Azhar’s crunching credit – June swoon

June was a baffling month. Inflation data didn’t subside substantially, so rates continued to sell off, but spreads took a cue from buoyant equity markets to tighten aggressively across the rating spectrum.

Key indicators

• High yield bonds outperformed investment grade bonds as the rate move offset the spread move in higher quality credit. Global high yield returned +1.4% and global investment grade 0.03%.
• Rates moved higher globally. In the US we saw the terminal rate (the highest point of future interest rate expectations) move up 18bps to 5.4% and move out from the end of July to the end of December.
• High yield spreads tightened to 467bps, 23bps tighter on the month – this meant that we hit a point we haven’t hit in 20 years as the yield composition of the higher quality index (BB-B) of the global high yield is now 50% composed of rates and 50% of credit spreads. Remember it was only August 2021 when this ratio was 90% spread and 10% rates!
• Investment grade spreads – tightened again at 144bps hitting levels not seen since pre the Silicon Valley Bank /Credit Suisse banking selloff.

Areas of focus

• We had a profit warning from Lanxess, an investment grade rated European specialty chemical company, they noted that they saw a volume decline greater than the pandemic and are expecting a volume decline to last longer than the Lehman period. The warning led to a rerating across chemical issuers in Europe. Lanxess market cap fell by 20% and bonds widened by 40bps to 200bps.

Market news

• We had notable new issues from US chemicals company Univar (to finance a leveraged buyout) and Israeli gas company, Energean (to refinance its 2024 bonds). Univar had to pay 8.5% for new seven-year debt and was able to preserve relatively lax covenants (despite pushback from ourselves amongst others) showing that whilst cost of capital has increased, the market is still overly relaxed about future releveraging (something we are far more attuned to*). Energean, an emerging market corporate name, paid 8.5% (to refinance a bond with a 4.5% coupon). Both issuers’ bonds traded well, showing the demand for good companies.
• In marked contrast we had Highpeak Energy, a US E&P company try and issue bonds to refinance its upcoming maturities. This issuer had left it very late as they had until the end of June to refinance their 2024 bonds or cause an event of default on their credit facilities. We couldn’t get comfortable with their lack of cashflow, the ultra-high cost of debt they would likely need to pay or indeed their asset base and neither could other investors. The deal failed and the company is currently under discussion with the lenders of its credit facilities to gain forbearance.

Credit story of the month

It was the hottest June ever recorded here in London, so the credit story of the month is a weather-related issuer – Copeland. This name tweaked our interest because of the nature of what Copeland produces makes this an ideal ESG credit.

This company makes the compressors used in heat pumps, which are much more efficient than our current unwieldy central heating systems. As a result, the growth of this company could be a key determinant in helping us meet our climate goals, showing that investing in ESG names can be accretive to portfolios. The success of Copeland could mean creating positive externalities (reducing carbon by substituting a more efficient means of heating) whilst giving a substantial economic return, a central tenet of our own approach.

*A footnote on yields versus valuations:

As to that tussle between yields and valuations. Univar was delisted into private equity ownership and with yields being so high the company could not be leveraged the way it would have been historically. Two years ago, we would have seen a capital structure with approximately 65% debt and 35% equity (as a comparison back in the heady days of 2007 we would have seen 80% debt and 20% equity).

As valuations haven’t receded materially so far (Univar was bought at multiple of 9x EBITDA arguably at the peak of a cycle), the capital structure had to be funded 55% with debt and 45% with equity. This makes it inherently less risky but clearly limits the return on the equity (compared to the past) so whilst we like the credit story, we believe it is one to be wary of as the private equity owners will only likely make the return that they want on their investment by adding additional leverage in the future if yields are lower. The cashflow profile of the company can’t support the traditional leveraged structure at current yield levels so the future will be one of lower returns for private equity (at the benefit of bondholders) or one where yields will fall and there will be releveraging (arguably neutral for existing bondholders who are buying into a higher yielding story). It shows this current market is proving to be a win/win for bondholders over equity holders as valuations are being supported by more equity than debt and gives an indication why the yield environment is more important than just looking at spreads alone.

Now there are two alternative scenarios that could alter returns for equity holders. The first one is the divestment of parts of the business, with proceeds diverted to shareholders before bondholders – this is the one we were particularly worried about as the covenants protections were not strong enough to stop this from occurring. We were active in pushing for a change to give the new bonds protection, but the company resisted, and eventually other investors relented. For us this was a red flag and made the business uninvestible.

The other scenario is one where the equity valuation of the company will fall, to be aligned with yields, in which case the new private equity owners have vastly overpaid and may lose money (in our minds thus increasing the probability of them seeking to divest parts of the business to limit their losses). This is the essence of the conundrum that markets find themselves in, and its interesting that we see this parallel in the largest asset market we have: the housing market, as asset valuations are, equally, not justified at current yield levels. The puzzle on a micro and macro level will likely get solved where funding costs translate directly into asset prices hence our focus on maturity walls and the scale and size of equity cushions when we invest in corporate debt.

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.