Credit over equities — coupons over dividends?
Jenna Barnard, and Nicholas Ware, members of the Strategic Fixed Income Team, share their views on the recent bout of market activity, with large companies accessing the capital markets and the stream of dividend cut announcements in Europe.
- For income investors, credit looks like a far more fertile hunting ground than equity markets at present.
- Corporate bonds may be more illiquid than equities when trading but they are fundamentally less risky given their holders’ seniority in a company’s capital structure. At this stage of the crisis, as well as the business cycle, this presents a plethora of opportunities for credit investors.
- For companies who can raise capital in public markets, it is equity investors who are going to bear significant pain as regulators, governments and corporates themselves understand that sourcing liquidity to survive the COVID‑19 crisis requires sacrificing equity investors — the recent dividend cuts are likely to become the norm.
Obvious as they are, there is a need to reiterate the facts
It is worth pausing to reflect on the fundamental fact that corporate bonds hold a claim on a company’s cash flow, which must be paid in order to avoid default and that debt holders have seniority over equity holders in any capital structure. Corporate bonds may be more illiquid than equities when trading but they are fundamentally less risky. At this stage of the current crisis, as well as the business cycle, this presents a plethora of opportunities for credit investors.
Despite being obvious, it does feel that this point needs to be emphasised for two reasons: first, there appears to be a general narrative emerging in recent weeks that credit markets are the weak link in the macroeconomies and second, we have already (without much attention) entered a stage of the business cycle where creditors are prioritised at the expense of equity returns.
Equity investors will mostly bear the pain
Corporate debt may well be a risk, but for companies who deserve to survive, it is equity investors who are going to bear the pain.
Developments in the last two weeks provide clear case studies highlighting this theme. Banking regulators in the UK and Europe have turned off ordinary dividends for banks but maintained coupons on subordinated hybrid bonds and preference shares. Other companies are effectively executing rights issues at speed, via equity placements to shore up liquidity for the next 12 months. Examples include SSP (multi‑national consumer discretionary group) and Hays (recruitment/support services) with more very likely to follow.
Dividend cuts are likely to become the norm
Both regulators/governments (via bailouts of certain industries) and more importantly, corporates themselves, understand that sourcing liquidity in order to survive the COVID‑19 crisis requires sacrificing equity investors.
As of 2 April 2020, 96 corporates in the European benchmark, STOXX Europe 600 Index, have either canceled or delayed their dividends. This includes such diverse sectors as travel and leisure, media, construction and materials, personal and household goods, industrial, retail, food and beverage, real estate, technology and banks. The French government warned that it will withhold any financial support if a company pays dividends. Germany also said that you have to suspend returns to qualify for support from the state‑owned development bank KfW. Cancelling dividends does appear to be the political price to pay for any form of state or regulatory support.
Clearly, for low quality companies and sectors, such as energy or retail — the existing ‘zombies’ — both debt and equity investors will suffer through bankruptcies. This is the culmination of a trend of ‘value’ as a style of investing, underperforming for a full decade. Why would capital markets save companies who do not perform in good times, let alone bad? However, defaults in energy and retail should be no surprise to any investor.
History doesn’t repeat but it rhymes
What this means is that history will likely repeat itself and credit will outperform the other asset classes as we move through this repair stage of the business cycle (see chart).
Credit is top of minds in the repair stage of the business cycle
Source: Bloomberg, BNP Paribas, as at December 2018
Note: Equity: S&P500; credit: US BB rated, return; rates: US Treasury. Data from 1995.
There is an economic time limit to this lockdown
A British Chamber of Commerce poll published on 2 April 2020 showed that six in ten UK firms have no more than three months of cash left to cover running costs. Despite recent government schemes, there appears to be an economic time limit to this lockdown before mass bankruptcies kick in.
This is particularly the case for small businesses. For the larger businesses, the kind that we lend to via the corporate bond market, we are seeing encouraging signs that corporates that need additional liquidity are managing to shore up their balance sheet for a prolonged period of 'no or low' cash flow, even in more challenged sectors. The luxury of accessing credit and equity markets affords this opportunity. Below are a few case studies from recent days and we expect many more to follow.
The German travel company TUI, having announced the suspension of the majority of travel operations because of the COVID‑19 outbreak at the beginning of March, received a €2bn bailout from the state‑owned KfW bank.
The EU commission guidelines on rescue aid, which stated that member states could only support stressed companies provided such support measures contributed to the public good, was suspended on March 19 to help European governments deal with the outbreak. The German government’s rescue package has supported a business which would have failed without any action. Simplistically, looking at it now, will the German government allow the company to fold considering it was performing well pre COVID‑19 crisis?
Loxam, a European rental equipment group head quartered in France, drew down on their bank facilities to the tune of €250m and are also looking to raise an additional €230m of loans using the French state scheme for government guarantees for corporate loans to bolster their liquidity position. So, the company finally saw sense and instead of having liquidity for the next three months, it managed to raise liquidity for the next nine. In the current environment, analysing companies has turned into re-underwriting credits by assessing how much liquidity a company has in order to survive in a ‘zero revenue’ environment.
The third example is Carnival Cruise Lines, the world’s largest cruise operator. The company that is arguably at the epicentre of the COVID‑19 outbreak, suspended all its cruise operations and was seeking to add US$6bn liquidity through debt, convertible bond and equity. It had roughly four months of liquidity left at hand to operate in a zero revenue environment. Through the recent fund-raising effort, the company has now added another nine months of liquidity to continue operating in a zero revenue environment.
Though this has come at a heavy cost to existing investment grade bondholders. Carnival was able to issue an unsecured, 10‑year investment grade bond in October 2019 at a 1% coupon. For this new deal, it had to pledge 86 cruise ships with an aggregate net book value of US$28.6bn to raise US$4bn debt with an 11.5% coupon. So, the new bondholders will be structurally senior to the existing US$16bn of debt outstanding, have a loan‑to‑value (LTV) of 14% and will be receiving a huge coupon.
Not without risks, but not without opportunities either
For income investors, credit looks like a far more fertile hunting ground than equity markets at present. While they are not without risk of course, at current valuation levels and with the actions being taken, there are significant opportunities. This is the normal sequencing of a business cycle. For our equity colleagues, we hope that the future years bring the prospect of economic and earnings recovery so that they enjoy the fruits of the sacrifices being asked of them during this crisis.
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