Compared to a decade ago there is significantly less liquidity in global bond markets. Last week I presented on this topic at a specialist bond-market conference in London.
I enclose a paper which summarises my presentation. I explain the extent of the liquidity challenges and consider the implications for investor expectations, pricing, capacity management, and the prospects for active investment fixed income strategies.
Most things in the bond market have an analogy with cars. So when a car manufacturer’s sticker prices are slashed, don’t expect second hand car values to look too perky. Same for bonds; as we saw this week with Volkswagen’s jumbo $8bn deal. Thus, one of the most obvious risks for credit markets is the capacity for new bond deals to aggressively re-price the secondary market.
Issuers seem determined to raise finance. For VW they offered a discount of around 0.5% to where existing bonds trade. Issuance at borrowing levels that are almost irrespective of the current secondary market pricing does little for the existing bonds’ valuations.
This price insensitivity is a feature of the trickier market conditions that have prevailed over recent weeks. The impact of re-pricing not only impacts bonds from the same issuer (i.e. VW) or sector (car manufacturers), but increasingly also bonds of the same rating in different sectors (ratings of Single A or BBB). This development has been most clearly observed in non-financial credit. Or to get back to cars – don’t expect your BMW 3 series’ value to remain stable if Audi’s A3 is suddenly five grand cheaper!
As ever, identifying what is currently happening is the easy part; the more pertinent question is what to do in such an environment? The re-pricing of credit in the face of such cheap new bond supply we suspect is a trend that is likely to continue, which today encourages a more cautious stance. However, there will be occasional anomalies and opportunities that present themselves. Just because the discount is aggressive doesn’t necessarily mean it’s wise to ignore what’s on offer. After all, if you’re in the market for a car, you need a car and price will be a key component. And an active bond portfolio needs well-priced bonds. Er… Vorsprung durch Technik.
Recent figures from the Office of National Statistics showed demand for UK goods and services continues to grow, with exports rising to £637bn in the year to August. A rise of 5.5% compared to the same time last year. One industry leading that charge is the Higher Education sector. The UK is the 2nd most popular location, behind the United States, for international students. We have some world class Higher Education institutions in the UK, which offer highly desirable courses to international students. Of the over 1.8 million full time student population in this country, 23% are from outside the UK. It is a key export sector for the UK economy. That’s not to say there isn’t strong demand from within the UK as well. Overall demand for applications continues to outstrip available course places. On average, over the last 6 years, demand for course places has outstripped available supply by over 35%. We expect demand for places to remain strong over the longer term with demographic trends implying a significant growth in the student age population from 2022 onwards.
Full time student applications continue to outstrip available places
Sources: UCAS, HESA, Unite estimates
Place of study for 4.5 million international students
Source: HESA,UNESCO, QS World University Rankings, NUS, Education at a Glance 2016, OECD
Providing good quality, affordable accommodation to students is vital to the ongoing success of the Higher Education sector. UK universities frequently cite their guarantee of accommodation to first year and international students as a key competitive point of differentiation. Moreover, students are increasingly opting for purpose built accommodation, which offers dedicated facilities like study rooms, high speed Wi-Fi, and 24/7 customer care. This has the benefit of freeing up the existing stock of housing for more general needs. However, financial constraints on many universities mean that they are building very little new accommodation themselves, preferring to spend their money on upgrading campus facilities like lecture halls, libraries, and laboratories. The gap has been filled by the independent providers of student housing such as Unite, who are the biggest in the UK with just under 50,000 beds. They let out accommodation both directly to individual students, but increasingly through “nomination” agreements with various universities. These agreements see the universities guarantee Unite, to a greater or lesser extent, that they will fill the rooms in their properties. For the universities this allows them to continue to attract students, and for Unite it provides a highly visible and recurring income stream, usually linked to the level of inflation.
Unite is a core holding for a number of funds in our Ethical range of products, across both their equity and bond instruments. Indeed, our Ethical Corporate Bond Fund recently participated in a new bond transaction from them, which offered an attractive coupon of 3.5%. We also have exposure to bonds issued by Liberty Living, a privately held provider of student accommodation in UK, with over 20,000 beds. For us, these are prime examples of the type of investments we are looking to make in these funds. Ones which help provide long-term, sustainable solutions in an important industry, whilst offering attractive returns for investors.
The UK needs more affordable housing. In 2017 there were 1,155,285 households on local authorities’ housing waiting lists in England alone. Development of new council housing has fallen off a cliff over the last half century and councils no longer have the resources to be significant developers of social housing. The burden has been left to the private house builders and, particularly for social housing, the Housing Association (HA) sector. HA’s have been somewhat reluctant participants in the development game, being happy to cautiously grow their housing stock, but not picking up the slack from the dearth of council housing.
New homes built by private and social sectors in England
Source – Ministry of Housing, Communities and Local Government
It has to be said that government policy has, at times, not exactly been favourable towards the sector. Under the Cameron government the onus was on advancing home ownership, rather than promoting social housing. HA’s pared back their development in the face of a series of cuts by George Osborne to the level of rent they were being paid. The Theresa May regime seems to be more predisposed to the social housing sector. Rent levels will return to being linked to inflation in the coming years, and there has even been a return of government grants, albeit relatively small, to fund new social housing development. The quid-pro-quo for this friendlier relationship is that housing associations have to get out and build new affordable homes. Many in the sector, especially the larger associations, have heard the call. They have responded with a spate of mergers designed to pool resources and flex balance sheets to launch ambitious development programmes. Some of this will be funded by government grant, but much of will come from debt raised by HA’s in the corporate bond market. Indeed, they have become some of the most prolific issuers of corporate bonds in the UK market in recent months. It is rare that a week goes by that my colleagues and I don’t have a meeting with one HA or another looking to raise fresh bond market finance to fund new housing.
These development programmes often consists of a mix of “tenures”. Some new homes will be for traditional social housing, some will be for shared ownership schemes, and some will be for outright sale on the open market. The profit from the open market sales is used to subsidise the new social housing. All very sensible and commendable. However, from a creditor’s point of view it introduces more risk. Developing homes for outright sale exposes them to potentially adverse movements in house prices, especially in volatile markets such as London. This increase in risk has been reflected in a drift downwards in the credit ratings of some of the larger issuers of corporate bonds in the sector. When I first started analysing the sector over a decade ago, the small number of issuers generally had very strong credit ratings – usually in the broad AA range. That has all changed. There are still a few who can boast of a AA rating, but they are the exception rather than the rule as the table below shows:
||Initial Moody’s Rating
||Current Moody’s Rating
|London & Quadrant
||Aa2 (Jan 2010)
||Aa2 (Oct 2012)
||Aa3 (Jun 2010)
||Aa2 (Mar 2009)
*Now part of Clarion Housing
Part of these moves reflect the downgrade of the UK’s sovereign rating (to which HA ratings are linked) in recent years, but the increase in development risk has taken its toll on the credit rating of many an association.
HA’s have a tricky path to navigate – developing new housing stock to keep policymakers happy, but also maintain good relations with bondholders on whom they rely to finance this development. The two aren’t mutually exclusive, but will provide a difficult challenge for management teams in the coming years.
At Kames, we have long been providers of finance to the housing association sector, often through our range of Ethical funds. It will continue to be an area of focus for those funds. However, now, more than ever, we are being increasingly selective about where we invest in this sector. We will concentrate on those HA’s with a proven track record of development through different property cycles, and on those whose focus is on developing primarily social housing, without taking outright sale risk.
Apple recently announced their latest range of new products. There were no surprises in the line-up given the usual speculation and leaks in the run up to the event. The iPhone range is now topped by the new XS Max with a base price in the US of $1,099 for a larger screen version of its latest phone, and $1,449 for the highest specification version. The price increases over the previous record levels for the X model were the big surprise. However, given the success of the iPhone X which was launched at a premium to the iPhone 8 (launched at the same time), there is clearly a part of the Apple customer base that is price insensitive and likes to acquire the latest technology from Apple at (almost) any price. This seemingly allows Apple to flex its pricing ever upwards. It also helps drive demand for its enhanced Watch which will now contain a heart-rate monitor medically approved by the Food and Drug Administration (FDA). Handy for when Apple bills you for the iPhone and Watch!
For bond holders in Apple, this successful projection of the iPhone as the ultimate luxury good continues to drive strong positive cash flows. This makes the commitment of Apple to reduce its net cash position to zero an ever longer prospect and supports the strong credit rating. It reduces the need to issue bonds which provides better technical support for the outstanding issuance.
It was quipped on the desk that the next model may be called “Max Gouge”.
Much has been written about the recent acceleration in global M&A (Mergers & Acquisitions) activity. The $1.4trn worth of deals announced globally year to date is 75% higher than 2017 and the strongest first four months of any year on record according to Dealogic.
Accelerating M&A is often cited as a late cycle indicator although Citigroup argue this year’s pace is not yet a sell signal for equities, given it is well below previous cycle peaks when considered as a percentage of equity market capitalisation.
Nonetheless, as credit investors increased M&A gives us considerable pause for thought. Despite the recent increase in global rates, companies can still take advantage of historically cheap debt funding to help finance acquisitions through increased corporate leverage. Indeed, the frequency of large, M&A-related debt issuance has increased in recent years (see chart 1).
Chart 1: Large debt issuance deals ($5bn or higher) which includes acquisitions among the use of proceeds
Source: Dealogic, Goldman Sachs Global Investment Research
Such issuance can create headwinds for performance at both the issuer and sector level. However, it can also create opportunity. Empirical analysis by Goldman Sachs suggests the evidence supports a “sell the rumour, buy the news” pattern.
Here at Kames we adopt a similar strategy in trying to avoid issuers and sectors, such as pharmaceuticals, where we see the risk of leverage increasing via M&A as high, and where current valuations do not compensate for the risk. Instead we seek to invest “post-transaction” in newly issued bonds used to help finance an acquisition, when management are able to provide clarity around the trajectory of balance sheet metrics. It is our approach to bottom-up analysis and active investing that helps us navigate the idiosyncrasies of M&A and increase returns for our clients.
Orange results reported today included the first information on their recently launched digital bank “Orange Bank”. This was launched on 2 November 2017 and had 55,000 customers by the reported year end. So far the impact on Orange is negative due to the launch costs and IT investments required to support the commercial launch.
They have ambitious aims of attracting 2 million customers (roughly a 2.5% market share) and the timing looks good as more and more people carry and use smartphones for daily services. Also, legislation such as the EU’s “Payment Services Directive 2” is allowing new entrants to access account data for customers and initiate payments. It opens up banking to other companies that can be innovative in the use of customer data and usage, potentially allowing new cross-selling avenues and generally reducing the “stickiness” that traditional banks have had with their customer.
It is early days with Orange Bank and it is likely to be loss making for a number of years during its build out, but potentially it adds more value for creditors of Orange providing an additional diverse stream of earnings that taps into the growth of on-line, smartphone linked transactions rather than just the sale of a generic “data allowance”. For the incumbent banks, it will require more investment in innovation to prevent the loss of customers and the disintermediation that has hit other industries such as retail. There could be some complacency in the sector – Philippe Brassac, chief executive of Crédit Agricole in an interview with the Financial Times recently commented …”Orange Bank? Ah, I had trouble combining the two words. It’s not a bank. Annoying? Maybe. But frankly it’s a mono-player on mobiles that does nothing more than what we offer.”
Certainly Orange starts the process with a strong brand and a large customer base that is increasingly tech savvy, so the gauntlet has been thrown down and we await to see if the banks pick it up.
One of our highest conviction views this year so far is that subordinated debt issued by southern-European banks is an attractive place to be invested. We are seeing bottom-up improvement, helped by regulatory zeal that still works in favour of bondholders versus shareholders, as well as a very strong technical picture.
In Spain we believe that the system as a whole is ripe for a rapid acceleration of real estate asset disposals by the local banks. We saw early signs of this trend in 2017, when Banco Santander and BBVA closed on large-scale transactions to remove the real estate risk from their balance sheets. We are of the view that this trend is not specific to these two names, but will spill over to the rest of the local banks.
In Italy we see the recovery as less-systemic and wide-spread versus that of Spain; nevertheless, the top two players have in our view improved sufficiently enough to turn the page in their credit recovery stories too, even if the challengers in Italy still have work to do.
From a regulatory point of view, there is a strong impetus to tackle the still high stack of bad loans in the periphery. Even without official targets, we see all Italian banks (bar UniCredit, which is already one step ahead) coming out of full-year 2017 reporting periods with updated three-year targets to halve the total stock of bad loans. This is quite a change in narrative versus the previous tone from local bank managers, and there is little doubt (in our minds) that this is a result of a close interaction with the central regulators as of late.
Broadly speaking, we have reached a turning point in the recovery cycle in Spanish (and partially Italian) banking systems. At the face of a stringent regulator, we reasonably expect that on one hand, the progress in credit health is solid enough to justify an overweight position, while on the other we still see ample room for balance sheet improvement. Therefore, unlike most northern-European banks, we continue to expect that the improving health of these financial institutions continues to accrue more to the benefit of creditors versus that of shareholders.
This means that from an investing point of view, we are very comfortable taking subordinated credit risk in the two markets. We continue to see the combination of a) a very strong technical picture in the asset sub-classes and b) the rapid improvement in fundamentals as not properly reflected in bond yields (versus comparable core European peers).
As always, good active management and strong issuer and credit selection will be key to optimising total returns in this space.
The market’s focus over the year to date has been dominated by concerns over the potential actions of central banks, and perceptions over the underlying strength of the global economy. Will the European Central Bank taper before September? Does the new regime at the Federal Reserve signal a change in approach to policy? How much will Brexit influence the Bank of England’s Monetary Policy Committee? And just how strong is underlying wage growth in Europe?
Whilst all of these factors are very worthy of consideration – and regularly demand analysis and debate in our own strategy meetings – the influence of bottom-up stock selection, including the term structure of credit curves, is equally as important for high conviction managers.
It becomes even more important in prolonged periods of low macro volatility, which are actually more frequent than a cursory glance of the financial press would have you believe. Actively managing portfolios from a bottom-up perspective and sweating the assets is of most importance in times like these.
If we are able to lend to a corporate for the same potential return for 10 years as we would get over 30 years (an increasingly common feature of global credit markets after the recent period of performance and credit curve flattening) why would we not effect such a switch in our portfolios?
We are continually reassessing our sector recommendations too. Does our telecoms analyst continue to see value in his sector? Or would the portfolio’s risk budget be better expended in a sector with a more stable M&A backdrop and that is less prone to event risk?
Managing fixed income portfolios is often assumed to be all about asset allocation and interest rate risk – at Kames we see the bigger picture.
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.
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.
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.
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.
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.”
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.
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.
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).
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.
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.
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.
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 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.
Italian government bonds are peripheral European investments and trade as such – they have embedded risk and are correlated to credit risk over the long term.
But this relationship has broken down over the last few months. The following graph tracks the Italian spread to German bunds against investment grade credit (as measured by iTraxx Main) over the last 12 months.
Italian spreads have widened significantly, reflecting a much weaker performance from Italy than corporate bonds. Italy has been hampered by the rise in political uncertainty across Europe, yet credit risk assets have carried on unburdened.
So is Italy overreacting, or is credit complacent?
We think the latter.
Political risks in Europe are not currently priced in to credit markets, across investment grade and high yield. While we have a relatively sanguine view on the most likely outcomes for Europe, the Brexit referendum vote has put previously inconceivable ideas into the future political landscape – and complacency is not recommended.
Certainly a cheapening of Italian bonds is a welcome move – while the country’s December referendum caused little stir, investors are realising that elections outside its borders in 2017 could intensify its existing economic problems.
We expect this to translate into a credit market wobble at some point this year as uncertainty about the strength and implications of rising populism hurts sentiment. In our view this will be a buying opportunity – overall we expect credit to perform relatively well in 2017, thanks to an improving macroeconomic backdrop and continued policy support.