We have been waiting for months for the credit markets to wake up and assign a significant risk premium to issuers, especially in the high yield segment. Last week, that moment may have arrived.
In the last two days of the week, the Iboxx € High Yield index lost 0.65% and the Iboxx € Corporate fell 0.45%. These are significant losses given the current level of yields.
As is often the case, almost by definition, it was not the risks that the market has long anticipated which may have unleashed a new period of stress in the credit market. The risks (China, the tensions between the US and North Korea, stratospheric valuations of certain American unicorns and multiple political tensions in Europe) were not responsible. Rather, investors were concerned with matters closer to home in the form of disappointing quarterly results from a number of companies which could lead to a deterioration in confidence. Although there are investors willing to lend to highly-debt-burdened companies at near-zero rates, it is with a certain skittishness and with one finger on the trigger that they anticipate trying to cash out. We say well “try” because during these pullbacks, as small as they are, it can be difficult to find a buyer willing to purchase over-priced bonds! The result is massive corrections in prices as we saw with certain issuers last week:
- Astaldi 2020: a 20 point loss during the week, with the yield increasing from 6.5% to 14%
- Teva 2027: a 7 point loss during the week, yield up from 3% to 4%
- SFR 2024: a 5 point loss during the week, yield up from 4% to 5%
- Europcar 2024 (recent primary issue): a 2 point loss, yield up from 3.5% to 4%.
Three of these companies have in common the fact that their growth has been largely due to having been able to sell debt at very low yields to finance projects with, at best, average profitability, in competitive industries.
Taking the example of Altice: some analysts claim that CEO Patrick Drahi is a magician, capable of turning all that he touches into gold and using this to justify financing Altice growth at yields of 3%-4%. We have only to look at recent developments in the telecommunications industry to judge.
Only 15 years ago the sector was less competitive, technological developments were less frequent and not as fast-moving. Nonetheless, the sector was already overly-indebted. The technological and regulatory barriers to entry are high, allowing for oligopolies to form, but this is to the detriment of the margins of the very oligopolies. We have never seen a company manage to beat its competitors by excessively high debt. Although oligopolies manage to ensure that only a few players share a market, there are unwelcome side effects:
- the players are required to make massive investments in the network and/or marketing. Each euro of interest paid in is directly drained by operating needs.
- competitors are, by definition, large-sized so that players have to maintain comparable financial profiles over time. Players have to keep debt at reasonable levels because too much debt makes them extremely vulnerable (to changes in technology, requirements for marketing offensives, a dip in market prices, mergers between competitors). Moreover, when there are oligopolies it may mean that the players are not interested or willing to purchase a struggling competitor as it may be more to their advantage to allow the failing competitor to fail in order then to move in and buy up the assets for a song. Brazilian telecom operator Oi is one such example.
So, Altice, with debt of €50bn on market capitalisation of €15bn, is beginning to flounder. Some analysts have retained their recommendations and stated that the results were not all that bad and that the share price should not have fallen so much or that credit quality is still solid. We suggest that Altice, after its massive debt-financed investments, needs to deleverage, that is, reduce investments and increase (or stabilise) the operating profit. That is the opposite of what it is doing at present: in 3Q2017, it lost 75,000 subscribers in France (and 16,000 in the previous quarter) and is attempting to counter the impact by ramping up investments in order to improve the network and stimulate its offering. Some analysts maintain that the bad performance is not that bad, but with such high leverage, each point less of profit has a multiple effect on the balance sheet and the group’s credit quality.
Others put forward the argument that, instead of the parent company’s housing the debt, it is spread out amongst the operating subsidiaries, and non-recourse to the other entities. This makes it extremely difficult to read the figures. And creditors prefer to finance global businesses, taking advantage of their regional diversification or market positioning. They do not like financing an entity which does not have recourse to others, so can easily go bankrupt and be placed under Chapter 11 protection.
In conclusion, last week investors were concerned about a number of high risk issuers and the concern spread throughout the HY segment. Indices and trackers heightened the effect which led to caution. With debt of €50bn Altice is heavily risk-weighted. So, beware of the HY telecom sector. Beware too of pharmaceuticals in the US (as the sector is suffering from low prices), high yield in Italy owing to persistent economic moroseness and retail in the US (which has been showing unfavourable figures in the last few months and is having difficulty coping with competition from the web). We also note that, as at end 2015, investors opted to position themselves less on HY but this did not lead particularly to a trend of “flight to quality” probably because the stress was not generalised. We also note that sovereign assets also saw their valuations deteriorate last week.
So, we shall remain cautious as 2017 draws to a close, retaining a high cash buffer in assets maturing within 3 years which are holding firm due to the ECB.