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17th September 2019

HY: Comfortably Numb (Free Content)

“May you live in interesting times”…

In my last note, I suggested a rotation from more expensive BBs into Bs as a means of reducing systematic risk and in preparation for a squeeze in yields as we enter the year-end period. YTD performance and valuations all point to caution as we enter the home straight. Q3 earnings will be critical in determining who is on the right side of the “Earnings Recession” debate. Over the next few notes, I plan on identifying those safe places to hide as well as (try) to develop a valuation framework for the asset class.

The old Chinese curse (May you live in interesting times) is certainly applicable to credit investors.  Last week’s power moves by Draghi have yet to sink in and, added to that, rising oil prices are increasing concerns of constraining sluggish growth. 

Systematic drivers (read rates, and a declining but stable economic background) could see spread compression increase. In an intensified hunt for yield, I wonder just how much incremental QE directly supports credit fundamentals. 

Clearly, easy money and low lending rates have made for low defaults. But given the amount of cash already in the system, the marginal benefit is likely to have diminishing returns. “Zombie” companies that should have gone to the grave long ago are still with us.

They have been operating in an ‘easy money’ environment for some time and natural selection has yet to pick them off. Unless they refinance at lower rates risk it is hard to see how fundamentals will improve significantly for such companies. The one thing they do have is time.

I wanted to (at least start) to get a sense for this. The above chart shows the number of 5% plus moves by month of the Pan European High Yield Index, plotted against the 10 Yr Bund Yield. 

It hopefully shows Systematic vs. Idiosyncratic risks. What’s more, you tend to see a decline in the idiosyncratic moves after a dose of yield compression. However – fundamentals will prevail. 

So, it looks like the cost of getting it wrong will increase while at the same time spreads can compress further if our view of IG/ HY compression takes hold.

Fundamentals look to have softened slightly and a continuation into Q3 could put that cat amongst the pigeons – Especially ahead of QE restarting.

We analysed the fundamentals of 300+ issuers and calculated several metrics – leverage, coverage and cash flow.  The number of issuers was roughly 73% of the Pan Euro High Yield Index. Outliers were removed and then the straight average was calculated.

Ideally, in the future, this can be done on an issuer weighted basis as well as digging into the trends seen in specific issuers. High Yield is seeing an increase in data providers and leveraging them for screens and other studies will hopefully deliver more insight.

The table below shows that leverage has increased on average since 2016, with Energy and Transportation showing a decline in leverage at the aggregate level Q2 ’19 vs. FY 18.

Rating-wise, the story is the same. BBs edging higher vs. Q4 ’18 +11% vs. Bs +2%. Which suggests some slippage in quality, plus the influence of new issues.

We use Funds from Operations to look at both the ability of Issuers to pay back debt and in terms of interest coverage. YTD and YoY there is little to cheer about with FFO down across the board. Consumer-facing and cyclical sectors down the most. Ratings-wise, BBs show a steeper decline YTD than Bs but fare much better on YoY and comparison against FY16.

Interest cover at the aggregate level looks relatively healthy, with any “zombies” lost in the mix.  Most segments have seen a decline based on recent history and point to a softening YTD and YoY.

Overall, the moves are not huge – but they are significant. A further decline would represent reasons for increased caution. Overall, the softness does look to be cyclical. Clearly, we have to be mindful of mix when extrapolating to the wider market.

There is an ever-growing list of “known knowns“  to contend with– distorted relative value, aggressive deals with weak covenants, additional financial stimulus, declining margins of error, geopolitics and a softening economy. The key is picking your spots into Q3.

“Complacency” is something that one does not often associate with the High Yield market where it pays to be a skeptic. 

Whilst “Animal Spirits” may not be rampant, there are signs of frothiness. The recent Pinewood Studio is a case in point. Split rated BBB/BB the business managed to print a £550mm deal of which £280mm (51%) was a dividend. 

The deal printed at 3.25%, and after tax that is roughly 2.8%. The cost of equity on the Euro Stoxx Real estate constituents is 6.6%. Pinewood managed to pay itself a dividend at a cost of 2.8%. The flip side is that debt investors are the ones effectively covering the additional risk – it is a zero-sum game.  Pushing back on primary is going to become more and more important in sustaining that margin for error. 

Fundamentals, though, are not flashing red yet, so well-rated dividend deals are a sign of the times rather than a sign of the end of times.  

We remain comfortably numb awaiting our next dose from Dr Draghi, but positioning needs to stack up.  Credit selection remains the number one priority with a view to managing downside. October looks to be a cash-rich month in terms of coupons and redemptions – some of the supply we are seeing now is pre-financing that but technicals look to be supportive near term. QE will drive compression between IG and High Yield, the risk is the fundamentals continue to slip and stimulus fails to keep a lid on volatility. 

Next time, I plan on looking at curves and convexity. You can follow me on twitter @EuroYield.