European high yield Fewer covenants do not mean less value An M&G Investments Fixed Income perspective September 2015 The quality of bond covenants in the European high yield market has deteriorated over recent years, causing some concern. David Fancourt, senior high yield fund manager at M&G, believes that while weaker covenants are less desirable, they force well-resourced investors to work harder to pinpoint value. The decline in covenants is far from a permanent structural market trend and is instead reflective of the current stage of the market cycle. Crucially, over the longer term, the credit quality and depth of the market is actually improving, making individual value investment opportunities ever-more available. The fall of covenants in European high yield Covenants are structural safeguards embedded in the legal documentation of certain debt instruments. Their purpose is to help investors manage the risks of their investments and provide greater confidence in being successfully repaid. Differences between covenant packages are dictated by the area of fixed income to which they apply and their strength can ebb and flow as market conditions change. Covenant structures have evolved throughout the relatively short history of the European high yield market, largely as supply and demand fluctuates, alternately placing power in the hands of borrowers and then lenders. Now, issuing companies are reining covenant protection back. They are doing so in three areas: 1) Shorter non-call periods High yield issuers are often able to repay lenders before a bond matures. If yields fall or the company s credit quality improves during the life of the loan, this option allows the issuer to save cash by retiring the bond early and issuing a brand new one at a lower interest rate. Bondholders tend to have little choice but to reinvest their repaid proceeds at reduced yields. However, investors usually receive the protection of a non-call period, which forbids early redemption. When market supply and demand favours borrowers, as it does now, they use their bargaining power to shorten non-call periods. 2) Claw back option This allows the issuer to retire 1 of the bond each year at 103% of par. This can also limit the investor s capital gains on the security. 3) Portability clauses Traditionally, when an issuer is acquired by another entity, investors have the right, but not the obligation, to immediately redeem their bond at 101% of par (known as a put option). This protects investors from the risks associated with an unfavourable change in ownership should the bond price descend below 101%. For example, when the UK financial services business Lowell Group recently announced its merger with German peer GFKL, the presence of this change of control put option caused the bonds to immediately increase from below par to around 101%.
Price (% of par) But borrowers deem such options costly, not least because they can necessitate a complete refinancing. To sidestep this problem, many issue bonds with portability clauses, which can render the option unexercisable subject to conditions relating to time period or leverage conditions. These clauses preserve the downside of potential M&A activity on a debtholder. Pinpointing value when covenants weaken As covenants can have a profound effect on the intrinsic worth of credit assets, investors have to analyse every covenant package to accurately value the securities 160 Over 7 of European high yield bonds are above par 140 120 100 80 60 40 20 0 High yield bonds ranked lowest price to highest Source: Bank of America Merrill Lynch, August 2015 The relationship between covenants and value is especially intricate when bond prices are largely above par. This is because the bonds embedded options become more volatile when bonds are trading close to the options strike prices. Today, over 7 of European high yield bonds are trading above par. With this in mind, investors have to make ever more acute judgement calls when answering the fundamental question, do the bond s prospective returns offer adequate compensation for the risks? As an example of a necessary quantitative assessment, consider a classic portability clause, which can negate investors right to sell their bond back to the issuer at 101% of par following a corporate takeover. As most bonds are currently trading above 101%, this option becomes less attractive. In this case, relinquishing the put option may not be as detrimental over the shorter term, but could over a longer time frame. Qualitative assessments are also important. For example, the question of whether the company is likely to become a takeover target becomes particularly prominent when faced with a portable capital structure. Taking an informed view across over 250 unique companies requires a well-resourced team of diligent analysts. Given the continuing boom in corporate takeover activity (intriguingly 2015 has already seen more bonds issued to finance M&A activity than any previous year 1 ) this is an important consideration. To ensure a comprehensive understanding of each deal, M&G s team has undertaken covenant training where required. In our experience, evaluating these terms and conditions will always be resource-intensive, but far from unachievable. 1 S&P LCD, August 2015
This is not a permanent trend in high yield The general quality of bond covenants has always been inversely related to the strength of the primary high yield market at the time. With investors currently hungry for yield, the primary market has boomed and it is no surprise that syndicate banks are able to structure deals with weaker covenants. Whenever demand starts outstripping supply in any market, the balance of power always shifts from the buyer to the seller. European high yield issuance continues to increase 90 80 75.7 83.7 70 60 60.7 50 46 40 30 20 18 17.6 28.6 24.1 26.5 37.1 37.4 10 0 1.9 Total issuance ( bn) Source: JP Morgan, August 2015 Experienced investors have witnessed this all before. During the early 2000s, the market produced a multitude of lower quality deals including a preponderance of payment in kind (usually called PIK) structures that allow coupons to be paid with bonds not cash. That trend reversed sharply following the telecoms crash of 2001. Issuers suddenly had to tread carefully to entice any buyers at all. During episodes of evaporating market sentiment, companies with any chance of issuing new deals have little choice but to sweeten them with attractive covenant packages. History repeated itself more dramatically during the mania preceding the events of 2008 and lower quality structures proliferated again. After the tide turned, high yield issuance became incredibly scarce. Even during less mainstream headline-worthy market swings, the pattern of covenants has always fluctuated. For example, portability clauses became uncommon after September 2014 and this was simply in response to faltering market conditions. With the market strengthening in recent months, portability started to return. Credit quality and overall structural protection are more important than covenants Counter to the covenant trend, the overall credit quality of European high yield is actually improving. Perhaps surprisingly, so too is the general level of structural protection. This is a particularly crucial point because the best covenants will never make the worst issuers attractive. Similarly, the worst covenants will never make the safest issuers risky.
Since the banking crisis, the European high yield market has been an obvious platform for bank-replacement finance. This led to an influx of new issuers that has broadened and deepened the market. 4 Issuance of lower-rated bonds is falling 3 25% 21% 15% 1 5% 12% 11% 1 7% 8% 7% 6% 3% % of issuance that is lower rated Source: JP Morgan, August 2015. Lower-rated bonds are defined as those with at least one CCC credit rating. Lower-rated issuance has fallen since the financial crisis. Today, the market s average credit rating is around BB- or B+. Ten years ago it was three notches lower at B-. Secured issuance was incredibly rare during the high yield market s earlier days. Now, with a large proportion of issuance substituting the bank loan market, this has changed markedly. Roughly a quarter of bonds are secured against company assets and the number is growing. As below, around 35-45% of all new deals are senior secured. 5 45% 4 3 25% 15% 1 5% A higher proportion of new issuance is senior and secured 14% 24% % Senior secured 38% 42% 37% 44% 39% Source: JP Morgan, August 2015
Should investors be concerned? In 2011, a collection of 22 buy-side investors sent a letter to the Association for Financial Markets in Europe (AFME) with the aim of agreeing a level of standardisation of bond covenants. Discussions continue. Whatever the outcome, well-resourced, long-term, value-based investors are the least likely to be concerned. The attractiveness of the market from a credit perspective is increasing over the long term, which means the high yield market deserves more, rather than less, attention from institutional investors. The current pattern of covenants is indirectly reflective of less attractive pricing in today s market. Investors should therefore focus on individual value opportunities (an assessment of which must take the covenant package into account) to outperform without taking excessive risk, while remaining well-positioned to take advantage of a more generally favourable repricing of risk. As long as a bond s covenants are fully disclosed, investors have the power to make informed value decisions. As long as they maintain vigilance, they have less to fear. As usual the ultimate value investing credo applies: there is no such thing as a bad bond, only a badly-priced one. About the author David Fancourt Senior Fund Manager David has worked in M&G Investments Fixed Income since 1995. He moved into the Institutional Portfolio Management Team in June 2009 from the Structured Credit team. Previously, David managed high yield retail funds after working for Prudential Portfolio Managers in Chicago with the high yield team. David graduated from Loughborough University with a degree in Banking and Finance and is a Fellow of the Institute of Actuaries. For more information contact: Andrew Swan +44 (0)20 7548 2375 andrew.swan@mandg.co.uk John Atkin +44 (0)20 7548 3466 john.atkin@mandg.co.uk Annabel Gillard +44 (0)20 7548 3258 annabel.gillard@mandg.co.uk Henry Barstow +44 (0)20 7548 3469 henry.barstow@mandg.co.uk Sunita Dey +44 (0)20 7548 3393 sunita.dey@mandg.co.uk www.mandg.co.uk/institutions institutional.clients@mandg.co.uk For Addressee only. The distribution of this document does not constitute an offer or solicitation. Past performance is not a guide to future performance. The value of investments can fall as well as rise. The success of these investment strategies and their suitability for investors are not guaranteed and you should ensure you understand the risk profile and products you plan to purchase. The services and products provided by M&G Investment Management Limited are available only to investors who come within the category of the Professional Client as defined in the Financial Conduct Authority s Handbook. They are not available to individual investors, who should not rely on this communication. Information given in this document has been obtained from, or based upon, sources believed by us to be reliable and accurate although M&G does not accept liability for the accuracy of the contents. M&G does not offer investment advice or make recommendations regarding investments. Opinions are subject to change without notice. M&G Investments is a business name of M&G Investment Management Limited and is used by other companies within the Prudential Group. M&G Investment Management Limited is registered in England and Wales under number 936683 with its registered office at Laurence Pountney Hill, London EC4R 0HH. M&G Investment Management Limited is authorised and regulated by the Financial Conduct Authority. 0507/MC/0915