Goldilocks is back, and the credit markets are acting as if the big bear is hibernating. Investment grade credit spreads may continue to offer reasonable value at current levels, but the lower reaches of the credit market have become particularly stretched. High yield has become not-so-high yield, with credit spreads almost back to 2007 levels in many cases, especially when excluding the handful of busted leveraged buyout (LBO) zombies that still walk the earth.
So who is buying selectively and who is just buying? Every credit fund manager will claim that he or she is avoiding the dreck and focusing on the hidden gems while providing ample downside protection. Of course, this only frustrates the ordinary investor – if every manager is being prudent, how can there be so much froth?
With this logical inconsistency in mind, we offer the following guide for the credit-market-perplexed: five emerging trends that PIMCO sees among credit managers who are churning the froth.
No. 1: The rise of the 100%-LTV high-yield deal
Everyone thinks that zero-down loans died when the subprime and Alt-A spigot was shut off in 2008. Not true. In the high yield and leveraged loan market, the 100% loan-to-value (LTV) loan is alive and well. In the last six months we have seen several new LBO deals with total debt essentially equaling the true enterprise value of the firm, and many more in the 80%–90% range.
Granted, the issuing companies and their investment bank syndicate partners will never present their financials as anything close to a 100% LTV structure, as the deals are always presented with “pro forma EBITDA.” The steps in drafting “pro forma EBITDA” can be the close cousin of those in the subprime “liar loans” from a not-too-distant past. Issuers will simply state that they expect cost savings from merging two companies, but generally they will give very little detail about where exactly those synergies will come from. In addition, issuers may simply give projections for EBITDA (earnings before interest, taxes, depreciation, and amortization) a year or two out, again without much detail about why lenders should believe those projections.
Do you want your credit managers making loans to borrowers based on the profits they’ve been generating in recent years, or on what they tell you they’re going to be generating a few years from now? PIMCO spends considerable time calculating what the real EBITDA will likely be – adjusting some of the aggressive accounting companies use to calculate EBITDA, drafting reasonable estimates for top line and margins, and thinking hard about the true cost savings. In more normal times our own EBITDA estimates will likely be much closer to the deal presentation EBITDA projections. Lately, though, issuers have grown increasingly aggressive, and our analysts’ estimates can differ significantly from the companies’ advertised projections.
Along the same lines, do you want your credit managers making loans to borrowers based on what they tell you their asset should be worth, or what you think it is actually worth? One of the reasons we see deals coming at or near 100% LTV is that the actual enterprise value of the issuing company is significantly less than the amount the private equity sponsor is paying to acquire it. We lenders (and ultimately you, the client) are then expected to calculate the LTV on a value that is the product of a possibly “optimistic” EBITDA estimate and equally optimistic enterprise value multiple. These two issues can compound the error, and a bond or loan that is supposedly “covered” is in fact highly exposed.
No. 2: “Cov Zero” is the new “Cov Lite”
Over the past two years we have been hearing a lot about the surge in “covenant lite” (or “cov lite”) issuance, the phenomenon of issuers bringing deals with skimpy covenants. More troubling is the recent appearance of what we would call “cov zero” issuance. A recent deal even went as far as stripping out the change-of-control put clause (which allows a bondholder to put a bond back to the issuer in the event of an LBO) that has been nearly universal in high yield issuance and is one of the few real protections bondholders have left. We have even seen a number of deep cyclical names come with perpetual bonds – the ultimate in covenant stripping, where lenders don’t even have a promise to be repaid.
Why are credit managers buying cov zero bonds? In our view, there are the obvious reasons: reaching blindly for “yield” (forgetting that a defaulted bond yields nothing), the tyranny of index benchmarks, passive or quasi-passive management behavior, etc. These are understandable and, if anything, active high yield managers with longer-term client relationships can use this behavior as an opportunity. More maddening is the rationalization we hear around the move to cov lite/zero, especially the claim that covenants are actually bad for lenders because they create more potential for default. Without covenants spelling out various events of default, according to this argument, there are fewer default triggers. Huh? Covenants are a critical part of the lender/borrower dynamic – crafted well, they allow management and shareholders the flexibility they need to run the business while providing robust guardrails to keep risk-taking to a manageable level. Lenders should prefer a borrower default sooner under a covenant than later on a payment default, after management and shareholders have stripped all the value out of the company.
No. 3: Dividends before coupons?
Another recent innovation in credit land is the emergence of the Alternative Tier 1 (AT1) capital instrument for European banks under the new Basel III rules. The Basel committee decided in its wisdom that new AT1s must be truly loss-absorbing and not constrain the issuer in any way as a “hindrance to recapitalization.” What might hindrances to recapitalization include? How about dividend stopper language, whereby the logical and historically tried-and-tested ranking of claims is respected and dividends cannot be paid to common shareholders so long as interest is not being paid on bonds? In theory, banks are now required to sell bonds with coupons that could be turned off while shareholders still receive dividends. That would be an extreme scenario, but one that warrants a highly discriminating approach to this emerging sector, in our view.
No. 4: When “cheap” is really just “zero liquidity”
This time really is different, but the difference is bad for bondholders – even while the credit markets have enjoyed a boom, the secondary liquidity has stayed historically tight. This means that the “roach motel” dynamic is as pernicious as ever – investors can buy aggressive deals at new issue, and they may be able to flip them for a day or two, but thereafter the secondary liquidity in the deal vanishes. The smaller deals that will inevitably be near-zero-liquidity issues generally come with a concession to more liquid deals, but that concession has dwindled to perhaps 25 basis points (bps) or even less in the high yield market, and maybe 5 bps in the investment grade market. PIMCO is generally an advocate of the buy-and-hold strategy in credit investing, and we would argue that investors should be willing to accept illiquidity if they are able to withstand volatility and if the illiquidity is appropriately priced. But investors should beware of credit funds that offer daily liquidity where managers are reaching for yield and are not paying close attention to the prospective liquidity profile of what they buy.
No. 5: The mirage of “net debt”
One final under-appreciated risk is the focus on “net debt” as opposed to gross debt or, better yet, gross liabilities. The consensus is that many companies are flush with cash, and therefore that cash can be netted against outstanding debt to get a fairer assessment of the true level of indebtedness. That may be sensible in many cases, but the devil is in the details. First, much of that cash may be trapped offshore in tax havens – in theory it could be repatriated, but only after a hefty tax bill is paid. Second, analysts often use 100% of the cash on balance sheet to calculate net debt, whereas in the real world companies have significant working capital flows for which they need to maintain a minimum level of cash. That cash could never be used to repay debt in a restructuring, as it is required to operate the business. The defaulted U.S. auto companies in 2008–2009 were the best examples of this: They had significant cash balances on their balance sheets at quarter-end, but intra-quarter swings in working capital meant that cash balances were much less supportive than they appeared.
A third critical point in the calculation of net debt is what debt number to use. The ratings agencies and the analyst community tend to focus primarily on the amount of straight debt liabilities. In bankruptcy, however, bondholders are far from the only stakeholders lining up to divide the recovery value. Pension liabilities, environmental abatement liabilities, litigation reserves, deferred tax liabilities and a host of other contingent liabilities could crowd out creditors, especially if those claims are deemed to be structurally senior to the debt. PIMCO focuses on this full range of liabilities, and tries to think ahead about where in the recovery waterfall these other liabilities will stand if a bankruptcy were to occur.
These five trends are far from the only pieces of evidence of froth in the credit markets, but they are a good place to start to understand what is driving the return to bad behavior. The bad news is that this questionable behavior is back, but the good news is that we believe the credit markets still offer plenty of opportunities to potentially generate attractive returns. As we’ve highlighted in numerous publications (see “Growth and Rising Stars,” by Mark Kiesel, September 2013, and “High Yield in 2014: Where Can You Look for Upside in a ‘Medium Yield’ Market?” by Andrew Jessop and Hozef Arif, January 2014), we still see compelling value in many energy, health care, financial and transportation credits, among others. Smart, rational credit investing that avoids some managers’ naïve reach for yield, and sticks instead to a deep focus on the long-term sustainability of companies’ balance sheets, may still reap rewards.
- Identify aggressive accounting and adjust models accordingly.
- Evaluate covenants and structural protections with an eye to maximize recovery.
- Apply a discriminating approach to bank capital instruments.
- Consider more liquid assets, or at least seek to get paid when you don’t.
- Focus on actual – not net – debt, on and off the balance sheet.