asda Income Tracker is broadly flat yoy), and with a low household savings ratio, it seems premature to expect a sustained improvement. Additionally, capacity growth continues and the overarching pressure from online retailers continues to strain the industry.

With October trends likely to be weaker, and the upcoming competitive pressures of Black Friday and Christmas trading, I would expect retailers to maintain some caution.

UK retail comparable sales get tougher over the next few months – winter is coming.

Love me tender…

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

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

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

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If The Cap Fits

The Conservative party has long been in favour of a free and open market economy. So it was no surprise to see, at the party conference, Theresa May extolling the virtues of this at some length. Then, after a brief pause to collect ‘her’ P45 from a prankster in the audience, the PM moved against the same free market economy to hit energy suppliers with a price cap.

Summary – free market economy works, except when it doesn’t.

Subtext – free market economy works, except when your main political rival (exogenous to your own party, that is, not Boris) is espousing a ‘grass is always greener’ alternative of nationalisation and shared profits for all.

May’s speech noted the broken energy market as customers are punished for being loyal with higher prices. Though this is very difficult to justify, energy market practices of increasing bills for those who are reluctant to switch are overlooked in other industries (when was the last time your car insurance renewal quote came down in price?).

Yesterday’s price cap announcement has grabbed less headlines than intended, being overshadowed by the P45 (on which reasons for termination included “neither strong nor stable” and “we are a bit worried about Jezza”, in case you were wondering…). And in true Conservative party style of late, the announcement was light on detail (“Brexit means Brexit!”). But as some details emerge, we can make an initial assessment of the impact:

  • Ofgem is likely to be involved in implementing the cap, and it is better for utilities in the hands of the independent regulator, versus being overly punitive in the hands of MPs.
  • There will still be incentives for switching customers and the regulator will be mindful of striking a balance between incentivising competition and penalising unfairness.
  • The cap will be temporary in nature, with a date set for its removal. Who said politics was short-termist in its outlook?

So what does the announcement mean for our bond holdings? Should we sell out of bonds issued by UK energy suppliers? In summary: no.

The big six UK energy suppliers are international companies with diverse business lines. A UK price cap, in whatever form it takes, will not affect Centrica’s robust US business, nor will it affect German utility E.ON’s substantial grids business. In addition, the substance behind the headlines noted above all suggests the implemented policy will be a watered-down version from the past reports of all customers saving £100 a year.

Economic history and the unintended consequences of restricting free market forces tell us that the consumer rarely benefits in the long run. As Reagan noted, the most terrifying words in the English language are: “I’m from the Government, and I’m here to help.”

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Is everything still on track?

The announcement of the agreement to merge Siemens and Alstom’s train assets will create a large European champion, which should be better placed to compete with increased competition from China’s CRRC. It marks the end of speculation on a number of outcomes, and on whether the vested interests of both France and Germany could be satisfied.

The framework agreement still has to be approved by regulators and shareholders. However, assuming the approval is forthcoming, the increased scale will make the combined businesses more able to compete with the behemoth of CRRC, which has annual revenues larger than the prospective combined European entity. CRRC has been increasingly looking to compete outside of China, and has already won projects in both the UK and Czech Republic. It is also expected to bid for work from HS2 (a planned high-speed railway in the UK).

Bombardier – a Canadian manufacturer with a large European business – is thought to be the biggest loser from the announcement, since it remains a subscale competitor in Europe. Bombardier’s bonds were already weak due to the headlines about its aerospace division, and this agreement is unlikely to help.

Rail infrastructure offers a variety of opportunities for bondholders to invest in, including the manufacturers of “kit” such as Alstom, Siemens and Bombardier. These opportunities also extend to the national rail companies such as Deutsche Bahn, Network Rail Infrastructure and SNCF Réseau, who pay for the signalling and other technical equipment that the manufacturers provide. The rolling stock companies such as Great Rolling Stock, Angel Trains and Porterbrook acquire trains and carriages and lease them to operators. These train operating companies (such as First Group and Stagecoach) run the trains. All will be affected by any changes to the choice or price of rolling stock and associated infrastructure, or to any further change in competitive dynamics. We are keeping a close eye on these developments, which have both potential positives and negatives for the end passenger and the bond investor in the railway industry.

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Where there’s smoke…

The US Food and Drug Administration (FDA) recently announced that it would seek public input to potentially lower nicotine levels in combustible cigarettes to non-addictive levels. The FDA took over tobacco regulation in 2009 and has the authority by law to reduce nicotine in tobacco products. The agency want to make cigarettes less addictive and encourage “Next Generation Products” by making the authorisation process easier – banning menthol cigarettes for example is also on its agenda.

In the past, the FDA has moved very slowly on tobacco. From the outset the FDA had authorisation to regulate cigars, but it only began to do so in 2016 – seven years after being granted that authority. The FDA is now in the process of changing rules around this governance; these changes will create a new programme with a multi-year time scale as it must consider the scientific evidence, write robust rules and finally implement them.

The market is understandably apprehensive about the proposed plan, but it will take a few years for the FDA to move through its mandated rulemaking process and yet longer to get to an effective date of implementation. Many questions still remain – such as “what constitutes non-addictive nicotine levels?” and “how will that be scientifically proven?”

Separately from this, British American Tobacco (BAT) has just completed the Reynolds acquisition in the United States, meaning 35% of its EBIT now comes from US cigarettes. Part of the attractiveness of the takeover was the exposure to the US market where regulation and tax has been benign for some time. Do the reasons for the deal look less appealing now? BAT owns the VUSE electronic cigarette brand which has the largest market share in the US. In an environment where Next Generation Products have more regulatory support this puts BAT in a good starting position; BAT also has strong e-vapour products in the rest of the world and these could be quickly introduced into the US market.

BAT’s yield curve has rightly steepened and is set to remain elevated given the potential increased regulatory risk. The tobacco sector also had a large technical overhang with the well-anticipated $20bn supply across currencies from BAT to fund the Reynolds American transaction. With the successful completion of that bond refinancing, BAT is committed to maintaining a solid investment grade credit rating with the company specifically targeting a high BBB rating. BAT’s management have stated it will not pursue share buybacks or debt-financed M&A until leverage returns to appropriate levels.

Volatility creates opportunity and recent weakness has been an opportunity to add at more attractive spreads. Gaining exposure to robust cash flow generative assets at the trough in credit ratings, with significant deleveraging to come makes sense. There is plenty smoke left in this sector and maybe even a little fire.

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The Future will be green, or not at all

Before President Trump began a period of mutual sabre rattling with North Korea, he made arguably his biggest decision so far as President in withdrawing the US from the Paris climate agreement.

The withdrawal of the most powerful country in the world failed to derail the other members of the G20 from their commitments, they were unwavering. Even in the States they are likely to meet their targets on emissions in spite of the President.  The move towards environmentally friendly policies feels inexorable.

It is perhaps no surprise then that issuance of green bonds is increasing (up 56% in the first half of the year) matching a growing desire among companies and investors alike to fund projects which will aid the fulfilment of the aforementioned Paris agreement.

Recently, we saw a green bond issuance from Anglian Water, the company already having several climate aligned bonds as estimated by HSBC. These are issues which are used to finance low carbon and climate resilient infrastructure. This was their first issue which could be officially labelled as green, being assessed for its eligibility by the company DNV GL.

Anglian have a practical interest in supporting action against climate change. The company operate in the British region most prone to weather related water shortages, which is likely to be exacerbated as population under their coverage is forecast to increase by one million over the next 25 years. As the company noted, environmentally friendly projects are efficient and cost effective, and in a sector that rewards efficiency (through terms set by the regulator Ofwat), this is a consideration of vital importance.

The Anglian Water green bond issue fulfilled Kames screening criteria for our ethical funds, and was added selectively throughout our fund range.

Trump may disagree, but the signs are that “the future will be green, or not at all” (Jonathon Porritt).

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Testing times

The recent egg scandal has once more brought the issue of food safety into the public spotlight. Along with the horse meat scandal and baby milk in China, there are strong reasons to suggest that food testing will continue to be required to ensure the quality of the food chain and human health.

One of our recent additions to portfolios is Eurofins Scientific, a global laboratory and advisory service that offers a wide range of testing services across a variety of industries. Eurofins believes it is the world leader in the food and feed testing market where it tests for dioxins and organic contaminants, pesticides, mycotoxins, allergens, authenticity, pathogens and vitamins. Its wider environmental testing services are underpinned by increasing regulations for a clean and healthy environment

The company also offers services to the biopharmaceutical industries and speciality clinical diagnostics where its laboratory services, backed by high R&D spend, support the more accurate diagnosis and treatment of diseases and improve healthcare.

The company has a history of growth through acquisition, but these are largely bolt-on services or geographies such as its recent acquisitions of Japan Analytical Chemistry Consultants (“JACC”) and Ecopro Research (“Ecopro”). JACC is one of the largest independent agro science testing laboratories in Japan and Ecopro is a leading food testing laboratory in Japan. The cost of these purchases remains relatively low and they have a strong track record in managing leverage downwards post deals.

This remains an attractive credit to own.

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Facing a squeeze – new issue premiums

Corporate bond issuance has been strong over the last two months despite a brief slowdown prior to the French presidential elections. Syndicate desks at investment banks continue to aggressively tighten guidance from the Initial Price Talk (IPT). The level of new issuance tightening is usually a strong guide to market appetite and the attitude to risk. It implies there is still a lot of mileage in investment grade credit.

At the moment syndicate desks are squeezing the new issue premium 15-20bps, bringing new deals at or very close to secondary curves. By pricing at levels near to existing bonds or comparable issues, we are seeing new issue premiums squeezed to 2bps. Earlier in the year the revisions to initial guidance were generally 10-15bps.

The continuation of the ECB’s bond buying programme is providing a strong technical push in Europe; it has now purchased about €90bn of bonds or the equivalent of 90% of net new issue (i.e. new bonds less redemptions). The hunt for yield and income is also continuing to attract strong demand in the US. Even large M&A-led issuance such as the recent Cardinal Healthcare multi-tranche issue tightened (in some tranches) by 30bps pre-launch. Normally these types of deals require some concession from the issuer to ensure that the new large supply of bonds finds a stable home.

But as long as books are reasonably well covered, this indiscriminate cutting by 20bps continues and it makes relative and absolute value analysis of individual deals harder to discriminate between the good, the bad and the ugly. With a number of outstanding M&A transactions yet to be financed, supply until the end of the year is likely to remain strong. As long as the market remains robust this supply will be readily bought; however initial guidance and the subsequent revisions are likely to be tested if demand into investment grade credit starts to slow.

A timely reminder – the importance of strong covenants

In certain sections of the investment grade market the credit cycle could best be described as “mature”. By that I mean companies are looking for ways to reward their equity holders, rather than bolster their credit rating.

There have been numerous examples in recent months where companies have taken advantage of historically low cost of debt to either finance acquisitions or return money to shareholders. More often than not this has meant a downgrade in the credit quality, and poor relative performance from their existing bonds.

It’s at times like these that credit investors seek out bonds with protection from a strong set of covenants. These are the rules and regulations laid out in the bond documentation that dictate what the issuer of the bond can and cannot do. These can include rules around distributions to shareholders, maintaining a credit rating, and importantly the amount of leverage that the business can run. In an environment where companies are generally adding more financial leverage to their business, these covenants are a valuable safeguard for bondholders.

In the UK credit market, the strongest covenants tend to be found in the fixed rate securitised sector, where companies pledge assets against their debt. We have been investors in this sector for a long time, valuing the protection these covenants afford.

A further benefit from a strong set of covenants is that when companies outgrow their existing debt structure and want to refinance they often have to pay their bondholders a premium to redeem their bonds early. These “make-whole” payments can be significant depending on the maturity of the bonds.

A very recent example of this is Annington Finance; a complex and highly covenanted bond structure secured on a portfolio of Ministry of Defence housing in the UK. We have been invested in its bonds for many years. The company has announced its desire to redeem its entire debt structure, and refinance in a more vanilla manner. Should it proceed, bondholders look set to benefit from material “make-whole” payments. It’s a timely reminder, in a world where credit quality is being sacrificed, of the worth in a well-covenanted bond structure.

Step out of the shadow

We believe there is a long shadow of the 2008 Global Financial Crisis (GFC) that still prejudices investor sentiment to risk and return within corporate bond markets.

Recently we were asked about default rates in investment grade credit, and what impact this had on our positive view of the asset class.

We answered that over time investment grade spreads more than compensate for the risks of generic ownership of investment grade bonds. To support our view we borrowed some long-term evidence from the 2016 S&P ratings analysis around defaults, covering the period from 1981 to 2016.

According to the study, the Lehman default was twice the size of the next largest defaulter – Ford Motor Co., in 2009 – which in turn was almost twice the size of Energy Future Holdings at $47bn in 2010. In each year prior to 2008 (excluding WorldCom in 2002), the total default amount was less than $10bn.

Yet the lingering concern for credit markets continues to be the revisiting of the scale and size of defaults in the GFC – and the knock-on contagion that curtails access to credit. Our brighter view is that there continues to be ready access to credit for investment grade issuers and that the outlook continues to be for solid, sustainable growth – which doesn’t have the same cyclicality as we have seen over the past 40 years (the period of the S&P study).

We would note that the 2008 GFC was the first systemic crisis within the S&P study period, while the next crisis is likely to take a very different format to that of 2008, not least due to the regulatory and macro prudential steps taken by authorities since 2009.

In the last five years, 99.7% of BBB issuers have not defaulted. In terms of the triple digit basis point spreads available in investment grade markets over that period (and today), the defaults have been almost de minimis. So we continue to believe that the ongoing benign economic outlook combined with active management can ensure good levels of capital preservation in well-constructed corporate bond funds.

2016 Annual U.S. Corporate Default Study And Rating Transitions – click here to view

The end of sterling corporate QE

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

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

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

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