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Skeletons in the Closet

11 October 2017 by George Curtis

Given the fundamental and technical strength of the European high yield market at the moment it is no wonder that spreads have continued to tighten, reaching post financial crisis lows and slowly grinding towards levels we haven’t seen for over a decade. Our view has always been that the tightest spreads will be seen much later in the cycle, but we would like to highlight that in these tighter conditions investors must be most rigorous with their credit selection.

The strength of the technical that is underpinning the high yield market has allowed opportunistic issuers to take advantage of this, issuing debt into a market that would otherwise turn them away. The hunt for yield breeds complacency, and this is what enables “next year’s skeletons” to enter the market. There have been several such examples already in 2017, and following a recent roadshow for a potential new issue borrower we were once again discussing this topic.

The example under discussion was a specialist manufacturing company that primarily provides solutions to the oil and gas sector. The company has suffered in recent years, in line with the wider energy sector, with EBITDA reaching a negative €220m last year (from roughly €850m just two years before). The company has taken measures to curtail the losses by undertaking a cost rationalisation programme and pulling back on capex, so are guiding for an improvement in EBITDA this year, although it is expected to remain negative. The rating agencies have confirmed the deterioration in the operating trends, downgrading the company from BBB in 2014, to B now.

The lifeline that investors have held on to is the fact that the company has a large liquidity buffer in the form of cash and a Revolving Credit Facility. It is true that the company has been a prudent cash manager when the market was in a better place, but we wonder how that liquidity buffer will erode if trends continue to remain negative. It would likely leave the company relying on bank lines to provide liquidity, and we know that the banks have been keen to reduce their exposure by terming out their old facilities into the bond markets. Banks generally know their customers very well, and bond investors need to be wary of this behaviour generally.

Yesterday’s borrower could well be a recovery story, we hope it is, but with yields starting with a 6 handle, investors are just not being compensated for the risk that this could also be one of next year’s skeletons. These are also the names that are likely to be most exposed should our economic cycle end abruptly.

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