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Avoiding Next Year’s Skeletons

1 June 2018 by

We still believe we are in a credit picker’s market, following the beta move in recent years. Quantitative easing and more accommodative lending conditions have allowed many high yield issuers to access the market. This has been a good thing, as performing credits have been able to refinance maturities with new issuance at lower rates and with longer maturities.

However, as is often the case, too much of a good thing – i.e access to capital markets – can become a bit dangerous. High yield corporates tend to have a higher frequency of idiosyncratic risks than other credit asset classes, meaning nasty surprises can also be more frequent. Ideally, these high yield corporates’ bonds would offer a yield that adequately compensates buyers for that potential default risk. However, combining a global search for yield with some late cycle issuance behaviour can lead to issuers with increasingly questionable credit profiles being given the keys to the capital markets.

While the underlying global economy and fundamentals broadly remain intact, the high yield market is showing signs of becoming fragile. For instance, when issuers are meeting or beating earnings expectations, there has been in many cases a muted reaction. But when issuers disappoint the market, the price reaction can be quite severe. This suggests many credits are priced to perfection.

In our recent blog What we are not doing in High Yield, we’ve written that we expect that many of next year’s skeletons will have a birth date of 2017 or 2018, and a few recent examples are worth highlighting.

Telecoms provider Lebara’s €350m first lien secured bonds, printed in September 2017, today are being quoted at around 70 cents on the euro, meaning bondholders have lost a cool 30% of their principal in less than a year. Holders of UK retailer Shop Direct’s £550m debut from November 2017, meanwhile, were paid their first coupon a couple of weeks ago but on bonds that now trade at roughly 80% of par value.

Sadly, the list goes on. Tesla’s 5.3% 2025 bond from August 2017 is marked around 87, while a trio of deals issued in April by WeWork, Yell and Samsonite are bid at 94, 95.5 and 95.5, respectively.

While these are certainly issuer-specific situations, they do highlight the fact that fundamental credit rigour, selectivity and risk management positioning are becoming ever more critical. We continue to believe that short-dated credit is attractive, but we would stress the increasing importance of credit selectivity as the cycle advances. Given current rich valuations this year there are likely to be fewer credits that post meaningful capital gains.

It appears that in 2018, avoiding the losers could be just as important as picking the winners.

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