BB or not to B: where is the value in high yield?
BB or not to B: where is the value in high yield?
High yield corporate bonds have rallied hard following the Covid-19 crisis of March 2020, with gains of well over 20%. The impetus for this has come primarily from loose monetary policy, with unprecedented expansion in money supply over the past year. Consequently, the yield on non-investment grade corporate debt has declined to just 2.5% in euro terms.
More recently, growth-sensitive markets, high yield included, have been further supported by sharply rising company earnings and improving fundamentals.
The rally has brought investment valuations to heady levels, coinciding with a number of rising macro level risks. Together this suggests there is a decent chance of a market correction or pull-back in the not too distant future. Two risks in particular stand out:
- Inflation becomes more permanent: the widely held view is that the current inflationary pressure is transitory and that at some point it will naturally return to more benign levels. This could be complacent. Sharp price increases in energy and materials are probably a one-off, due to supply shortages, but areas like wages and owner equivalent rents could be more durable.
- Central banks behind the curve: at best, markets are accepting of central banks’ guidance of gentle asset purchase tapering, starting in December in the US, and in March in Europe. At worst, the market sees quantitative easing continuing indefinitely. The risk is that inflation invalidates the slow tapering or no taper tantrum assumptions.
Closely linked with these risks are the numerous countries which are now committed to an operating model of high fiscal deficit spending funded by higher levels of debt. This requires interest rates to be kept permanently low. If this dynamic is disrupted, investors could get nervous around debt sustainability.
Europe stands out
Should market turbulence arise, we think European high yield would have a good chance of outperforming other markets. European high yield has low and falling default rates, with rising earnings feeding into stronger balance sheets. It also contains a large contingent of higher quality, or less risky companies than seems to be appreciated, which we expand on further below.
Firstly, default rates are modest and expected to fall to below 2% over the next 12 months, according to Moody’s. Default is one of the main risks for high yield, and at present the outlook is benign.
Secondly, the recovery has spurred a strong rise in earnings, helping to strengthen company balance sheets and reduce default risk. Leverage (net debt to earnings before interest, tax, depreciation and amortisation) is at about 3.5x, the lowest since 2017.
Thirdly, while high yield is still often referred to as “junk”, 70% of the European market is comprised of BB-rated bonds, the higher quality end of the non-investment grade spectrum.
This section of the market includes constituents like Virgin Media senior secured bonds, a cash generative, stable, subscription based media and telecoms business, as well as the subordinated bonds of well capitalised banks like Natwest Group.
Where is the value?
This higher quality BB part of the market is where we find some value. The spread on BB is three times that of BBB (the lowest investment grade rating), which is far from challenging and looks unjustified.
To illustrate the step down from BBB to BB in individual company and risk terms, this would be Tesco (BBB) versus Asda (BB), or Volkswagen (BBB) versus Schaeffler (BB), in the automotive industry.
European high yield looks well placed in terms of asset allocation, against record high equities, some speculative commodity valuations, and near-zero or negative yields among many government bonds.
Where are the specific opportunities?
The Covid crisis produced large divergences in sector performance and valuations. This dispersion has reduced to some degree, but we continue to look at the potential for investing in businesses which will benefit from reopening of economies, particularly given the build up in household savings. In developed markets notably, savings have accrued significantly and the consumer looks in good health coming out of the pandemic.
We have therefore sought out opportunities geared to the consumer. Germany-based Birkenstock is famous for its sandals that are popular with celebrities and mass market alike. While the company has a significant amount of debt following its buyout, it has a loyal customer base, generating positive cash flows and exceptional margins.
In terms of opportunities arising from a broader post-Covid recovery, the sterling market also offers potential. The cruise industry was one of the worst impacted by Covid in 2020.
This included the UK’s Saga, which specialises in providing cruise ship holidays and insurance products to the over-50s. Amid the Covid crisis, as leisure travel literally stopped overnight, its bonds halved in value.
Investor fears were in a sense understandable, but also underappreciated the value of the insurance business. This supported shareholders to inject £150 million in a rights issue, in anticipation that it should benefit from reopening and the return of tourism. The company has recently refinanced, at par, via a new issue which paid a more attractive coupon.
Elsewhere, we have found opportunities in UK pubs and other leisure oriented companies. These will benefit from reopening, and in many cases the bonds are secured against physical assets, such as real estate and transport infrastructure, against which bondholders would have a claim in a downside event.
Finally, opportunities have arisen from the inflation shock and supply chain disruption, notably in the container freight shipping sector. Rates have leapt higher as demand for physical goods has roared back in to life. We could see this would feed through to strong earnings and a dramatic balance sheet improvement for a company called CMA, which the wider market and ratings agencies were slow to appreciate.
This would go down as one of our more obvious investment decisions, but sometimes doing the obvious works!
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