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Next Year’s Skeletons

10 February 2017 by Mark Holman

One of the features of hot fixed income markets is that participants are more willing to accept lower yields than perhaps the borrowers deserve to pay.  When supply becomes quite short, and dealer inventories get too low, this problem is exacerbated and borrowers that cannot always access bond markets, find a way to get a deal done.

Quite often this can be driven by the banks; they have loans to these corporates and may want to scale down their exposures, and an accommodating bond market allows them to refinance at cheaper levels.  Either way, lending to borrowers who do not have regular access to capital markets can be a risky business, as ultimately the bonds do need refinancing at some point and if the market is closed to the borrower, the result is often not a good one.

A feature of current markets is that they are as wide open as they have been since the tight point in the cycle back in mid-2014. There will be borrowers entering the market today that are quite simply next year’s headaches. At this stage of the cycle investors need to pay particular attention to what new credit risk enters their portfolios.  Conversely, when the market is tough, only the most pristine borrowers can print their new issues, and this problem hardly exists.

In the US, CCC rated issuance has been abundant and yields on this lowest rated band of bonds has collapsed in the last 12 months from over 20% down to about 10%.  Better rated issuance, but from sectors that the market would have baulked at a year ago, is also coming to market at spreads that maybe should be avoided.

By way of a current example, yesterday Peabody Energy, a US coal producer returned to the market, having been in Chapter 11 since April last year.  Initially the price talk on the new entity was high 6%, which is probably reasonable for the credit metrics, however, by the time the enormous book had built, the bonds priced at 6%.  It has now rallied in the secondary market by a couple of points, so the yield is now less than 5.5%. Bear in mind that only 9 months ago this particular borrower was essentially in default and bond holders faced heavy losses.

I am not suggesting that this will happen again to Peabody, as the new entity is restructured and has a lot less debt, but it goes to show the extraordinary demand that currently exists in credit markets and you need to question if you are being paid for the risk.

Most high yield new issues have been passed upon by the team in the last few weeks. Value and sensibly priced risk is becoming difficult to find, therefore, we have gradually been reducing risk and are seeking to avoid next year’s skeletons.

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