Azhar’s crunching credit – High yield market steadies in June but is trouble ahead?

June was a steadier month with marginal spread widening offset by the risk-free rate lower leaving yields little changed.

Key indicators

• The US 10-year Treasury yield tightened by 10 basis points (bps) during the month to end June at 4.40%.
• High yield bonds outperformed investment grade bonds. Global investment grade returned 0.70% (+0.28% year-to-date) and global high yield returned +0.88% (+3.38% ytd).
• High yield spreads were 8bps wider at 358bps, CCC’s were 21bps wider, whilst single B’s were 11bps wider and BB’s were 7bps wider.
• Investment grade spreads widened by 8bps to 105bps.
• The default rate fell by 0.3% to 2.5%, this breaks down as US 1.9% (-0.1%), EU 2.1% (-) and Emerging Markets 6.6% (-1.4%), The gap between smaller issuers and larger issuers fell to 0.9% from 1.4% as the small cap default rate was down 0.5% at 2.2% whilst large cap default rates were unchanged at 1.3%.

Issuance continued apace in June with $26bn in global high yield bonds, $98bn in investment grade bonds and $54bn in leveraged loans. This takes the high yield volume to $256bn year-to-date, (versus $285bn for all of last year). Investment grade is currently tracking at $843bn (versus $1.1trillion last year) and loans at $289bn (versus $233bn last year).

Credit stories

Margarine manufacturer Upfield came to the market to issue a senior secured bond to refinance an unsecured issue. This refinancing of a leveraged buy out from 2019 was an interesting example of the tussle between yields and valuations. Operationally the company has confounded most doubters and the owners have grown earnings - both in terms of revenue and EBITDA - but free cash flow has almost entirely been eaten up by increasing funding costs, making a sale of the business a much more challenging prospect than otherwise. It was bought at a 10x EBITDA multiple and it seems the existing owners are struggling to find a valuation which justifies their investment at current yields preferring to wait until the yield environment retreats further restoring some free cash flow cushion for the company. It’s an interesting example of the tussle between yields and valuation and how valuations have not eroded as much as we would normally have expected because there is a gap between the selling and asking prices with reluctant sellers preferring to wait and gamble on a lower yield environment. 

We had struggling car hire company Hertz issue an (upsized) $750m first lien bond with a sizable 12.75% coupon – the bond traded up five points as the market dictated that the yield for Hertz should be 11%. Hertz has a debt load of $4.7bn and a market capitalization of just $1bn and is currently burning about $550m in free cash flow per year as it tries to turnaround operations after a disastrous foray into electric vehicles. As a clear CCC credit, the access to the market indicates that animal spirits have returned to the US high yield market.

And finally, we had news at Millicom, the Latin American focused telecoms company, as the company rejected a $24/share bid for its stock from entrepreneur Xavier Niel valuing the company at a 4.9x EBITDA multiple. The company had recently issued 7.375% 2032 bonds and those bonds didn’t overly react to the news (down 1 point to a 99 cash price) – whilst the bonds do have ‘change of control’ protection the covenant is driven by a rating downgrade within six months of an event – something we think it would be relatively easy to skirt around by parking debt in an outside entity. We see the attraction of the company to Mr Niel as there are readily monetizable assets (tower assets) that can be divided within current covenants but struggle to see why bondholders are so placid given the downside risk of a leveraging event.

So, with that whistlestop tour of margarine, car rental and mobile phone companies, we can see that capital is flowing at a range of yields to issuers, leading to some aggressive balance sheets that may well turn into the problem credits of the future. But, for now, the technicals mean that capital continues to keep good and bad businesses alive.

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