jamestomlins_100

Stand up for your rights! Covenant erosion in high yield bond documentation

2013 saw a record year for new issue volumes in the European high yield market. A total of $106bn equivalent was raised by non-investment grade companies according to data from Moodys. Whilst this is beneficial for the long term diversification and growth of the market, there have been some negative trends. Given the intense demand for new issues, companies and their advisors have been able to perpetuate the erosion various bondholder rights to their own advantage. What form has this erosion taken and why are they potentially so costly for bondholders? Here we highlight some of the specific changes that have crept into bond documentation over the past 2 years and some examples that demonstrate the potential economic impact for investors.

1) Shorter call periods – high yield bonds often contain embedded call options which enable the issuer to repay the bonds at a certain price at a certain point in the future. The benefit for the issuer is that if their business performs well and becomes less financially risky, they can call their bonds early and re-finance at a cheaper rate. The quid pro quo for bond holders is that the call price is typically several percentage points above par, hence they share in some of the upside. However, the length of time until the next call is important too. The longer the period, the higher the potential capital return for any bond holder as the risk premium (credit spread falls). The shorter the call period, the less likely the issuer will be locked into paying a high coupon. Take for example the situation below: reducing the call period has an associated cost to the investor of 2.6% of capital appreciation.

Shorter call periods

2) 10% call per year at 103 – Similar to the example above, the ability to call a bond prior to maturity has the impact of reducing potential upside to investors. One innovation that favours issuers has been the introduction of a call of 10% of the issue size every year within the so called “non call” period, usually at a preset price of 103% of par. So assuming a 3 year “non call” period, almost 1/3rd of an issuers bond can be retired at a relatively limited premium to par. Take for example the counterfactual scenario below. Here we see the inclusion of this extra call provision has reduced the potential return to bondholders by 3.3% over the holding period.

10% call per year at 103

3) Portability – One of the most powerful bondholder protections is the so called “put on change of control”. This gives the bondholder the right but not the obligation to sell their bonds back to the issuer at 101% of face value in the event the company changes ownership. Crucially, this protects investors from the potential re-pricing downside of the issuer being purchased by a more leveraged or riskier entity. For the owners of companies, this has been a troublesome restriction as the need to refinance a complete capital structure can be a major impediment to any M&A transaction. However, a recent innovation has been to introduce a “portability” clause into the change of control language. This typically states that subject to a leverage test and time restriction, the put on change of control does not apply (and hence the bonds in issue become “portable”, travelling with the company to any new owner removing the need to potentially re-finance the debt). With much of the market trading well above 101% of par, the value of the put on change of control is somewhat diminished so some investors have not seen this as an egregious erosion of rights. The owners of the issuers on the other hand enjoy a much higher degree of flexibility when it comes to buying and selling companies. There are costs to bondholders, however. In particular, as and when bonds trade below face value, this option can have significant value. In the example below we see that the inclusion of portability has an associated cost of 2.4%

Portability

 

4) Conditional Restricted Payment Basket – Another protection for high yield bondholders has been the restrictions on dividends. This prevents owners of businesses from stripping out large amounts of cash leaving behind a more leveraged and riskier balance sheet. If a company was performing very well and the owners wished to take out a large dividend, they would usually be forced to re-finance the debt or come to a consensual agreement with bondholders to allow them to do so. Consequently, the call protections would apply and the bondholders would be able to share in some of the success of the issuer’s business. However, another recent innovation has been the loosening of this “restricted payments” provision to allow a limitless upstreaming of dividend cash out of the business subject to a leverage test. This limits the ability of owners to load up the balance sheet with debt at will, but without the need to re-finance the bonds bondholders loose some of their bargaining power and once more are likely to lose out in certain situations. In this example, we see an impact of 1.0%

Conditional Restricted Payment Basket

What can investors do to cope with these unwelcome changes? Some sort of collective resistance would probably be the most effective tool – bondholders need to be prepared to stand up for their rights – but this is difficult to maintain in the face of inflows into the asset class and the need to invest cash. Until the market becomes weaker and negotiating power swings back toward the buyers of debt rather than the issuers, the most pragmatic course of action is for investors to asses any change on a case by case basis, then factor these in to their return requirements. This way investors can at least demand the appropriate risk premium for these changes and if they deem the risk premium insufficient they can simply elect to abstain. In the meantime, the old adage holds as true as ever – caveat emptor.

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High yield: bullish or blinkered?

I recently attended JP Morgan’s annual US high yield conference. It’s one of the best conferences around: well attended, and with more than 150 companies, panel discussions and specialist presentations. As such, the topics covered give a good flavour of the market’s latest thinking.

Unsurprisingly, many of the well-rehearsed arguments in favour of high yield resurfaced once again, with presentations focused on the following:

  • The structurally low default rate (see chart below), largely a function of accommodative central bank policy, limited refinancing risk and growing investor maturity, with spreads over-compensating as a result.

Slide1

  • Projections that US high yield will outperform other fixed interest asset classes in 2014, returning 5%-6% (leveraged loans likely to deliver 4.5%).
  • Room for spreads to tighten further given that they remain over 100+ bps back of the lows in 2007. Currently 378bps vs 241bps in May 2007.
  • How refinancing, rather than new borrowing, is driving the majority of issuance in the US. Refinancing accounted for 56% of issuance in 2013, though down from 60% in 2012.
  • The need for income in a low interest rate world is providing a strong technical support, evidenced by $2bn+ of mutual fund inflows into the US high yield market year to date. Significant oversubscription for the vast majority of new issues has also been a notable feature of the market for some time now.
  • The short duration nature of the asset class – particularly attractive in an environment of potentially rising rates. Modified duration for US and European high yield is 3.5 years and 3 years respectively. This compares to 6.5 and 4.5 years for the investment grade equivalents.

Now these are all relevant arguments in favour of the asset class, and indeed I believe that US high yield will likely be one of fixed income’s winners in 2014. What did surprise me, though, was the almost total absence of discussion around some of the headwinds that it faces.

For example, presentations seemed to gloss over the fact that much of the good news, from the perspective of default rates at least, has arguably already been priced in. The market is unlikely to be surprised by another year of sub-2% defaults, rather the risk lies in an outcome that sees a higher default rate than anticipated by the consensus, even if that is difficult to envisage right now.

Other challenges are presented by liquidity (while this has improved since the immediate aftermath of the credit crunch, investment banks are still reluctant to offer liquidity given the high capital charges they face and the low yields currently on offer); by the lack of leverage available to end investors compared to 2006-7, when banks had the ability, strength and desire to lend to those investors on margin; and by the increasing negative convexity the market faces at the moment.

Slide2

With US high yield paper already trading at an average price of 105 and as high as 107 in Europe (see chart above), the threat of bonds being called will act as a cap on further capital appreciation. And, of course, the flip side of these high prices is low all-in yields. With these standing around 3.8% on the European non-financial high yield index and 5.2% on the US high yield index, investors can only question how much lower they can go.

Slide3

Perhaps in this environment, with inflation ticking along comfortably below 2%, investors should accept that a nominal return of 5-6% looks decent. That said, returns this year are likely to be driven by income rather than capital appreciation, and may well look skinny versus previous years. As I said before, I’m still constructive on high yield, but after the stellar returns in the past few years, we must be careful to avoid being blinkered.

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Tomlins’ guide for getting the best from High Yield in 2014

2013 was another decent year for returns in the high yield market. The US market returned 7.4%, with Europe a little way ahead at 10.3%. Bonds saw solid income returns, low default rates and a small capital gain as a tightening in credit spreads was enough to overcome weakness in the government bond markets. Once again this illustrated how high yield can be one of the few fixed income asset classes that can generate positive returns within a rising interest rate environment.

However, the dead hand of mathematics weighs heavily upon the prospects for the market in 2014. We still believe it will be a positive year for total returns, but expectations are for returns to be in the mid-single digits.

How then can we seek to potentially enhance these returns and reduce volatility in High Yield this year ? Here are five strategies that could help:

  1. “Clip the coupon and conserve your capital” – with lower return expectations, we think coupons (or rather income) will form the bulk of returns this year. On the other hand, with average bond prices above par, protecting the downside and lowering the volatility of capital returns will also be key.
  2. “Dodge duration” – one of the ways to lower the volatility of capital returns and protect portfolios from downside risk is to reduce exposure to volatility in the government bond markets, i.e. reduce the exposure to interest rate duration.
  3. “Financials are your friend” – recently we’ve been much more positive on the scope of financial high yield to enhance returns, especially in Europe. There are still many fundamental issues to be resolved, but the relative valuations and excess yields on offer to gain exposure to a sector that is essentially de-leveraging and de-risking are attractive in our view.
  4. “Learn to love liquidity” – if we do see opportunities to put capital to work at a later stage of the year, it’s important to have the liquidity on hand to take advantage. This may take the form of wider volatility and a sell off or indeed a rush of new issues hitting the market at the same time.
  5. “Don’t burn and certainly don’t churn” – keeping unnecessary transaction costs to a minimum will have a proportionally high impact when returns are expect to be more muted. Trading to try and capture a 10-15% upside is very different from trying to capture an additional 1-2% return when transaction cost can be anything for 50 – 100bps.
jamestomlins_100

A vintage year for high yield issuance?

Much like fine wines, we believe that the year in which a bond is issued is an important factor in shaping its inherent character. The right climate in the markets, like the right weather conditions in the Gironde, can influence the nature of a security for better or for worse. 2013 is already a record year for the new high yield issuance in Europe (see the chart below). But will 2013 be one of the great vintages, or will investors just end up with a bad taste in their mouth and a nasty hangover?

Record HY issuance already in 2013

First of all, let us consider the conditions in which the current crop of deals has been grown. By and large, it’s been fairly benign this year. With a brief hiccup in the summer, the market has enjoyed promises of excess liquidity from all the major central banks, the Eurozone has shown the first green shoots of stabilisation and default rates have remained low.  Happy days then? For issuers and their investment bank advisers, yes, but for investors looking for future returns this is not the case.  The perfect conditions for investors to invest capital is when the storm clouds are on the horizon, there is the sniff of panic in the air and only the juiciest of yields from the highest quality issuers can tempt people to part with their cash. In these times, the power rests with the buyers and the risk premiums extracted can be very attractive.

In contrast, we can see from the chart below that in today’s sunny climes a) the quality of issuance has been deteriorating (measured by credit rating and leverage) b) structural features such as weaker legal covenants*, optional coupons and subordination are becoming more common and c) given the market has been strong, the coupons and hence future returns investors can expect has greatly diminished. Valuation, as always, is at the heart of it all.

Debt/EBITDA of first-time rated HY companies continues to rise

Take for instance, the respective returns experienced by two bonds issued by German healthcare provider Fresenius (one issued in 2009, the other issued in 2013). The USD 9% 2015 bond issued in the vintage year of 2009 performed admirably over the first nine months of its life. In contrast, the EUR 2.875% 2020 bond issued in January 2013 has been far less fruitful for investors. Products of the same vineyard, but with some very different results.

Same vineyard, very different results

Of course we are not comparing like for like; 2013 is not 2009, but it illustrates the importance of market conditions and your starting point for valuations when it comes to assessing prospective returns.

There is a silver lining, however. The wave of new issuance is good for the long term development of the European high yield market. More bonds and issuers means more depth and more diversification. There is also greater scope for differentiation between different fund managers as the investment universe grows. The stock selection decision is becoming ever more important.

Nevertheless, whereas the quantity of the 2013 vintage is beyond dispute, we believe its quality is somewhat dubious. The 2013 crop is arguably more Blue Nun than grand Bordeaux.

*One new development has been the introduction of “portability”. A standard high yield covenant obliges the issuer to buy back all bonds at 101% of face value in the event the business is sold. This protects bondholders from an adverse outcome in the case of unexpected M&A. Exceptions to this are now being introduced into the legal language governing the bonds allowing issuers to be bought or sold without the obligation to redeem their bonds – allowing a so called “portable capital structure”. We do not like this dilution of bondholder rights.

stefan_isaacs_100

Equity multiple expansion to the rescue. A benefit to high yield ?

The high yield market rightly pays a good deal of attention to leverage trends (the relationship between debt and earnings). The larger the quantum of debt a business carries relative to its earnings, the greater the risk. Other metrics are arguably as important, though it is the leverage metric that consistently garners the lion’s share of attention. With spreads near the post Lehman tights, it is unquestionably concerning to see a trend of rising leverage as earnings plateau and companies generally take on more debt.

Slide1

Slide2

The very same central bank policies that have kept bond yields low and encouraged high yield companies to take on more debt have also helped to support higher equity prices. As money has flooded into the asset class, the market has not surprisingly re-rated upwards. What this has meant for high yield investors is that one measure of the ‘margin of safety’, or an equity cushion has, at least temporarily, been increased. The chart below shows the implied equity cushion by subtracting the average level of US high yield leverage from the S&P Mid Cap trailing 12 month enterprise multiple. The higher the implied cushion the better. So for example with stock markets at the lows in early 2009, the implied equity cushion fell to a mere two turns, but has since recovered to a far more healthy and above average six.

Slide3

Many will no doubt point out that an implied cushion is exactly that- implied. And the argument is clearly a pro- cyclical one that relies on an imperfect comparison. We’d concur with that and emphasise the fact that there can be no substitute for thorough credit analysis. We will always prefer to invest in appropriate financial leverage, strong interest coverage and free cash flow generation over equity implied multiples. The former gives a business flexibility and exposes it less to market vagaries.

Yet there is no getting away from the fact that central bank policy has, and can still yet, come to the rescue of even some of most levered high yield companies. In hindsight, few of us would have predicted the surprisingly low level of defaults we’ve witnessed through this cycle. And whilst IPOs of high yield companies has been a fairly rare thing over the last few years, higher equity multiples, an on-going return of animal spirits and a desire/need to put money to work may yet alter that trend.

Slide4

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Five reasons why the European high yield market is better value than its US cousin

Since the start of 2011 we have seen the onset of the Eurozone crisis, endemic political uncertainty, a return to recession and a de facto Greek sovereign default. Contrast this to the path the US has taken with aggressive QE, positive growth and a recovery in the housing market. The somewhat surprising fact is that in spite of all this, the European high yield market has outperformed its US counterpart, returning 29.0% and 24.8% respectively*.

There is little doubt that the US presents a more benign fundamental and macroeconomic environment for leveraged companies. Nevertheless, there are still compelling reasons to believe the European market offers the better investment opportunity. Here are 5 reasons why:

  1. Lower sensitivity to interest rates – since the genie of “Tapering” has been let out of the bottle this summer, investors have become acutely aware of the interest rate risk inherent in their holdings. The European high yield market has an effective interest rate duration of 3.2 years compared to 4.4 years for the US. Accordingly, the European market will be less sensitive to a further sell off in government bonds all other things being equal.
  2. Lower average cash price – European high yield bonds trade with an average cash price of 101.98 with the US at 102.92. This may seem like a small difference, but given the presence of call options in many high yield bonds, a cash price above 100 indicates limited scope for capital appreciation. The European market suffers from the same constraint, but with an extra 1% of headroom.
  3. Higher quality market – viewed through the prism of credit ratings, the European market is lower risk. BB rated bonds make up 67% of the market compared 42% for the US. Higher risk B rated bonds make up 23% and 41% respectively with the remainder within CCC’s. This means two thirds of the European market is rated just below investment grade, whereas over half the US market is well into “Junk” territory with a B or CCC rating.
  4. Higher credit spread – the European market as a whole trades with a credit spread over government bonds of 508bps compared to 471bps in the US. When controlled for credit rating, the difference is even more stark. European BB rated bonds trade at 410bps over sovereigns with US BB’s at 342. The numbers are 607bps and 454bps respectively for B rated instruments. We know the European economy is struggling but this is already factored into valuations.
  5. Lower default rate – According to Bank of America Merrill Lynch statistics for the public bond markets, the trailing last 12 month issuer weighted default rate for the European market is 1.2% compared to 2.1% for the US. There is little to suggest that this trend will dramatically change in the near future given low interest rates and supportive refinancing trends.

Of course there are always mitigating elements to this argument – the all-in yield of the European market , for example, is lower at 5.1% (US is 6.1%) – reflecting both the lower duration of the market, but also the divergence of European and US government bond market yields over recent months. Nevertheless, with lower interest rate risk, lower average cash price, higher credit quality, higher credit spreads and lower default rates, the investment case for the European market continues to look more compelling compared to its American cousin.

*BofA Merrill Lynch US and Euro High Yield Indices 31/12/2010 – 26/07/2013

 

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Caveat emptor – new deals in the high yield market

The volume of new bond deals in the European high yield market has been very strong this year. One (unscientific) measure of this has been the growing pile of bond prospectuses on the desk; already the 2013 pile is more than halfway up the 2012 pile after just three months.

An unscientific measure of new HY bond deals in 2013

A marginally more robust measure is the data below published by Morgan Stanley. The year to date number of €25.2 bn is running well ahead of last year as more and more companies take advantage of lower yields and looser financing conditions in the wider credit markets to term out their debt and reduce interest costs.

A scientific measure of new HY bond deals in 2013

Whilst this is generally good for the long term development of the high yield market in terms of depth and diversification, at this point in the cycle there are a few factors that are beginning to cause us to pause for thought.

In brief they are:

  1. Capital structure – in recent months we have seen the re-appearance of more equity like instruments being issued. This can take the form of deeply subordinated debt, or bonds that pay interest in the form of more bonds rather than cash (aka payment in kind notes). These instruments are typically used to fund dividends to the owners of businesses and can expose bond investors to equity like downside.
  2. Covenants – less of an issue for the bond market, but several leveraged loans in recent months have been issued on so called “cov-lite” terms (i.e. with significantly looser legal restrictions)
  3. Quality of issuer – looser conditions in the credit markets make it easier for riskier issuers to refinance their debt. In early 2012, the market was largely closed to cyclical or more challenged southern European issuers. This is no longer the case.
  4. Pricing – all the factors above are acceptable as long as buyers of the bonds are being compensated for the inherent risks. However, given that these deals are being priced in a market with an average yield of 5.6%*, the general prospects for attractive returns are more limited.

We believe that on a case by case basis there are still some attractive opportunities. Nevertheless this is very much a seller’s market. The terms are arguably more attractive for the issuers of bonds rather than the buyers. Accordingly, when looking at new deals, now is the time for a healthy dose of cautious discrimination – caveat emptor.

*B of A Merrill Lynch Euro High Yield Index yield to maturity 02/04/13

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HY default rates showing the divergence in the Eurozone

2012 was not a good year for peripheral European defaults in the high yield market. Spain’s default rate doubled from 7% to 14%, while Italy’s went from 5.7% to 9.5%. Clearly, that the Spanish and Italian economies are under stress is not news, but what I thought was interesting though was that German defaults have continued to fall. It is important to point out that this is not just the public high yield market, it also includes private bank loans and it has been those that account for the majority of the defaults.

As the chart below shows, in 2010 Germany had the highest level of defaults of the three countries but over the subsequent years the situation there has improved. The opposite has been the case in the periphery with last year’s jump in defaults looking particularly worrisome.

High yield default rates showing Eurozone divergence

We have been speaking for a while about the strain that operating under inappropriate policies puts on an economy, and this looks like empirical evidence of just that. Italy and Spain need looser monetary policy and less constrictive fiscal policies. In a pre-euro world these countries would have had full control of these policy tools, been able to devalue their currencies, relieve some of the strain and increase the competitiveness of their economies. This is not an option open to them now (short of leaving the euro) and I can see no way the situation will improve anytime soon. Even with Mario Draghi and the ECB willing to do whatever it takes to save the euro, the only outcome I can see for the next few years is the strong getting stronger and the weak getting weaker.

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The Real Income Enigma

“The question isn’t at what age I want to retire, it’s at what income.”

George Foreman

The carry trade, the grab for yield – call it what you will, but this has been a persistent fact of life in today’s investment climate, especially as larger cohorts of the developed world join the ranks of the retired. As Mr Foreman points out above, the financial aspect of retirement isn’t really dominated by how much capital you might have, but how much income can be generated from your savings and various entitlements. Furthermore, safeguarding this income from the rapacious grasp of inflation is crucial. Real income is the goal.

While there is plenty of demand for real income, the supply of assets that can provide this is now dwindling. The chart below is a very simple one (and arguably too simplistic), but it paints a stark picture for income hungry investors. On the left hand side is the nominal income yield from various asset classes (dividend yield in the case of equities, yield to maturity for fixed income). The right hand side merely takes away the last inflation number to give you a snapshot of real income yields. This does not take into account the possibility of earnings and dividend growth from the equity markets (an important aspect) or indeed any changes in the inflation rate. For any income orientated investor, this essentially gives you the menu of options for generating inflation beating income in the here and now.

Comparing real yields across asset classes

One thing that should come as no surprise is that cash and government bonds offer negative real returns on a buy and hold basis, but what is less obvious perhaps is that the number of asset classes that offer a positive real return has shrunk dramatically. Indeed, only high yield bonds offer a significant pick up above and beyond the inflation rate. (This pick up is there in part to compensate investors for the risk of default, volatility and lack of liquidity). Whilst we do not expect dramatic capital gains from high yield in the near future, absent a major negative shock for risk appetite, this context provides very powerful structural and technical support for the asset class. Investors, particularly those seeking income, ignore this at their peril.

jamestomlins_100

High yield – it’s pickin’ time

It’s fair to say that we have been toning down our view on the high yield market of late. We could well see returns in the high single digits for 2013, but the potential for more substantial capital gains is less apparent in today’s context.

This does, however, ignore quite a powerful feature of the current high yield environment – the scope for exploiting opportunities and pricing dislocations within the market itself. To use a more technical term, spread dispersion within the market is very elevated. What do we mean by this?

Here is a snapshot of the European high yield market back in 2007 with credit rating plotted against credit spread. As credit risk increased, you got paid incrementally more credit risk premium. This produced a gentle upward sloping curve. The market was fairly efficient and the level of spread dispersion within a credit rating category was fairly limited.

European high yield spreads June 2007

Compare this to a snapshot of today’s market below: not only is the average risk premium significantly higher than in 2007, but more importantly, there is a much higher range of spreads within each rating category.

European high yield spreads January 2013

How can this obvious dislocation be exploited? If you can correctly assess credit risk independent of the ratings agencies, then you can start to pick and chose the bonds that are mispriced. Furthermore the reward for getting this “stock selection” correct can be meaningful. If for example you purchase Bond X at a credit spread of 750bps and sell Bond Y at 250bps, this is a 500bps difference. Let’s say that this difference moves to zero over time with both Bond X and Bond Y converging to a credit spread of 500bps, with a duration of 5 years. This is a relative price performance of 25% (a capital gain of 12.5% for Bond X, and avoiding a 12.5% capital loss for Bond Y).

If an active manager can realise even a small element of these sorts of opportunities across a portfolio, then the additional returns can be meaningful. It’s (stock) pickin’ time.

It's Pickin' Time

 

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