There has been an increased focus recently on where high yield default rates may be heading, with Moody’s predicting the European rate to double in 2020. Naturally we feel that should defaults increase, they will be concentrated in more vulnerable, lower rated issuers.
However, one group of issuers that appears vulnerable to us as we move into a new decade is those facing increased investor scrutiny due to Environmental, Social and Governance (ESG) factors.
The case of CoreCivic, a listed real estate investment trust (REIT) in the US, is a good example.
CoreCivic has a $1.9bn market capitalisation and is the largest owner of properties used by government agencies in the US. Its recent fundamental performance has been strong, with revenues growing by 10% last quarter and EBITDA up 16%. This allowed the company to reduce its leverage ratio over the course of this year and at the end of the last quarter, CoreCivic reported asset value of $3bn and debt of $1.9bn.
Importantly, though, CoreCivic properties are mostly used as prisons and detention centres. Private prison operators typically score poorly in ESG assessments, and a number of major banks have withdrawn financing from the controversial sector this year. In March, JP Morgan decided to back away entirely from financing prison operators, followed shortly by other large lenders, contributing to CoreCivic pulling a $250m loan deal in June after it failed to find support.
Last week, the company returned with another $250m term loan rated Ba1 by Moody’s. The new issuance was secured by a pool of assets and the deal was priced below par, with a spread of Libor plus 450bp and a 2024 maturity. Proceeds were earmarked to pay down $325m of bonds due in April 2020. In its latest credit assessment for the transaction, Moody’s wrote: “By pledging previously unencumbered assets as collateral, Moody’s notes that the transaction is a material shift from the REIT’s historical unsecured capital strategy and evidence of reduced market access within the private prison sector”.
CoreCivic’s difficulty in placing the deal is the result of the increased inclusion of ESG factors in the investment process of many fixed income investors. Despite the company’s improving fundamentals, this increased focus on ESG has eroded its access to markets and made placing even a small, BB+ rated loan a significant challenge.
To us, the ultimate risk for this sector resides with the further integration of ESG factors by investors. As we have been witnessing, access to capital markets for similar credits has been narrowing fast over the last 10 months and we do not see the risk abating.
CoreCivic’s strong fundamentals should buy it time to address its refinancing risk, but ultimately it might mean the company has to evolve from its current business or find alternative sources of financing. For a company that had weaker fundamentals, the ESG impact might have been much more significant.