Market Wrap

Friday Workout - Revising Default Positions; Stretched Lycra; Oil be Back

Chris Haffenden's avatar
  1. Chris Haffenden
18 min read

While we in the UK were preoccupied with extended holiday weekend travel chaos, and strange repositories for marmalade sandwiches, the US HY market saw its largest inflows since October 2020. This sparked a surge in US issuance, raising hopes European primary could win a vote of confidence. But there was just a doorstop-sized Inovie add-on, plus a small euro-denominated canapé from Kofax to snack on this week despite an impressive spread of IG deals, as secondary stabilised.

New deals are being priced to sell, as banks look to clear their books and issuers face up to the grim reality of the new costs of finance. Plenty of jam (or marmalade if you prefer) for investors.

The €300m tranche for Kofax is a great example — the B2/B/BB- rated deal is guided at E+525 bps with a 93-94 OID, well at up from the 425-450 bps at 99, seen earlier in the year for B2/B deals.

An impressive Morrisons scoop for LPC, outing PIMCO for taking-down most of the €545m 4.25% SSN tranche at 85, more hefty losses for underwriters, though one bank declined to play. Just a £1.5bn-equivalent TLB and a £500m TLB2 on special offer: “our brand, lower prices.”

Now earnings season is behind us, and with some semblance of stability returning to markets, there is more time for us to take stock of events over the past few weeks.

The bifurcation trend continues with decent demand for good BB credits, but CCC paper continues to struggle. In the US, the average CCC-rated bond is yielding a mighty 12.5%. Over in Europe, we saw some recovery, as according to our screeners, 34 bonds from 21 issuers had price rises of over 5% in the past month. But after tightening 40-50 bps from its wides in early May, the Crossover had appeared stuck around 450 bps, but widened again to 471 bps yesterday on ECB hawkish talk, as Sovereign bond yields hit multi-year highs and peripheral spreads blew-out.

Leverage loans were also quiet, a few print and sprint CLOs had mopped up cheap secondary paper, but the arbitrage is not working to take out paper held in loan warehouses from earlier this year. For more check out Owen Sanderson’s latest Excess Spread – and watch out for Owen’s and Kat Hidalgo’s content from Global ABS in Barcelona next week.

So, how much of the widening of spreads in the past 3-4 months is an aversion to risk, and how much is down to pricing in higher default expectations?

Deutsche Bank’s 24th annual Default Study landed in our inbox earlier this week, titled ”2022:  The end of the ultra-low default world” it certainly raised some eyebrows in 9fin Towers. It may provide some answers – although admittedly, they are at the Haff-ish (More Bearish) end of the Investment Bank Research desk’s spectrum.

Before you read on, if you are a HY investor, I recommend staying away from sharp objects.

Deutsche says that the 20-year structural trend lower in corporate defaults is over, predicting a US recession in H2 23, with defaults hitting 10.3% in the US and 6.6% in Europe (lower due to a higher proportion of BB’s this side of the pond) in 2024.

Scarily, they expect a peak 12-month default rate of 11% for single Bs and a whopping 45% for CCCs – perhaps 12.5% isn’t so cheap after all!  Deutsche adds it is “currently unattractive to a buy-and-hold investor under anything other than the most benign outlook for defaults seen through history.”

They go on to say, “assuming a 40% recovery, HY spreads today would not compensate for the defaults seen in six discreet 5-year cohorts formed over the last 35+ years.”

Deutsche’s view is that inflation will be stickier than expected on the way down, leaving Central Banks with less ammunition to cut rates as growth slows and even goes negative. In the near term HY spreads may have some room to compress, but they caution they are historically tight to IG spreads, which they interpret as investors being more focused on rates volatility than slowing growth. For end-2023 they expected US HY spreads to hit 850 bps, and IG at 210 bps.

The unwinding of QE and CB balance sheets means that peak CB support for bonds is over.

Longer business cycles and shorter recessions led to improved investor confidence in corporate bonds. This was due to a decline in inflation from 1980-2020 which allowed policy makers to aggressively intervene at every market wobble without stoking inflation. This is less likely going forward, and business cycles could roll over more frequently and investors can no longer rely on the authorities.

Another reason to be fearful is that corporate profit margins are close to historic highs. I agree with DB, corporate’s ability to pass on higher costs is getting harder, as consumers start to hurt and demand falls – a double-whammy for margins. The big increase in consumer credit in the US in the past couple of months is worrying, how long can they try to retain their strong spending power? Leverage remains elevated historically (not counting the 25% plus EBITDA add-backs that are now the norm) which means that downturns could be more punishing for borrowers.

Whether you think spreads compensate you for the upcoming default wave depends a lot on expected recoveries and cost of finance. There is a whole section devoted to this in Deutsche’s report, if you don’t have access – I highly recommend that you ping an email to Jim Reid.

If you’ve got this far, you will be pleased to find that this is a German Real Estate free Friday Workout edition – Adler’s Q1 call last week failed to deliver the expected fireworks. But for those looking for a property fix - we did release our Corestate QuickTake to clients earlier this week. If you are not a client but would like to request a copy, please complete your details here.

Lycra stretched to fit

The machinations at Lycra’s shareholder level have intrigued us for months.

We were unsure how the default of a mezzanine loan made to Ruyi Textile and Fashion International Group) would play out. The appointment of Edward Simon Middletown and Ms Wing Sze Tiffany Wong of Alvarez & Marsal Asia as receivers on 21 February triggered a change of control under its existing $100m revolver and its 2023 and 2025 bonds.

In return for waiving a change of control Lycra’s debt burden will increase by another $34m, according to its first quarter release. An additional $15m of its 7.5% SSNs due 2025 were issued to its majority bondholders as payment for the waiver, with another $19m of non-interest-bearing debt to be entered into this month — whose repayment is contingent on an exit, refinancing (of the 2025s) or an insolvency event.

There was some incredulity on the conference call, when management said that the agreement was struck between the majority of its SSN holders and mezzanine lenders, with zero company involvement. No equity or cash consideration was given in return for the waiver and the new $19m debt obligation will rank pari passu to the existing SSNs.

On 25 April, RCF lenders agreed to allow continued availability, revising the maturity date to 1 February 2023 (from November 2022) and replacing the springing leverage covenant with a minimum liquidity requirement (size undisclosed) to be tested monthly. The $50m drawn balance remains the same as at FY 21.

Management appears to be happier to deal with the receivers rather than working with the previous Chinese shareholders. Auditors gave Lycra a qualified audit opinion after failing to gain sufficient financial information and access to management at a newly established Chinese Joint Venture Laika to which Lycra has contributed $30m.

Lycra is in dispute with its related party minority partner in the JV, Jining Ruyi Wanzhong Venture Capital, and launched legal proceedings after the formation documents were “amended to effect capital increase requirements in Laika that would result in approximately $80m additional capital contribution by the company in the form of contributed property, plant, and equipment from our manufacturing facility in Foshan (Subsequent Contribution Requirements).”

China is an important market for the US-based manufacturer of shape retention clothing materials, making up around 30% of its business, mostly re-exported as completed goods.

Covid restrictions and higher raw material, energy and freight costs impacted margins in the first quarter, but were part mitigated by the declining cost of PTMEG — its main input for Lycra.

There are worries that the capital structure won’t stretch to fit the current business performance. In addition to the $100m February 2023 revolver, Lycra has €250m of 5.375% SSNs due May 2023 and $690m (not including the newly issued notes) of 7.5% SSNs due May 2025.

Their yields have expanded in recent months, and with leverage hitting around 5.2x (net senior secured) as at end March. A refinancing will be highly challenging in the current market environment. We suspect that a more elastic A&E or a soft restructuring is more likely.

Management told analysts they were evaluating all options, for the RCF, the 2023s and the 2025s, adding “we need to understand what would be best for us.”

Oil be Back

The Oil & Gas sector has had a tough time in recent years, with several high-profile restructurings, most notably in the rig sector and for the US Shale Gas operators.

Over here, we had restructurings for Premier Oil and KCA Deutag, with Tullow having to pay double-digits last year to takeout its bank debt, while Enquest took the opposite route.

Despite a surge in oil prices, many of these O&G names remained trading at stressed levels. Concerns over the energy transition and end-of life assets have weighed on bond prices. Exploration remains subdued too, with firms preferring to return super-profits to shareholders.

Last week, there was some evidence that confidence is returning to the sector with significant M&A deals providing a boost to Tullow Oil and KCA Deutag stakeholders.

Post completion of its ‘merger of equals’ with Capricorn Energy (formerly Cairn Energy), Tullow Oil is seeking to significantly reduce its debt quantum and cost of debt. In an analyst call outlining the merger with its UK-based Oil & Gas peer, it outlined that the combined group would have net leverage of less than 1x by end-2022, with a cash balance of $1.8bn.

The intention is to optimise the debt structure and cap stack post completion, said James Smith, Capricorn CFO, who will become CFO for the combined group.

Tullow is offering 3.8 new shares for each Capricorn Energy share, with Tullow shareholders set to own 53% of the combined group and Capricorn shareholders 47%. The deal is expected to complete in the fourth quarter of 2022.

Capricorn has oil & gas producing operations in Egypt and in the North Sea. The strategy is become a leading player in Africa, concentrating on organic growth and existing exploration opportunities in Israel, Egypt, Kenya, Ghana and Gabon.

According to a presentation accompanying the call, production from the combined group will increase from 100,000 bpoed to 120,000 by 2025. The aim is to provide baseline dividends of around $60m per year, with $2.4bn of capex spend from 2022 to 2025.

Higher oil prices and enhanced liquidity puts the combined group in a very strong position, said Rahul Dhir, the Tullow CEO, and proposed CEO for the combined group. At a $100 average oil price the group could generate $3.6bn of pre-financing cash flows, he said.

Last May, Tullow refinanced its debt stack with $1.8bn of 10.25% senior secured 2026 notes and a $600m super-senior RCF, taking out a jumbo $1.8bn reserve-based lending facility and 2021 convertibles and 2022 SUNs. It left their $800m 2025 SUNs in place.

The $800m 7% 2025 SUNs jumped from 77.25-mid to 92.10-mid on the M&A announcement, but have since slipped back to 87-mid. The bonds are callable at 101.75, but this steps down to par in March 2023. Moody’s have them rated at Caa2 (the SSNs are B2) — put on positive watch this week — but ratings will be constrained by its African and most notably Egyptian risk.

To finance the $550m purchase of Saipem’s onshore drilling business, KCA’s largest shareholders (former creditors from their 2020 restructuring) are providing $475m of debt facilities. A $200m subordinated PIK, $250m backstop facility and $25m equity, alongside the rollover of $500m existing SSNs, $100m from a new RCF, plus $155m from existing guarantees lines and $200m of cash.

Under questioning, management said that the new PIK loan would pay a 15% margin and that the back-stop facility would either be via a tap of its 9.875% 2025 SSNs or from a new loan facility. The new RCF ranks super senior and uses availability under existing baskets.

According to KCA Deutag’s proposal, net leverage will jump to 2.0x from 1.2x pro forma the acquisition which is expected to complete in October. The Saipem sale price is fixed, and no changes are envisaged under SPA.

This handy slide from the presentation drills down the key financials of the takeover:

The main threat to KCA Deutag’s current operations is its exposure to Russia.

The company is aiming to reduce this through the buyout of Saipem and subsequent expansion in the Middle East and Latam. KCA’s revenues were negatively impacted by the ongoing Russian sanctions and it has been forced to close nine rigs (representing around half of its fleet) as a result of EU sanctions. Following the takeover, it expects to generate 15% of its revenue from Russian operations compared to 21% at present:

Grave concerns

In hindsight our piece on Orpea, following its Q1 results had a more positive prognosis for the French Care Home operator than was the case.

Looking at our patient notes, CEO Yves Le Masne was dismissed following allegations of patient abuse by the company detailed in Victor Castanet book Les Fossoyeurs (The Gravediggers) and its annual net profit plunged 59% due to costs associated with the ongoing investigations. In late March, the French government filed a criminal complaint against Orpea over allegations of patient abuse and a ‘media furore’ dented its reputation.

In early May, Orpea had hoped that unveiling an ‘Agreement in Principle’ with its banks (following a conciliation procedure supervised by the Nanterre Commercial Court) to provide a new €1.733 billion syndicated credit facility would alleviate debt concerns, and arrest (pun intended) the slide in its bond prices. But it had to cough-up, pricing on the new facility is E+390 bps, compared to the group’s current average cost of E+220 bps. Orpea also has an optional €1.5 billion syndicated facility to refinance existing unsecured bank lending at E+500 bps.

But it didn’t take long for more ailments to emerge, with allegations of fraud levelled against its managers by Investigate Europe on 18 May. The allegations centred on Lipany a Luxembourg HoldCo which had 40 subsidiaries related to a number of property transactions. Orpea’s 2% 2028 bonds dropped almost 20-points on the news into the 60s.

This week, the prognosis looked even worse. On Tuesday, 200 Gendarmes raided the group HQ, with the French police also entering 20 other Orpea properties. Alvarez & Marsal and Grant Thornton released results of their investigation into claims of patient abuse at Orpea and former CEO Yves Le Masne was questioned by French authorities over alleged insider trading.

The consultancy firms found evidence that Orpea committed financial wrongdoings but did not find proof of widespread abuse of patients. Orpea admitted that it did receive a surplus of allocations from the government which “may have contributed to the group’s results”.

So, with the bonds now in the mid-50s, for those willing to take headline risk, is this the time for distressed funds to get involved? We understand that the new debt facility will be approved by the court in mid-June, which appears to remove short-term default risk.

But, with a huge €8.837bn debt stack, and a property valuation (Orpea owns 46% of its homes) of €8bn — the asset value backing isn’t great — above 100% LTV. There must also be concerns amongst their landlords over reputation and business risk, and from my experience covering distressed UK care homes, many might be considering their existing agreements and the use of other operators to be palliatively careful. I’m not familiar with the French regulatory regime, but there must be real concerns that Orpea could lose its license to operate.

We will be undertaking a more detailed examination of Orpea in the coming days and weeks.

Wood Stock Piece Un-loved

Estonian wood pellet producer Graanul divided opinion when it launched its HY bond last October. Biomass is controversial, especially the use of whole trees, with some NGOs reporting controversial felling, with a number of outstanding lawsuits, as noted in our ESG QuickTake. Clients can click here to read the report. If you are not a client but would like a copy, please click here.

The Russia/Ukraine conflict has had a significant impact on its wood supply, with the company giving a downbeat forecast for FY 22, which felled its bonds this week, with yields rising into double-digits. Adjusted EBITDA came in at just €25.5m from €34.4m a year earlier.

In Q1 2022, despite sustained high power prices and strong profitability, many biomass plants were running at reduced output, which Graanul said was due to maintenance pauses, planned or unplanned, as well as postponement of scheduled deliveries due to a lack of spot pellet supply.

Before the conflict, there were already shortages, but this has intensified given that Russia was one of the major suppliers of wood pellets to the European industrial and heating markets. Graanul used to source 10% of its production from Belarus which is no longer certified. Replacing will take time “as it requires additional investments to forestry or development of new sourcing channels. At least in the short run the availability remains very tight and at high price levels.”

Other costs are significantly higher, for fibre, freight and energy, with the Baltic producers worst affected, given most forest product manufacturers are reliant on Russian and Belarusian wood.

Graanul says that “Nearly all sales agreements were successfully renegotiated by the end of the Q1 and effective from starting Q2-2022, these sales contracts have a full pass-through clauses for major costs (raw material, power, logistics) with immediate effect.” It adds that the time lag for the pass thru’s has reduced from 3-12 months to 3-4 months.

The conference call is next Tuesday pm — we will be listening in.

In brief

In the past two weeks, a number of in-progress deals edged closer to completion, including some long running situations. Schur Flexibles managed to secure unanimous consent from its SFA and supply chain lenders to its restructuring plan. On Saturday, 4 June, the two sponsors B&C and Lindsay Goldberg signed an SPA handing over their shares to lenders. In total, 100% of lenders signed up for provision of €150m of new money, with €30m of interim financing available today (6 June), with two further €15m tranches. The transaction is expected to complete in October.

Abengoa yesterday provided an update on its financial restructuring. Pending approval from SEPI, Abenewco 1 will receive €249m in financing, with €200m coming from TerraMar. Creditors have until 24 June to “adhere to the new restructuring agreement.

Nordic Aviation emerged from its Chapter 11 on 1 June. As reported, the restructuring plan envisages $537m of additional capital, a $170m DIP facility and a c.$4bn reduction in the $6.3bn of debt, with NAC creditors becoming the largest shareholders.

The Milan Tribunal has released (In Italian) the modified Concordaria restructuring agreement for Moby, the Italian Ferry Operator. Under the plan MSC will inject €81m for a 25% stake with the right to own 49% if it pays another €69m.

The English Scheme of Arrangement for Haya Real Estate was sanctioned yesterday (9 June) by Justice Fancourt. Creditors to the Spanish Real Estate loan and NPL servicer voted on 31 May with 111 of the 126 creditors in favour, with 14 abstentions and one, Davidson Kempner against — subsequently said to be in error. Scheme docs were amended at a late stage for a number of changes, including a recapitalisation agreement already agreed by creditors. The intent is to go through a Spanish Homologacion process to implement the restructuring.

Despite earnings tailing off last week for most borrowers, there were a few laggards holding conference calls.

Inflationary pressures for Kloeckner Pentaplast appear to be easing, with a return to EBITDA growth for the first quarter since Q4 20. Successful cost pass-throughs are driving revenues and EBITDA growth, but volumes are lower, however. A €43m draw on the company’s €150m RCF to combat seasonal inventory build pushed leverage slightly higher (+0.3x) versus Q4 21, now at 8.4x on a net basis. As 9fin’s Ben Hoskin says “[The] results were good on the face of it, reversing an ugly set of consecutive quarters for the packaging provider, but questions still remain about the company’s ability to grow into its capital structure.”

With refining margins nearing record levels, Raffinerie Heide should have had a good first quarter, but performance was held back by facility shutdowns and higher input costs. EBITDA generation and liquidity development were disappointing. Management declined to give guidance for FY 22, but expect a strong Q2 performance to support its long-awaited bond refinancing. Many questions on the 8 June call were about the refi, but management just reiterated previous comments, failing to give more detail on deal size and timeline. For more analysis from 9fin’s Denitsa Stoyanova click here.

Last week, Hurtigruten announced covenant waivers for the June 2022 test. This week it announced a €25m tap of its €50m 11% Green bond (launched in Feb at 98) in conjunction with a €25m contribution from its shareholders as it continues to tap additional financing to keep afloat as its cruises get back to normality.

In early March, Technicolor announced plans to list its Technicolor Creative Solutions (TCS), spun off with 65% to shareholders via a special distribution, with 35% retained. The proceeds, plus a €300m mandatory convertible and €100m in cash from the sale of its Trademark Licensing operations to reduce debt. In May, it said it was putting in place €300–€375 million of private debt and an Asset-Based Lending (ABL) Facility at Technicolor Ex-TCS, and a €575-€650 million Term Loan and a €40 million Revolving Credit Facility at Technicolor Creative Studios. This week it said further progress had been made with the listing and refi should be completed in Q3.

9fin’s Bianca Borer, revealed that holders of Frigoglass’ €260m senior secured notes, maturing in 2025, have opted to work with the same advisors they worked with on the group’s previous restructuring in 2017 appointing DC Advisory and Weil, Gotshal & Manges as legal and financial advisors. Neil Devaney from Weil worked on the previous restructuring when he was at Akin Gump, as reported. The largest holders of the group’s SSNs are Davidson Kempner and Invesco.

Finally, we published our Diebold Nixdorf Stressed QuickTake this week. If you are not a client but would like to request a copy, please complete your details here.

What we are reading/watching this week

Not much time for deep reading this week, with plenty of distractions, most notably at the head of Government. 211 is a great score, or 148 means he is holed below the waterline, you decide.

On my reading list for the weekend is a cracking investigation on Binance by Reuters. The world’s largest cryptocurrency exchange served as a conduit for the laundering of at least $2.35 billion in illicit funds, alleges Angus Berwick and Tom Wilson

One of my ex-colleagues was so paranoid that they couldn’t stop their company computer screensaver from coming on after five minutes of inactivity, concerned their employer was using it to track them, they downloaded a third-party app to help. It resulted in a massive boost in her productivity, being ever present, 24/7, seven-days per week! It seems that she wasn’t alone, JPMorgan employees have also downloaded mouse jiggler — according to Sarah Butcher.

Given the sheer amount of content I have to monitor on a daily basis, I am a fast skip-reader and have to pluck out key information without reading through in depth. But does this help you learn — Thomas Oppong says no — the average person only retains 10%, whereas slow-pace learning helps you retain 90%.

My son, Charlie, finished his journalism degree in Sheffield this week. It didn’t go unnoticed:

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