High Yield: Beyond traditional metrics
There are no short cuts in the evaluation of high-yield opportunities, according to Anthony Harrington
At a glance
• Diverging US and European default rates mean managers must look beyond traditional high-yield metrics.
• Macro-economic factors and country of issuance have become more important.
• The ECB’s investment grade bond purchase plans will affect the high-yield market. But to what extent?
• Do managers have a true picture on recovery values?
‘Know your stocks’ seems to be the only appropriate mantra for high-yield-investment managers these days. Two useful rules of thumb for approaching the task of evaluating a new high-yield issuance are provided by interest and capitalisation coverage ratios which, taken along with the rating assigned to the issue by agencies, provide some guidance.
However, with a slowing global economy in progress and intervention by central banks on an unprecedented scale, these are difficult times and traditional metrics might not be as useful as they used to be. Default rates look likely to rise and fixed-income managers need to tread warily.
Jean-Luc Hivert, CIO of the fixed-income team at La Française, says while his firm will look closely at leverage ratios and at a ratio like net interest over EBITDA (earnings before interest, taxes, depreciation and amortisation), the really important thing is assessing how the company’s margins are likely to hold up against the amount of debt it is taking on.
“We had some very bullish years in 2013 and 2014, in both Europe and the US in high-yield, but about 12 months ago with the stresses introduced by the collapsing price of oil, we saw the US and the EU diverging sharply on likely defaults in this space and this impacted the usefulness of traditional metrics,” he notes.
For Hivert, European company boards are characteristically more cautious than US boards for the simple reason that they have become accustomed to living in a no-to-low-growth environment, so they manage their balance sheets cautiously. In the US, by contrast, boards started to show a lot more optimism about two years ago and M&A (mergers and acquisitions)came back onto the agenda as companies looked to acquire smaller competitors to speed up growth.
“What happens when you do that is you put more debt on the balance sheet. If you add in share-buyback programmes, that too creates leverage, which does nothing for bond holders except add risk,” he says. At the same time, yields kept on falling in Europe while staying more or less stable in the US. “Right up to the end of 2015 we saw companies in the European high-yield space able to refinance more cheaply each time they came to market, while default rates stayed at a historic low of 0.14%. In the US they now stand at 2%, and even if you strip out the energy sector, where defaults are growing rapidly, you still have the accumulating risk of all that releveraging going on across all sectors,” Hivert notes. Taking all this into account, the difference in yield between the two markets could be as high as 250 to 300 basis points, so despite the warning metrics, US high-yield still looks to have some value, in Hivert’s view.
David Zahn, head of European fixed income in Franklin Templeton’s fixed-income group, is adamant that there is no substitute for a “deep dive” into an intensive evaluation of an investment target’s balance sheet and management. Metrics count for little or nothing, he says. “We have a lot more macro drivers on credit right now than we have had for years.
“The ECB’s purchase of investment grade bonds, announced in March, is bound to have a rollover effect onto the high-yield space, even if we don’t know exactly what or how much the ECB will be buying. It is bound to tighten spreads and thus push more money out into the high-yield space,” he notes. “So you need to keep a sharp eye on both the micro details, at the individual company level, and the macro, market level action as well.
“We saw the macro impact very clearly in the European high-yield space over the last few years. Where a company was domiciled, for example, could make a huge difference as to the returns on the bond,” Zahn notes. He points out that it is not unusual to hear a manager say something like: “We like Italian companies but we hate Italy,” which neatly sums up the national state factor.
As to bonds outside Europe and the US, Hivert argues that investors need to monitor carefully the markdowns that are going on: “A lot of big issuers that were in the investment grade space are being marked down as fallen angels and are coming into the high-yield space. We are being very careful here because of the negative trends in a lot of big issuer countries outside the EU and the US, such as Brazil and Russia. When these companies come back into the market to refinance they are likely to be rated triple-B and will have to pay a very large coupon, probably a double-digit rate, in my opinion. Each opportunity will have to be analysed very thoroughly.”
Marc Kemp, institutional portfolio manager for high-yield at BlueBay Asset Management, is another who feels traditional metrics in high yield can hide probably as much or more than they reveal. “One of the things that we are conscious of is the way that adjustments to EBITDA that we see are specified in new issuances. The danger is that a heavily adjusted number paints a false picture of the company’s ability to service the debt and it’s crucial to look through this,” he says.
“We have always been very concentrated and in-depth in our analysis of individual companies. Our starting point in evaluating an issuance is always preservation of capital – does the company have sufficient assets, if the worst comes to the worst, to allow us to recover 100% of our principal?” His point is that traditional metrics tell you only half the story about the real assets the company has – as opposed to, say, overvalued intellectual property.
Picking up on the differing default rates for the US and European high-yield bond markets, Niklas Nordenfelt, senior portfolio manager of the Wells Fargo US High-Yield Bond fund, says investors and managers need to be much more fine-grained in their approach. “The rising default statistics in the US are well earned, but mostly industry-specific. Many oil and gas companies were not generating free cashflow and were out spending all the cash they were generating when oil was as high as $100, so they were a very poor risk reward. However, if you look carefully, even here bond prices have dropped to the point where there are some investment opportunities,” he says.
In particular, managers need to get smarter about looking for the recovery values in bankruptcy cases. In many instances the bankruptcy recovery value is likely to be higher than the bond’s current market value, he suggests. Traditional metrics would be completely silent on a theme like that.