With notable dispersion in high yield in 2019, CQS and BlueBay Asset Management see further upside as energy and automotive sectors respond to technology disruption…
High yield credit will likely present further idiosyncratic opportunities in 2020 thanks to elevated dispersion in US high yield, in particular. Relative to investment grade, CQS’s Sir Michael Hintze is of the view that “there is room for significant outperformance”.
In the latest CQS Insights research study, “Looking into 2020”, Hintze, the founder and CIO of one of the world’s best known credit hedge funds, thinks there is still some way to go in the credit cycle.
As investors moved away from HY credit and higher up in the capital structure last year to catch the rate rally over recessionary fears, this created mispricing opportunities for active managers.
Within HY, this created significant dispersion between CCC and BB rated bonds. Also, pricing for credits rated BB tightened whereas pricing for single-B credits widened; such conditions play to the strengths of active credit managers as they build idiosyncratic positions.
Performance last year was strong. According to Intercontinental Exchange, the US market showed a return of 14.4 per cent, while euro HY bonds returned 11.8 per cent.
Hintze says that CQS is positioning for underperformance in BBs potentially rates driven and unwinding of crowded positioning versus lower rated issuers in more cyclical sectors, such as auto, manufacturing and industrial sectors.
Speaking with Hedgeweek, CQS head of credit, Nick Pappas, says that part of the dispersion story in global HY, which has doubled in size since the financial crisis, can be attributed to the disruptive influence of technology on traditional industrial sectors such as energy and automotive.
“ESG is increasing the cost of capital for businesses that aren’t viewed as compliant or having insufficiently adopted ESG criteria, and do not yet have a high ESG rating, and part of this is also related to green and clean energy, which has become even more important. For traditional automotive companies, oil and gas companies – basically any with large carbon footprints – the cost of capital has spiked dramatically,” says Pappas.
In his view, some of these companies are over-levered “and there really isn’t a path out of this”, because as refinancings become due, the interest expense rises.
“Only pockets of the market want to support these companies,” continues Pappas, “but there isn’t much general demand in the market. If interest expenses go up, leverage goes up and at the same time these tend to be old economy businesses that aren’t growing; some are even contracting.”
Credit managers have seen the global high yield market double in size since 2008. The depth an and breadth of credit names is significantly greater.
Pappas goes on to say: “A lot of companies that issue in the high yield and loan markets are usually mature economy businesses that are proven to generate cash flows historically. But that doesn’t mean they will continue to do so in the future. At the same time, you have a lot of new economy businesses that don’t generate cash flows currently but will in the future.
“That transition from companies that do make money to those that will in the future is causing dispersion in high yield.”
Justin Jewell is co-Head of Global Leveraged Finance at BlueBay Asset Management.
He agrees that price dislocations in HY are partly being driven by the technology revolution referred to above. The reality is, companies like Tesla are trading at 70x earnings and driving the electric vehicle revolution. Some auto companies will respond quickly, others less so.
“The risk of capital obsolescence in areas such as legacy automotive is very high,” says Jewell. “The vast majority of today’s car producers are a mixed bag in terms of those who have embraced change and those who might have made the wrong investments and are pouring away good money after bad. A whole spectrum of opportunities exists in automotive, and the same applies to the energy sector.
“Last year, we were making money from businesses that are on the right side of that technological curve and stayed away from those that are still wholly reliant on the combustion engine and who face long-term structural decline which as a creditor, you don’t want to be exposed to.”
Similar headwinds are being faced by oil and gas; old economy, cyclical businesses.
Before, says Pappas, some of these companies traded in a volatile manner because they were cyclical. Now, it is because of secular decline and issues around cost of capital (as the world moves into a cleaner energy environment).
“Banks are re-assessing their portfolios and lending activities; they are determining whether they have too much oil and gas exposure in their loan book and if they do, they are looking to shrink it and increase the cost of it,” he says, adding:
“I think the larger companies will transform and find ways to change their technology. I see problems with those who are maybe five times levered, and already threading the needle. This change in cost of capital, plus the technology shift, will lead to the lights being turned off much quicker. We are avoiding such companies facing near-term maturities.”
Last year’s dispersion in high yield was as much about where the money was going as it was where it wasn’t going. “Assets that did well were central bank sensitive assets with perceived low default risk and a lot of duration; it was a year where beta worked well in terms of longer duration lower quality investment grade assets,” says Jewell. “That was where a lot of investors wanted to allocate and to some extent, managers followed that trend.”
The flip side of that is there were some assets that were left behind. Investors were avoiding any kind of earnings challenge, and they didn’t want to take on illiquidity either.
“Those two simultaneous factors led to a period where you had dislocation. It was a have’s and have not’s theme and if you were tainted by difficult earnings or outlook, it was a problem.
“That then creates the opportunity whereby if we are going to have a bit of a recovery, could some areas of HY that underperformed do a bit better? We started to see that in the last few months of 2019 and in the first six weeks of 2020 before coronavirus completed changed the investment dynamics,” adds Jewell.
The team at BlueBay believes there is room for lower-rated credit, especially in leveraged finance, to catch-up after lagging higher-quality debt in 2019. But greater dispersion and idiosyncratic risk underscores the importance of bottom-up credit selection.
At CQS, Pappas says they see more upside opportunity for HY credit in the UK than the US, citing UK real estate (both commercial and residential) as one area of interest.
“Some cyclical assets have restructured and set up to do well,” he says.
“At one point we were looking at 25 companies restructuring their balance sheets in the UK; they were caught by sterling falling sharply last year, potentially pushing their leverage from 4x to 5.5 or 6x. They needed to address that by bringing leverage down significantly lower as they prepare to participate in what they hope will be a rebound.”
In his view, dispersion will continue given that the HY market has grown so much, observing that even in a low default rate environment, say 4 per cent, the market throws off USD100 billion of new distressed product.
“There is a lot of product in the stressed distressed space between 70 and 90 (cents on the dollar), which is tending to get orphaned because the market is bifurcated: on the one hand you’ve got investors who want to own par credit and are afraid to touch it, and on the other hand it’s not cheap enough for private credit or distressed funds to buy,” comments Pappas.
With markets falling and fears of a recession looming large because of the fallout from coronavirus, this could present compelling mispricing opportunities for credit managers.
Is this a time to be putting more risk on the table?
Jewell concludes by stating:
“We had quite a lot of risk on at the start of the year and today that’s not the case.
“It’s a tactical question around how to get portfolio construction right in the face of a big unknown. US HY spreads were inside 350 but have widened past 500 basis points, which is close to the wide end of last year’s range.
“If we can get to a place where the issues of coronavirus are contained and there has been no particular uptick in defaults that becomes an attractive entry point. But it’s so conditional on what happens over the near term.”
