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Chris Haffenden

After a better than expected CPI print in the US, the iTraxx Crossover on Thursday morning opened at 380bps, the tightest level of this year. But despite the optimism around soft landings, rates remain elevated, if a couple of hikes or so away from their terminal points, as core inflation stays high and central bankers worry about wage inflation. 

This narrative has been around for some months — albeit with a brief redraft around SVB and CS — there has been more of a change at the longer end of yield curves, as recession risks recede and rate cuts expectations fade.

This arguably reflects reduced expectations of cuts in response to a slowing economy, and increasing evidence that squeezing the last couple of percent of inflation back to target is harder than originally thought. 

Recession predictions over the past few months have been very wide of the mark. Admittedly, some was driven by the faith in the divination powers of inverse yield curves, but we also saw a number of manufacturing and purchasing managers surveys dive sharply and point to the same. 

In hindsight, some of the survey pessimism could be down to the bullwhip effect, where distortions are created across the supply chain by large demand swings. As I outlined in October 2021, there was a reverse bullwhip effect where difficulties in meeting supply arising from surges in demand as we emerged from lockdowns. 

The recent improvement in supply chains and reduced container costs came at a time of nervousness about an impending recession. Companies were already overstocked, partly to mitigate concerns about rising prices and partly due to overestimating demand. No wonder they were so pessimistic on the order front earlier this year. 

While a manufacturing recession is probably underway, spending has shifted into services and here the consumer is still spending like there is no tomorrow, despite cost of living concerns and sharply rising mortgage rates. 

So why haven’t the sizeable rate hikes had a bigger effect and resulted in a H1 23 recession?

In the latest European Credit Research report Barclays has a decent explanation:

“We see two factors that have allowed Western economies to hold up thus far - other than lags in policy. First, this was not a credit-driven expansion. The strength of household demand has derived from savings accumulated during the pandemic and income gains from government subsidies and wage growth. Given that this has not been a credit-fuelled expansion, it’s not clear that the credit channel is the fastest or most efficient way to slow activity and demand. Second, and related to the first, economic strength is coming from services that are labour intensive, but not capital intensive. Hence, the cost of capital has limited impact on those sectors running hottest - again speaking to a slower and less powerful transmission of policy to growth and inflation.

In this sense, we could liken the current expansion to the protagonist in Dorian Gray who was able to go on partying in a state of apparent perpetual youth and vigour, while the cost of his excesses were tallied by a portrait that was kept out of sight and out of mind. We believe that policy tightening is being transmitted to capital-intensive sectors of the economy, but this is not apparent when gazing upon the spritely and robust services sector. This situation may continue for some time yet.”

I would add that there is also a wealth effect from booming stock prices and rising rates, while fixed income investments are yielding once more, further boosting boomers’ spending power. Financial conditions are not that tight (given market pricing and fiscal boost post SVB) and monetary policy may have reduced job openings, but it has not put that many people out of work. 

All we’ve seen so far is reduced activity in sectors which are interest-sensitive such as Real Estate (more on this later, in a German RE report teaser). As economist Dario Perkins suggests, credit tightening cuts lending indiscriminately, which could have wider impacts.

Perkins thinks that risk of recession is finely balanced, with the main risk that higher rates could reduce labour demand in sectors without excess demand. The mismatch and aggregate job losses would end up as a true recessionary dynamic, he notes, citing the Beveridge curve shifts. 

But moving closer to home in European leveraged finance and distressed debt, current pricing isn’t reflecting either a recession or a surge in defaults. As Barclays notes, 400bps spread on EHY implies a 2% default rate — ratings agencies are much higher at 3.5-5% in 2024 — while I would add that anecdotally, based on recent and upcoming defaults, expected recoveries in this cycle are likely to be below 40%, and perhaps markedly so. There is a nice ready reckoner on this below:

But spreads are in the mid-range historically, despite elevated recession risk. I would argue there is little value on a risk-adjusted basis, especially in single-B names.

There is a caveat here. On a yield basis, HY can look much more attractive — I’ve lost count of the pieces from asset managers and hedge funds putting out opinion pieces that current yields are offering a once in a generation buying opportunity, as if this was the only consideration. 

I admit that current running yields may offer reasonable compensation for the odd default. Another reason why EHY is trading tight is a market technical, with the size of the outstanding debt reducing by 13% in the past year, and investor flows slightly positive. 

However, it will be interesting to see how robust the market is, if issuance picks up markedly. To my view, the size of the new issue premium for Telecom Italia’s latest bond doesn’t smack of a market in rude health, nor does the noise around performance and allocations of the Avis Budget euro deal (it looks very cheap on a spread basis to dollar paper btw, a mere 250bps wider!). 

Bulls will also talk about the impressive number of amend-and-extends in the European Leveraged Loan market (by my calculations the number is up to 30) which has shifted the maturity wall markedly — Barclays estimates that 2025 maturities have dropped from €41.6bn as at end of 2022 to ‘just’ €29bn today, around 10% of the ELLI index. 

I mentioned last week that weighted average life issues for CLO funds is becoming more of a factor. 

There appears to be a race to get A&Es over the line before more deals exit reinvestment, and more WAL tests fail. 9fin colleagues have a couple of excellent pieces on this — CLOs are hitting the WAL, Wide spreads forcing CLOs to pay down triple As, and Owen Sanderson also touches the subject in this week’s Excess Spread. 

BofA research also produced an excellent piece on this topic, titled Impact of CLOs failing WAL tests on the EUR loan market which delves into this issue much deeper. 

”Currently, around 52% of CLOs outside the RP are failing their WAL test and another 21% have very slim WAL test cushions. This will create refi challenges for some loans.” 

Debt advisors and DCM bankers reading this, you’ve been warned. 

It is also worth noting that we’ve seen very few A&E transactions for bonds. This has left a number of debt structures looking particularly wonky. In addition there are a number of deals with significant stub issues (from those who don’t want to or can’t extend) — witness the €500m odd of Upfield Flora stub notes this week. 

And while A&Es might be fine for decent credits, for many stressed names it does mean handing over temporal seniority to either recalcitrant lenders, senior secured bondholders, and often the juniors too. 

This is where some investors are belatedly waking up to documentary issues, mostly around leakage and asset sales. If a business subsequently needs to sell assets to pay down debt, could they pay out second lien pro rata to the first, and how much flex do have with the proceeds? Is there strong MFN language in the A&E to prevent them addressing the stub later at more attractive terms? Do we need springing maturities to avoid being at the back of the queue?

Another interesting dynamic is the large spread between senior secured bonds and unsecured, which might seem odd, given the overall tightness of spreads and the recent market spread compression. Barclays has this at a whopping 350bps.

One name that pulls some of these themes above together is Altice SFR. 

An exceptionally large cap stack, its 2027s SUNs trade in the mid-50s, which is a humungous 2500bps spread-to-worst, with its 2028 SSNs at just 900bps spread-to-worst. After a poor first quarter, overall net leverage is 6.9x, which is close to or above the likely enterprise value. 

But there is just over a turn of leverage between senior secured and the juniors, which suggests if you buy the SUNs at current levels, it could be a great entry point. Complicating matters is a chunky early 2025 SSN maturity — luckily Altice SFR A&E’d the loans before the Q1 earnings shocker was released. 9fin’s Nathan Mitchell will be producing a report on this in the coming days. 

Perversely, given the recent announcements from Lanxess and Evonik— which have said their outlooks are among the worst they have even seen — and the uncertainty about the global economy, cyclical credits have performed well. Barclays note that the premium for cyclical credits is far below what is usually seen in slowdowns. Conservative managers which have moved into defensive credits just haven’t seen the benefit. 

Or at least so far. I don’t see much more room for improvement for European LevFin bonds and loan prices in the second half, so the best to hope for is a boring sideways trade. If so, this may lead to some of this dispersion reverting nearer to the mean, as managers struggle to find value. 

One of the few sectors which has reacted to cyclicality is Real Estate, most notably in Germany. Borrowers over the past couple of years have been reeling from short-seller reports, investigations into related party transactions, amid concerns of round-tripping and inflated asset valuations. 

Many German RE companies have seen substantial falls in their bond prices, with many now trading at distressed levels. Those with listed shares are at a significant discount to their net asset values, reflecting severe pessimism from investors over underlying real estate valuations.

Quite rightly, there is concern over future defaults, following notable restructurings for Adler Group, Corestate and Accentro, driven by their inability to meet near term maturities.

The remainder are facing secured debt and unsecured bond maturities between 2023 and 2026. Their ability to handle these maturities will depend on various factors including overall financial health, the suitability of their portfolios for disposals, the level of headroom available under incurrence covenants and the depth or diversity of funding sources.

These companies are unlikely to return to the European High Yield (EHY) market, opting instead to raise alternative financing and sell assets to fund redemptions. But their ability to raise funds elsewhere is hampered by interest coverage covenants and much higher cost of financing, and a lack of property transactions is making valuation difficult.

Many of these companies will be forced sellers of property assets as their maturities loom, and may have to do so at significant discounts to where these assets are marked. 

But as we will reveal in our upcoming German RE report — authored by 9fin’s Emmet Mc Nally and Hazik Sidiqui — it is not all gloom and doom. 

There are pockets of value and opportunities for non-bank lenders. We note that two credit funds have taken control of two development assets that on paper are worth a lot more than the principal claim against which they were pledged.

It’s not an easy market to understand, so we will also be detailing the key terminology and metrics used in assessing real estate businesses. 

Our report (drop us a line if you are non-subscriber and want to be on the wait list for the public release) will look at the current state of the market, key risks and considerations for addressing maturity walls, why we think valuations have not yet bottomed, and our view for H2 2023. 

It covers 12 companies, nine in EHY and three Investment Grade (IG) peers for comparison.

As I had anticipated, Thames Water shareholders were bounced into providing the interim support needed, after the leaked threat of special administration. But the equity provided is £750m not the £1bn earmarked, and the promised £2.5bn comes after the next Ofwat review in 2025 with the notice caveating: 

“but the nature and level of such medium-term support will depend on the finalisation of the business plan and the regulatory framework that will apply to the AMP8 period.” 

It is difficult to see how they can put this amount in without being offered a decent return. But most money needs to stay in the business to reduce ratios, raise service standards and maintain the higher ratings demanded by the regulator. As academics would say, it is a wicked problem. 

“Big picture, the investment Thames needs can either be funded by shareholders (and recouped from water bills) or funded by the government (through some kind of nationalisation and forced recap). The politics of both are roughly as appealing as a bath in a sewage farm, so expect a lot more toxicity before the headlines die down.”

SIGNA Development is one of the names in our German RE report, and this week announced a comprehensive disposal plan in light of a ‘crisis’ that the sector is going through. 

Gross proceeds will reduce overall leverage post settlement of secured debt attached to the properties, and fund their development pipeline. With ~€1bn of proceeds expected in 2023, SIGNA confirmed it will start buying back small volumes of its €300m 5.50% SUNs due July-2026 (€289.4m notional amount outstanding) over the coming weeks in the open market and over-the-counter. The notes rallied six points to 73-mid (17.5% YTW) on the news. 

TalkTalk’s earnings call this week was eagerly anticipated (they only do twice per year), with concerns on how it would address its fast approaching £685m maturity wall. The update provided many answers, with the imminent sale of its B2B asset, a demerger of its businesses, and new investors are all key parts of the refinancing strategy. Our report is here, and its also worth looking at its entry in B2BS. 

We are now getting into the key negotiations stage with Groupe Casino, as the company and the conciliator review the proposals on offer. We were surprised a further update on preliminary second quarter trading in France, as we had up to the first 26 days of June in an investor presentation at end-June. But the numbers were worse than previously outlined, meaning as one FinTwit observer noted, that the final four days of the month trading must have been truly terrible. The release also outlines next steps, with revised offers due by 9pm today (14 July). These offers will be assessed “with regard to the following elements (i) the unconditional nature of the equity commitments and (ii) the level of liquidity available to the group following completion of the restructuring, which will reflect the financial robustness of the restructuring plan.”

French care home operator Orpea is ahead of Casino in the Sauvegarde queue, and is about to check out the cross class cram down available under the revised French process, after applying to the court on 11 July. It delivered a further earnings shock, saying that EBITDAR in 2023 would be 15-20% below previous estimates, blaming lower occupancy rates and higher than expected staff costs.

Diebold announced yesterday (13 July) that its Plan of Reorganisation has been confirmed and that it hoped to exit its Chapter 11 process during the third quarter after final conditions are met and Dutch legal processes and court processes are concluded. Our latest analysis is here

AI is one of the hottest topics right now. One of the best listens this week was Odd Lots with Bridgewater co-CIO Greg Jensen on the use of AI to test and update their trading models, and his views on the market, which are similar to mine — investors are far too optimistic. 

A Canadian judge has ruled that the “thumbs-up” emoji is just as valid as a signature, and courts that need to adapt to the “new reality” of communication methods, ordering a farmer to pay C$82,000 ($61,442) for an unfulfilled contract. 

Closer to home, ahead of producing a H1 23 legal update, I have been closely reading lawyer alerts and some of the recent cases to go through the UK Courts. Fitness First’s UK RP saw landlords once again lose out via the process and like Virgin Active, the shareholders were not compromised. There was also the added twist that the company’s secured creditor (which voted in favour) was also a 75% indirect shareholder. 

The UK insolvency service’s weighty Post-Implementation Review of the 2020 GIGA act is also on my reading list, mostly for their views on UK RPs. Luckily K&E have summarised in this useful note

And finally, as we await further signings announcements, Brighton and Hove Albion are upping their pun game:

Friday Workout — Dispersion, Reversion, & Perversion; German reel estate

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