Identifying Credit Investments With Near-Term Upside Potential

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1 Identifying Credit Investments With Near-Term Upside Potential In this piece we discuss 4 types of catalyst events that highlight our ability to add value even in today s low yield environment: 1. Capital Appreciation from Index Inclusion (Trade Example: Deutsche Bank) 2. Extracting Value from the Primary Market (Trade Examples: Alimentation Couche Tard & AT&T Inc.) 3. Upside From Early Tenders (Trade Example: Perrigo) 4. Opportunities in the Crossover Space (Trade Example: AerCap) Using Bond Microsurgery to Find Value in a Low Yield Environment Following years of accommodative policy by central banks worldwide, risk assets of all types equities, credit assets, real estate have consistently appreciated in value. Most commentators would agree that we re likely in the later stages of the credit cycle. That is to say, by most metrics credit valuations have been more attractive in previous years. Set against this, the global macroeconomic picture is increasingly constructive, and as long as central banks adjust their policy stances gradually, we re unlikely to see a meaningful uptick in defaults in the near term. Against this backdrop we re more conservatively positioned than we were at earlier points in the credit cycle. In the long-short mandates we manage that means increased relative value trading, less use of leverage and more excess margin. For the long-only mandates we manage it means more conservative positioning and a focus on higher quality and more liquid credits. Increasingly, the Portfolio Management team looks to identify securities where there is adequate compensation for carrying the position but where we believe there is a tangible and identifiable near-term catalyst to unlock capital appreciation. Despite credit valuations in aggregate being somewhat underwhelming, below the surface there continue to be interesting thematic trades with an attractive risk-return profile. The structure of the bond market many heterogeneous securities, imperfect dissemination of information, participants with restrictive mandates, dealers with diminished ability to take risk means there s more room for alpha generation relative to other asset classes. Conversely, traditional buy-and-hold strategies may be less effective in today s low yield environment and managers must remain nimble in order to exploit these discrepancies Canadian Investment Grade Corporates U.S. Investment Grade Corporates Euro Investment Grade Corporates U.S. High Yield Corporates (Right Scale) 2,500 2,000 1,500 1,000 Credit investing, when done well, has been likened to microsurgery with managers looking to consistently identify and profit from small pricing discrepancies amongst the universe of securities and this is an approach we practice at RPIA

2 Example #1: Capital Appreciation From Index Inclusion A technical characteristic of a bond such as whether that bond is in the investment grade index can make a substantial difference to the pricing of that instrument versus comparables. This is because a large swath of bond investors are only permitted to invest in index-eligible securities. Likewise, ETFs tend to gravitate towards investing in index-eligible securities. Where the discount between two bonds that are otherwise identical is large enough, then it can make sense to own these non-registered securities. This is particularly so when there s a chance that later on the issuer may look to register that security to ensure a tightening in spreads. That tighter spread won t impact the coupon that the issuer pays on existing debt (those coupons have been set) but will reduce the cost of debt going forward when new issues come to market. This type of trade reinforces our belief that managers should be benchmark agnostic and able to exploit pricing anomalies that may exist outside of the investable universe prescribed by an index. Trade Example: Deutsche Bank In October 2016, Deutsche Bank ( DB ) received significant reverse interest in a new USD 5yr senior deal from a small group of investors. Given the proximity to earnings and the potential for material information to transpire it was not possible to issue a broadly distributed and registered deal at this time. As an alternative, DB decided to issue a private placement 144A deal as this required less regulatory disclosure. The issuer printed 3bn at T+300 which represented something like a 50 bp concession to secondary levels. Less than two weeks later given strong follow-on demand, the issue was re-opened for another 1.5bn at T+295 to the same small group, still a large discount to the on the run registered 5yr bond. Note that both the unregistered bond and the on the run bond are senior obligations of the same issuer the only difference is that one bond is a constituent of the index and one isn t. In April 2017 the issuer announced that they would be registering the security. The rationale for this was that by registering the security they would ensure a tightening in spreads, which would effectively help reduce their borrowing costs next time the issues wanted to access the market. In addition, investors received an early tender premium of $3 (per $100 of face value) as an incentive to accept the tender. Following the registration of the issue, the securities now trade 5bps apart. Given the 5 month differential in maturity this makes sense the structural discount has been fully realized. 350 Index inclusion leads to convergence between registered and unregistered securities Issuer announces intention to register 144 A DB securities A DB security trades at a significant discount to on the run 5 year 100 Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Mar-17 Apr-17 May-17 Jun-17 Jul-17 Existing 5 yr DB Bond New 144 DB Deal 2

3 Example #2: Extracting Value from the Primary Market The issuance of bonds in the primary market can act as a catalyst for secondary spreads to move either tighter or wider. There are a number of relevant considerations when thinking about how secondary spreads will behave, for example: How frequently does the issuer come to market? Is there a specific use of proceeds for the bonds and if so what is it? Are the funds being used for shareholder friendly actions such as buying back stock? How strong is the syndicate bringing the deal? Is the issue an opportunistic drive by or has it been anticipated beforehand exemplified by weakness in secondary spreads? The primary market is a key area where it s possible to extract value from positioning and active trading. Below we discuss two examples. In our first example, a recent AT&T issue shows that for a frequent issuer making a large acquisition, the market will often demand a spread concession for the new issue, which tends to re-price secondary spreads wider. The second example - Couche Tard -shows how a deal from an infrequent issuer to finance an M&A transaction which makes strategic sense can lead to secondary spreads tightening after a primary transaction. Trade Example: AT&T Inc. AT&T represents a good example of an instance where activity in the primary market has a direct effect on secondary market spreads. In October 2016 AT&T announced they had entered into an agreement to acquire Time Warner Inc. for $85.4bn. The strategic rationale was the acquisition of a huge library of content that they could distribute to their TV, mobile and broadband customers. Market participants in general expected to see the company would issue approximately 15bn in the US market to fund transaction. In August 2017 the company announced a 7 tranche deal with bond tenors ranging from 5yr to 40yrs. Each tranche had a Special Mandatory Redemption ( SMR ) clause this specifies that the bonds can be called at $101 if the deal does not get full regulatory approval. In practice a clause like this can impair price performance as investors might shy away from owning the bond at a level above the 101 call price. A combination of the SMR inclusions and the fact that the deal size was increased from 15bn to 22.5bn meant that the issuer was unable to tighten the initial spread guidance as much as they would have perhaps liked. The deal therefore came with a concession which re-priced secondary bonds wider in sympathy. M&A funding leads to re-pricing of secondary bonds wider AT&T spreads widen versus Verizon in anticipation of new issue supply 0 Apr-17 Apr-17 Apr-17 May-17 May-17 May-17 Jun-17 Jun-17 Jul-17 Jul-17 Jul-17 Spread differential between AT&T 10yrs and Verizon 10yrs 3

4 Trade Example: Alimentation Couche Tard Couche Tard is an example of the opposite impact. In August 2016 Couche Tard announced its acquisition of CST Brands Inc. and the simultaneous disposition of certain of CST s Canadian assets to Parkland Fuel. The all cash transaction attributed enterprise value of USD 4.4bn to CST including net debt assumed. July 2017 Couche then acquired convenience store operator Holiday (private transaction price not disclosed). The company drew down on its credit facilities to finance these acquisitions. Spreads widened in anticipation of a large volume of supply in the Canadian market to meet this financing need. Given the amount of funding required and the geographical location of the assets, our working assumption was that the majority of the funding would take place in the USD market. Couche Tard had never issued in the USD market before, but given the familiarity of US investors with CST Brands and Circle K (which Couche Tard acquired from ConocoPhillips in 2003) we were confident the company could get a USD deal done. What s more, when we looked at where other retail issuers are able to fund in USD, we suspected that Couche Tard would be able to issue in the USD market at better levels than Canada. Given this view, we took advantage of the weakness in spreads to acquire a position in the C$ 2019 bonds and registered interest with a syndicate desk in a new term issue in Canada. On 19th July Couche Tard printed USD 2.5bn across 5yr, 10yr and 30yr. This left a funding need of only 700mm 7yr in CAD. The USD tranches printed 10 through Canadian levels. Our early indication of interest ensured we got a good allocation on the new issue in Canada and our 2019 bonds tightened some bps on the back of the deal as the Canadian curve re-priced tighter. 180 Less than expected C$ funding leads to spread compression CAD bonds pre-deal G Spread (CAD equiv) New Issue USD-bonds CAD levels pre-usd deal New USD Issue 100 Post USD deal, CAD spreads tightened Example #3: Upside from Early Tenders Term to Maturity Corporate strategy can change over time in recent years bondholders have become accustomed to changes in corporate strategy that have negatively impacted them, for instance the issuance of debt to buy back stock. However, the following example is an illustration of a management team changing tack to the benefit of bondholders. In this instance, we were able to position ourselves to benefit from a bond tender at a premium to the market. This was a result of our own fundamental research, conducted with an eye 4

5 towards targeting specific bonds within the company s debt stack which we believed had the highest probability of tender. Trade Example: Perrigo Perrigo is a large international healthcare company that manufacturers over-the-counter and generic pharmaceuticals. In mid-2016, new management put forward a strategy of selling non-core assets in order to streamline the business and reduce leverage. One of the assets earmarked for sale was the Tsyabri royalty stream which was essentially a purely financial asset. This represented a more bondholder friendly stance than previously communicated by management. Our healthcare analyst looked through the debt stack to identify the bonds that would be most likely tendered for once non-core assets were sold. The EUR-denominated debt could not be taken out early owing to some restrictive covenants. This left the USD-denominated issues. In late 2016 we established positions in the longer-dated higher-coupon securities as taking those out would be associated with the greatest cost savings for the issuer. In May Perrigo announced a tender offer for up to 1.4bn USD of their notes with dates ranging from As an example, the PRGO 4.9% 2044 which we owned at T+195 were tendered for at T+175 and in addition there was a 3 point early tender premium paid. This tender offer at prices comfortably above market levels in addition to an early tender premium - represented a windfall for bondholders. Early tender of bonds at a premium represents a windfall for investors Tender offer leads to significant spread tightening 200 G-Spread Mar-17 Apr-17 May-17 Jun-17 Perrigo 2044 Bond Example # 4 Opportunities in the Crossover Space We conduct our own credit research at RPIA, but nevertheless it s very important to be cognizant of how rating agencies view credits. Changes in issuer ratings can often lag market reality and conducting our own fundamental analysis allows us to identify high yield ratings that we believe are soon to cross the threshold into investment grade territory. The views of the agencies can be impactful on spreads, particularly if an agency changes its rating either up or down based on their perception of the creditworthiness of the borrower. We recently discussed a specific case of how impactful rating upgrades can be when a company is straddling the borderline 5

6 between investment grade and high yield using the example of AerCap Holdings ( Opportunities in the Fixed Income Crossover Space ). This piece can be found on our website. Conclusion In an environment where value is harder to find and investors are not adequately paid to clip coupons, we believe active and nimble investing is an essential tool within the portfolio managers tool kit. At RPIA our investment management platform has been designed to extract returns in all areas of the fixed income markets. We achieve this, in part, by screening global fixed income markets for investments that provide near-term catalysts for spread compression and capital appreciation. These strategies add meaningful alpha to our portfolios and allow us to continue to extract returns despite the current low yield environment. Important Information The information presented herein is for informational purposes only. It does not provide financial, legal, accounting, tax, investment or other advice, and should not be acted or relied upon in that regard without seeking the appropriate professional advice. The information is drawn from sources believed to be reliable, but the accuracy or completeness of the information is not guaranteed, nor in providing it does RP Investment Advisors LP ( RPIA ) assume any responsibility or liability whatsoever. The information provided may be subject to change and RPIA does not undertake any obligation to communicate revisions or updates to the information presented. Unless otherwise stated, the source for all data cited is RPIA. This document does not form the basis of any offer or solicitation for the purchase or sale of securities. Products and services of RPIA are only available in jurisdictions where they may be lawfully offered and to investors who qualify under applicable regulation. Forward-Looking statements are based on assumptions made by RPIA regarding its opinion and investment strategies in certain market conditions and are subject to a number of mitigating factors. Economic and market conditions may change, which may materially impact actual future events and as a result RPIA s views, the success of RPIA s intended strategies as well as its actual course of conduct. Specific trade examples are for illustrative purposes only. These trades may have occurred in one or more RPIA mandate and the securities may have increased or decreased in value, leading to a financial gain or loss. 6