"2006 - The Year of the Dog"
23 February 2006
No.19
Credit Strategy - Credit barbell (overweight government debt, emerging markets and high yield, underweight investment grade)
It may just be coincidence, but while 2006 is the Chinese Year of the Dog, it may also turn out to be Credit's Year of the Dog, too. After the ups and downs of the 2001-2004 period, 2005 was a mercifully dull year for credit. By contrast, 2006 is already shaping up to be more exciting, with greater dispersion of returns between both high yield and investment grade bonds, and between sectors. According to a popular astrology website, "The dog is an ethical and idealistic sign, and the year that bears its name will also bring increased social awareness and interest in society's less powerful members. Any tendencies to take, take, take will be replaced by a widespread sentiment of generosity and selflessness." Well, let me tell you, as an under-privileged debt investor, I'm seeing a lot of "take, take, take" in terms of transfer of wealth from creditors to shareholders in several pockets of investment grade. So far we have had:
- Pedigrees becoming mongrels (e.g. E.on sacrificing its long-held AA-rating in pursuit of a debt-financed €29.1bn takeover of Spanish rival Endesa);
- Companies making poodles out of bondholders (lack of covenants, hybrid bonds - equity without the upside?) This particularly applies to investment grade where pension funds are desperate for assets that can closely match their liabilities;
- Cash cows at risk of becoming dogs. No longer can you analyse an investment grade company purely in terms of its willingness and ability to preserve or enhance credit quality. If a third party (e.g. activist shareholder, private equity firm or more aggressively financed bidder) proposes a more leveraged structure, even a financially conservative board may be compelled to gear up (or break up) to some extent as its defence against a bid. Smiths Group would be one example. With low gearing and a diverse group of businesses, it is an attractive combination for a debt holder but, unfortunately, it makes an ideal LBO prospect too. With its huge capex plan, BAA is hardly a cash cow, but it was at least strongly committed to a BBB+ credit rating. However, following Ferrovial's bid there is speculation that share buybacks and increased dividends will be major parts of the defence (and this is likely to lead to further moderate rating downgrades).
On the flip side, this step-up in leverage and M&A activity plays to the strengths of the high yield market. As:
- It's predicated on a benign economic outlook which should keep default rates low and high yield spreads tight;
- Dogs are more likely to be acquired (even dogs with fleas can be given the treatment). This can bring significant rating upside (e.g. if acquired by a cash-rich investment grade predator);
- High yield bond issues are generally much more tightly covenanted to protect against financial engineering.
Furthermore, within investment grade, financial sector bonds can also be strong performers in this environment, because:
- High volumes of M&A and debt issuance is profitable;
- M&A in the financial sector is on balance neutral to positive (often at least part equity-financed) as opposed to negative to neutral in industrial sectors (mainly debt-funded);
- Need for continuous access to funding means credit quality is of paramount importance - banks will not lightly risk downgrades and higher funding costs.
In addition, as investors eschew "event-risk laden", poorly covenanted investment grade issues, asset-backed and well-covenanted bonds should be beneficiaries.
This environment is also supportive of emerging markets debt, where fundamentals are improving and "event risk" is of the political rather than financial engineering kind.
There are no adverse signals for aggregate credit quality coming from default rates yet (the blue line in the chart below) - indeed quite the opposite: the expected rise in defaults keeps being put back, which is very supportive of high yield bonds especially. But there are signs in Moody's of rating drift, i.e. the ratio of upgrades to downgrades (the higher the pink line is in the chart above, the worse the trend is). Anecdotally at least, this is due to investment grade rating drift deteriorating, not high yield downgrades, and the rating drift for emerging markets is still clearly positive.
Source: Moody's/Newton
So, 2006 could indeed be the Year of the Dog (in fact, even Rover is making a comeback, it seems!)
Portfolio response:
- Credit barbell (overweight government debt, emerging markets and high yield);
- Underweight investment grade overall, but overweight those sectors where leveraging up is a less attractive option (i.e. banks), or those specifically protected.
The views and opinions contained in this document are those of Newton Capital Management Limited at the time of going to print and should not be construed as investment advice. In the U.S. services from Newton Capital Management Limited are available from Newton Capital Management LLC. Newton's registered office is located at: 1209 Orange Street, Wilmington, DE 19801. Newton Capital Management Limited is an investment management firm authorized and regulated in the United Kingdom by the Financial Services Authority in the conduct of investment business and is a wholly owned subsidiary of Mellon Financial Corporation Inc. Registered in England no. 2675952. 'Newton' refers to the Newton group of companies that includes Newton Investment Management Limited, Newton Capital Management Limited, Newton International Investment Management Limited and Newton Fund Managers (CI) Limited.
Please remember that the value of investments and the income from them can fall as well as rise and investors may not get back the original amount invested. Past performance is not a guide to the future. The value of overseas securities will be influenced by fluctuations in exchange rates.
The information contained in this document should not be construed as a recommendation to buy or sell a security. It should not be assumed that a security has been - or will be - profitable. There is no assurance that any security will remain in a portfolio.
A Mellon Financial Company SM
