May 2014 - Credit - Earnings misses and aggressive documentation reflect growing risks in HY primary market

An overall favorable picture… full of pitfalls

We wrote for several months that the broad picture of European credit markets remains very favorable, with improving credit fundamentals in HY and financials, low default rates and efficient access to capital markets. Yet, this picture hides a growing number of pitfalls. In particular, two concerns are worth highlighting this month. First, the significant number of recent HY corporate issuers which released disappointing Q4 2013 and/or Q1 2014 earnings, only a short time after the completion of their bond issuance. Second, the emergence of investor-unfriendly features in bond documentations, particularly for less-than-pristine credits.

In the past couple weeks only, three examples can be taken to illustrate our first concern. Spain-based bus operator Avanza announced Q1 2014 revenues and EBITDA declines by ca. 9% and 25% YoY, respectively, which was far worse than expected. Such disclosure drove the bonds issued by the company less than one year ago down by 8 to 12 points. Similarly, UK-based insurance brokerage firm Towergate released a 25% fall in its Q1 2014 EBITDA, pushing down the trading level of its bonds by 4 to 7 points. Finally, Czech Republic-based coal mining group New World Resources – a serial “profit warning issuer” since the launch of its first bond in 2010 and its 2013 refinancing – just announced the final terms of its debt restructuring plan, which will permanently haircut a portion of its existing bonds in exchange for some cash, convertible bonds and equity contingent value rights.

With regards to our second concern, we wanted to share three examples of looser execution/documentation features. UK-based ice cream manufacturer R&R Ice Cream announced that they made a very significant debt-financed acquisition only two weeks after the issuance of a £315m new bond. Interestingly, such M&A transaction was hinted in the new bond documentation but very few market participants noted it – as they were probably carried away by the current new issue frenzy in European HY. UK-based food services group Brake Brothers made its own mark in the European HY market by tapping its existing bond for an amount 25% greater than that of the original £200m outstanding at a price 1.5 points above par. The fact that the new bond trades around its reoffer price is more a testimony of the current market strength rather than that of best deal execution practices. Third, Germany-based chemical group CABB managed to issue 3 bonds successfully for a total amount of €585m despite certain aggressive legal provisions. The new bond documentation provides that CABB can sell a large part of its business and distribute the disposal proceeds as a dividend to its equity sponsor without triggering any asset sale covenant protection.

The example of Germany-based metal recycling company Befesa offers a summary of both categories mentioned above. Since the issuance of €150m of subordinated notes in October 2013, the company’s earnings have somewhat disappointed the market. This, in turn, led management to announce during their Q1 2014 earnings conference call that they will use a feature in their bond documentation allowing the company to stop paying its 10.5% coupon in cash at the next semi-annual payment in December 2014. The coupon will instead be paid in kind with a 75-bp step up, small consolation for Befesa’s bondholders. Although the bonds barely sold off by 1 to 2 points post the announcement, we regard this example as a template for the risks embedded in several recent HY bonds in a more adverse environment.

So while the HY market continues to offer us very attractive catalyst-driven investment opportunities (we have 11 such positions –i.e., long HY via cash bonds or CDS, naked or hedged with the Xover index- in the Fund at the moment that embed a significant potential P&L that we expect will materialize in the coming quarters), such developments highlight the need for an increasingly disciplined credit selection on the long side. Moreover, while we think that it is still early and dangerous to fight against the very strong investor flows in the asset class, situations like the ones described above may provide us with single name HY short opportunities in the future.