In the second of our series of articles on credit, Hartej Singh, Portfolio Manager, looks at what increases in supply and index weighting for a sector has indicated historically and why this means they are proceeding with caution among technology, real estate and healthcare bonds.
It is not hard to pick out the fixed income investors at a conference. We tend to congregate around the fire exit. Cautious in nature, we are constantly trying to work out where risks might emerge. A notable indicator of looming problems is when there is heavy issuance in a sector that causes its weight within a bond index to rapidly increase. Time and again, this has been the canary in the coal mine.1
1Canaries were used by miners as a warning of dangerous methane or carbon monoxide gas levels. The bird’s lungs were more sensitive so it would be rendered unconscious before the levels of gas were hazardous to humans.
For bond markets, what do the telecoms crash of 2001, the Global Financial Crisis of 2008 and the energy crisis of 2015 have in common? Each crisis was preceded by a significant increase in the weighting of one sector. The collapse in confidence in equity markets was mirrored in the debt markets. As earnings and share prices in each of the three sectors tumbled, covenants began to be breached and companies found it difficult to raise further capital.
Defaults led to severe losses on individual positions. Although the investment grade indices reported single digit losses around each of these crises, this masked the true position. As cash flows came under pressure, several investment grade borrowers were downgraded and the true extent of the pain was reflected in substantial losses within the high yield index of the crisis sector. For example, the ICE BofAML Global High Yield Telecom Index reported double digit losses for 2000, 2001 and 2002 in local currency total return terms. WorldCom, the telecoms group, epitomised the problem. Within just two months of being downgraded to high yield, it defaulted on US$30 billion of bonds.
While each of the three previous crises had different origins there were some commonalities as the table below highlights.
Figure 1: What went wrong?
Source: Janus Henderson Investors
Today, the sectors that are showing the heaviest issuance and the greatest increase in weight within the investment grade universe, as represented by the ICE BofAML Global Corporate Index, include technology, real estate and healthcare.
Figure 2: Proportion of global investment grade indices (%)
Source: ICE BofAML Global Corporates, 30 June 1998 to 30 June 2018
A sharp increase in the weighting of a sector provokes a number of questions in our minds:
- What is happening in the industry to entice borrowers into the market?
- Is the level of cash flow or projected cash flow sustainable or does it rely on selling at unsustainably high prices or with unsustainably high volume growth?
- In an environment where a company or industry undergoes a moderate reduction in expectations, will the company still be able to pay down its debt?
So how does each of these sectors fare and are there any parallels with previous problem sectors?
The technology sector is in a maturing stage and it is not unusual for more mature companies to issue debt instead of equity to prevent shareholder dilution. There are also certain special cases, such as Apple, which has been issuing debt to release cash for dividends (that were backed by un-repatriated overseas earnings). The decision by President Trump to lower taxes on repatriated earnings may mean less need for this sort of debt issuance.
Cash flows within technology are improving alongside earnings but optimism is currently very high. At the end of June 2018, Amazon shares were trading at more than 170 times earnings on a trailing 12 months price/earnings ratio basis, although this is expected to fall to around 50 times earnings within three years if consensus estimated earnings go to plan. Let’s not forget that similar confidence was displayed in companies like Cisco at the time of the dotcom boom in 2000 only for earnings to collapse in the subsequent downturn when companies saw IT expenditure as a simpler and more palatable cost cut than staff reductions. While the disruption to older business models from the technology giants seems all-pervasive, and cash levels among these companies is high, there remains the danger of extrapolating buoyant times too far forward.
The real estate sector is going through disintermediation with many borrowers accessing the public markets rather than borrowing from banks, particularly in Europe. The increase in borrowing may be a rational response to expectations of rising interest rates, with property companies keen to take advantage of cheap financing while it is still available. The US Federal Reserve has repeatedly cautioned on commercial real estate values in its Monetary Policy Reports. Reassuringly, however, US real estate values appear to have plateaued according to Green Street Advisors US Commercial Property Price Index. It would be far more concerning if it were a steep climb followed by a steep fall as that would be more likely to lead to a collapse in collateral values, causing heavy losses at real estate firms and difficulties in repaying debts. US economic indicators and survey data remain robust, which should underpin rents and property values in the near term. Technological disruption and behavioural shifts, however, mean it is important that property portfolios are not rendered obsolete by economic developments.
Figure 3: Green Street Advisors US Commercial Property Price Index
Source: Green Street Advisors US Commercial Property Price Index (indexed to 100 in August 2007)
The sector has been undergoing regulatory change, with governments becoming more price sensitive in response to the US taking a more aggressive approach to drug pricing and several high profile scandals. Companies have responded to the tighter pricing regime with vertical integration and purchases of growth areas by larger players. Patent expiry on several blockbuster drugs also means that there is heavy expenditure on research and development to protect drug pipelines. So far, we have little evidence that the measures being taken have worked. A case in point would be Teva Pharmaceuticals. The company underwent a merger with rival Allergan in a quest to boost its revenues and maintain an investment grade rating. But the merger (and management) has failed to deliver on its revenue targets and was downgraded to high yield in early 2018.
We remain sceptical of unsustainable optimism hence the need for a selective approach. Given that supply trends form an element of our fundamental credit research we:
- Avoid companies that are likely to make large debt-fuelled acquisitions at this point in the cycle;
- Assess prospects for cash flow generation conservatively.
While we continue to invest in bonds issued by companies in these sectors, we do not want to be the ones to utter the most dangerous words in investing ‘This time it’s different’.