“The Chinese use two brush strokes to write the word ‘crisis’. One brush stroke stands for danger; the other for opportunity. In a crisis, be aware of the danger – but recognise the opportunity.”
John F Kennedy
2012 was a very good year for the European high yield market, total return coming in at 27.2% . Whilst we do not expect to see the same magnitude of performance in 2013, there are still some interesting pockets of value in the market. One of these is the “peripheral” region of Europe. In line with JFK’s sentiment above, we think it’s very important to engage pragmatically with Spanish, Italian, Greek, Irish and Portuguese companies. There is little doubt that the “periphery” is a major source of risk in these uncertain and austerity-bound times, but is also a good source of opportunity. So how can investors navigate these dangerous waters? When it comes to trying to pick out the better opportunities within the periphery, we think the following guidelines can be useful:
- Right company, wrong postcode – It’s often easy in the first instance to dismiss a company due to the location of its business. This is why it’s so important to look at the underlying fundamentals of a business, no matter where it happens to be based. The market can often apply an unfairly harsh peripheral risk premium to some very high quality businesses.
Example – Guala Closures SpA is a specialty packaging business based mainly in Italy. We view Guala as a high quality business that has a strong competitive position in a fast growing, niche area of the packaging world, namely tamper-proof spirit bottle closures that help drink manufacturers defend their product against counterfeiters.
- International earnings – Looking at where a company’s underlying cash flow and earnings actually originate is important. This is something that helps to mitigate the downside of weak domestic earnings. Also, if international operations become the dominant source of earnings and cash flow over time, the market will start to reduce the peripheral risk premium to the benefit of bond holders.
Example – Fage Dairy Industry SA is a Greek yoghurt manufacturer with significant domestic operations. However, over the past few years, the business has made major investments in the fast growing US market with a plant based in upstate New York. The US business now accounts for the majority of the group’s cash flow.
- Recession resilient balance sheet – If a company does have significant exposure to an austerity hit economy, it’s important to discriminate in favour of those who can survive a weak economic environment. Going into a recession with a relatively healthy balance sheet means a business has the ability to endure a few setbacks and thus greatly increases the chances of survival in the medium term. If and when a weak domestic economy stabilises and returns to growth, then these businesses will also be the first to benefit.
Example – Bormioli Rocco is an Italian glass packaging and tableware business. The company has had some poor operating results in recent quarters. This has resulted in the Net Debt to EBITDA increasing from around 2.5x to around 3.5x over the space of a year, a negative move but from a low starting point and in our view still manageable.
- Hard currency bonds – This is arguably less relevant in the post Draghi “whatever it takes” world, but if we ever return to an environment when any country’s membership of the Eurozone is in doubt, then the currency of a company’s liabilities will also become a factor in limiting your downside risk. If, for instance, the markets begin to entertain the possibility of a euro bond issued under domestic law being re-denominated into a weaker currency, then the price of these instruments would be much more vulnerable than a foreign currency bond (USD or GBP) governed by US or UK law.
Example – Ono, a Spanish cable business, issues both EUR and USD debt. Everything else being equal, USD denominated bonds issued under US law would be the favoured holdings should Spain’s membership of the Eurozone ever be called into doubt.
- Value, Value, Value – there is no point in exposing yourself to risk unless you are being compensated for it. There must be a risk premium attractive enough in the first instance to engage with these bonds and issuers. Not only can you capture a favourable yield, but if this risk premium dissipates, bondholders can benefit from additional returns. The table below illustrates the pick up in yield relative to the broader European and US markets for some of the bonds issued by the aforementioned companies. Above everything else, the value argument remains the definitive starting point for looking at potential opportunities.
|Guala Closures||EUR 9.375% 2018||7.5%|
|Fage Dairy Industry||USD 9.875% 2020||8.0%|
|Bormioli Rocco||EUR 10.000% 2018||8.6%|
|Ono||USD 8.875% 2018||8.3%|
|European Currency High Yield*||–||5.3%|
|US High Yield*||–||6.0%|
*Bank of America Merrill Lynch European Currency High Yield Index and US High Yield Index
Source: Bloomberg / M&G as of 27/12/12
Full disclosure: M&G has an interest in the bonds issued by the companies mentioned