Azhar’s crunching credit: The valuation conundrum

The year started with volatility in both equity and government bond markets driven by the emergence of a low-cost Chinese AI Large Language Model (LLM) competitor, followed by lots of Donald Trump rumblings as a trade war with Mexico and Canada was seemingly started and averted.

Credit was a safe haven amongst all this volatility, with spreads tightening through the month.

Key indicators

• The US 10-year treasury yield tightened by 3 basis points (bps) during the month to end at 4.54%, mid-January this was at 4.79%, +23bps wider before retreating 26bps.
• High yield bonds outperformed investment grade bonds. Global investment grade returned +0.59% whilst global high yield returned +1.19%.
• High yield spreads were 25bps tighter at 299bps, CCCs were 57bps tighter, whilst single Bs were 27bps tighter and BBs were 17bps tighter.
• Investment grade spreads ended tighter by 4bps at 85bps.
• The default rate was marginally (+0.1%) higher at 1.9%, this breaks down as US 1.6% (+0.1%), EU 3.7% (+0.2%) and emerging market 1.9% (-0.2%). The gap between smaller issuers and larger issuers increased by 0.2% to 2.4% as the large cap default rate increased by 0.3% to 1.0% whilst small cap default rates increased by 0.5% to 3.4%.

We had issuance of $34bn in global high yield bonds, $185bn in investment grade bonds and $59bn in leveraged loans. 

January was busy with new issuance (mainly for refinancings) and there were a few interesting stories highlighting some themes we have been writing about over the last year. As interest rates have increased over recent years, valuations for many businesses haven’t reduced as much as the cashflows suggest they should. This leads to businesses being marked at higher valuations then can be realised and is also leading to an increase in ‘liability management exercises’ as some capital structures are not financeable.

As a result, we expect 2025 to be the year of ‘dividend recapitalisations’ as mature businesses are re-levered by existing owners rather than sell at a valuation below expectations.

One of the most interesting facets that we have seen is private equity owners struggling to obtain exits from leveraged businesses as the higher cost of capital hasn’t reduced the valuations sufficiently for new buyers to be interested. This ‘bid-offer’ mismatch has caused some congestion issues for private equity owners in a rush to return capital to their end investors. As a result, we expect 2025 to be the year of ‘dividend recapitalisations’ as mature businesses are re-levered by existing owners rather than sell at a valuation below expectations. 

A good example of this was Clarios – the old ‘Power Solutions’ business, a car battery maker which has operationally navigated the last few years well, but a business which doesn’t have a compelling equity story for an IPO, and so one of the existing owners decided to re-lever and pay themselves a dividend rather than sell below the lofty (some might say unrealistic) multiple they were looking for. The B+ rated deal comprised of an additional $4.5bn of debt was appreciated by the debt markets despite taking overall debt to $12bn – the deal was multiple times oversubscribed achieving a cost of capital of 6.75%.

Another theme we think is important for 2025 is that of private equity owners preserving equity optionality in over-leveraged businesses where the equity should have no value as many debt owners are unwilling to see companies go through a bankruptcy process and prefer a liability management solution which ‘kicks the can’ down the road. 

Intrum, Ardagh and Altice France and in all three cases it looks like the companies followed our template of preserving temporal seniority by repaying the first maturity in each case.

We saw this with debt collector Garfunkel (the irony of a debt collector not being able to repay its own debt is not lost on us). Garfunkel, with £2.0bn of its £2.5bn debt balance due over the next two years, achieved a consensual solution (with over 90% of bondholders) agreeing to extend maturities and take ‘haircuts’ to reduce the debt load with the ‘carrot’ of a slightly higher coupon. History tells us that ‘kicking the can’ for over-levered companies rarely ends well so we fully expect a restructuring sequel in a few years.

We have written at length about the concept of ‘temporal maturity’ and January brought us two more examples as Altice France paid its 2025 maturity in full (despite the well sourced stories referencing debt reduction agreements with the rest of its bonds and loans). A year ago, we cited three examples: Intrum, Ardagh and Altice France and in all three cases it looks like the companies followed our template of preserving temporal seniority by repaying the first maturity in each case. As we mentioned last month, the next name on our list is Tullow and in January it too stated its intention to repay its first, upcoming March 2025 maturity. What will be interesting is what follows as Ardagh and Intrum have already struck deals to not pay their next maturities, Altice France is in discussions to do the same and we think Tullow will be stretched to achieve a refinancing without bondholders agreeing to extend their maturities as well.

So, a busy start to the year with the year starting as we expect it to go on – dividends and debt extensions continuing to mask the valuation issues in the credit markets whilst all the headlines and noise is captured by the developments in equity markets.

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