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Chris Haffenden

Investors are starting to need higher compensation for investing in the UK as evidenced by sterling corporate credit yields breaking through the 5% barrier last Thursday. Gilt yields are soaring, with the 10yr UKT now at 3.1%, up from 2% just three weeks ago. Markets are not only finally waking up to the huge fresh borrowing requirements under Liz Truss’ new tenure as PM, but are also realising that the pound may have to weaken significantly to attract foreign buyers of UK Gilts. Risk premiums to Europe are rising, as shown by ICE below (hat tip BofA research).

While most of yesterday’s announcement on energy support and price caps didn’t come as a surprise after days of media leaks, we detect some disappointment that businesses get only six months of support compared to two-years for households. After this period, the government will focus on vulnerable industries (note not businesses), which could lead to concerns of politicisation of decision-making and vested interest lobbying – surely not with this government?

We must wait until a mini budget later this month to find out more. The IFS wasn’t impressed:

While there was a slight thaw for Iceland SSNs this week, as leaks of business support led to a five-point rise in prices, there was a much more limited recovery for the swathe of sterling HY bonds such as Pure Gym, Punch Taverns and Pizza Express whose prices were hit hard last week.

Admittedly, there are few UK-based businesses in HY which have immediate default risks (Cineworld filed for Chapter 11 this week but is more US-heavy, more later in the Workout), but it is a very different picture in the SME space.

In the gym earlier this week, I listened in to the Today programme and the chief economist for Red Flag Alert Nicola Headlam. She said that there are 355,000 companies with over £1m of turnover which are high energy users – including those in steel, glass, concrete, and paper industries – with 75,972 at risk of insolvency, and 26,720 specifically due to high energy costs. She also highlighted the hospitality sector, facing a triple-whammy of higher energy bills, higher supply and staff costs and a sharp drop in consumer spending as the cost of living crisis bites.

If that wasn’t enough for me to break into a sweat, the example she used certainly did:

"A business turning over a million pounds two years ago would have spent around 8% of that on energy costs and made profits of around £90,000.

"If the cost of energy doubles to 16%, that instantly wipes out profitability, and they're straight into a scenario where it threatens the viability of the business within a year."

Expect to hear a lot of about trickle-down truss-nomics in the coming weeks (btw it reminded me of this cracking sketch) but for us in LevFin it may be more about trickle-up. What could be the effects of these insolvencies on £250m plus revenue businesses in our space?

Anecdotally, I’m seeing more filings in the insolvency courts in recent weeks, which tallies up with data from the insolvency service.

My first trading job in the city was an Australian Eurobond market maker at Barclays.

It was a hairy retail market, plus I was obliged to make prices – there was no ducking out of making firm bid/offers and offering to work orders for clients instead as we mostly have now.

Most A$ Eurobonds had mid-teens coupons, targeted at Belgian dentists attracted by the high interest rates and familiar triple AAA borrowers such as M&S (Tom Freke, Rob Smith, that’s how I knew that fun fact). Inevitably the dental surgeons had to re-invest their Aussie currency at maturity to avoid booking heavy FX losses, this was perfect as it kept this strange market going.

Aussie Eurobonds were a pure retail product, they traded with little relation to the underlying govt bonds, making for interesting conversations with our risk team. Underlying govvies may move two points a day, but the retail bonds would sometime move by less than 0.5-pt.

To recoup the difference meant actively trading our hedge, mostly via the Sydney futures exchange – but they were 10-12 hours ahead of us. So, leaving orders was the way to go, with the odd phone call in the early hours from the exchange floor if stops or certain price levels were hit.

This meant I got to live out the effects of significant global events in real time. Most notably, the first Iraq war, as the Australian market was one of the few open for trading when hostilities commenced. Crazily, at the time the market used to trade up and down markedly on the launches of scud missiles heading towards Tel Aviv. Thankfully they didn’t contain chemical warheads and often missed their intended targets.

If that wasn’t mad enough, we had a controversial finance minister Paul Keating whose far too candid comments about the economy (the polar opposite of Greenspan speak) often got him and the Australian currency into trouble. His famous comment about Australia losing its lucky country tag and becoming a banana republic caused a huge flash crash in the Aussie dollar:

We took the view in the 1970s – it’s the old cargo cult mentality of Australia that she’ll be right. This is the lucky country, we can dig up another mound of rock and someone will buy it from us, or we can sell a bit of wheat and bit of wool and we will just sort of muddle through… In the 1970s … we became a third world economy selling raw materials and food and we let the sophisticated industrial side fall apart… If in the final analysis Australia is so undisciplined, so disinterested in its salvation and its economic well-being, that it doesn’t deal with these fundamental problems… Then you are gone. You are a banana republic.

It was no surprise that some of the Sydney futures traders renamed it the Pacific Peso.

Australia had to pay up massively to attract foreign investors to service its debt.

Rates were sky high to crush persistent inflation worsened by currency weakness – for the life of me, I don’t know why they published CPI just once per quarter – I had huge P&L swings and volatility one day every three months, and it certainly tested my nascent trading capabilities.

Reading an excellent research piece from Deutsche this week, it reminded me of this past life.

I then traded EM from time of Mexico’s near default, through the Asian currency crisis, Russia’s default, and witnessed two Argentine defaults in my tenure. I saw at first hand how balance of payments crises develops and the pressure they put on currencies and interest rates.

Deutsche’s research report title certainly pulled no punches – Crunch time for sterling: Assessing the risks of a UK balance of payments crisis - they said:

“With the current account deficit already at record levels, sterling requires large capital inflows supported by improving investor confidence and falling inflation expectations. However, the opposite is happening. The UK is suffering from the highest inflation rate in the G10 and a weakening growth outlook. A large, unfunded, and untargeted fiscal expansion accompanied by potential changes to the BoE's mandate could lead to an even bigger rise in inflation expectations and - at the extreme - the emergence of fiscal dominance.”

Deutsche estimates that trade-weighted sterling would have to fall 15% to bring the deficit back to its ten-year average. But that could mean importing yet more inflation. The parallels to the 1970s are there to see, and that period didn’t end well, blackouts, three-day weeks, and a huge run on the pound.

If that sounds alarmist, these two charts illustrate the comparative problem for the UK:

While the UK doesn’t have the EM currency mismatch problem – it has little debt outside sterling, it is much more dependent on foreign investors than say Italy and Japan which have big local support. Our exposure to and reliance on gas is much higher than European peers and our storage is just 4.5-days which means a greater delta from energy and power prices.

Deutsche says: “From a starting point of an 8% deficit – a reasonable assumption with energy prices having stayed high – our model suggests that sterling would need to fall nearly 20% in trade-weighted terms to return the current account to its 10-year average (a ~4% deficit). In the event of a hard sudden stop that required the UK's current account to return all the way to balance, i.e. 0%, a 30% weakening in the pound would be required.”

For those who are keen to learn from history (and not repeat it), in 1972, chancellor Anthony Barber went for a “dash for growth” in which income taxes were cut sharply. We then had an Opec supply shock, national strikes and a nasty period of stagflation. The pound in your pocket, contrary to Harold Wilson’s reassurance was devalued (several times in a decade) and at the mercy of the Gnomes of Zurich. The final ignominy was going to the IMF for a bailout in 1976.

I’ve been saying that the UK is a short since 23 June 2016. Finally markets are starting to think about tail risk, but UK CDS is still cheap insurance IMHO.

Yesterday, the first day hearing for Cineworld’s Chapter 11 finally kicked off, after some initial streaming difficulties – the irony!

Wednesday’s filing for its UK, US, and Jersey businesses (the CEE biz is not included and dealt with separately) will not be surprising for regular workout readers. It has been slithering towards insolvency for almost two-years, as we reported it narrowly avoided insolvency in late 2020.

In total around $5bn of its $5.3bn of total debt is subject to the process, detailed below

Our eyebrows at 9fin were raised by the size of the DIP financing, $1.94bn in total, of which $664m will fund the operations throughout the process and the rest to repay emergency ‘pre-petition priming facilities’ ($1bn) and $271m to purchase RoW loans (CEE business).

The Judge, Marvin Isgur seemed to agree with 9fin, querying the $1bn element.

The short period of time since the filing gave limited opportunity for other creditors to appear before the court and have their say. He was keen to reduce the amount to $500m and attach a number of conditions, adding before breaking for lunch that he wanted to reach a decision by the end of the day, saying that his wife wouldn’t see him until he signed the DIP form.

The company advisors were keen to stress the process wouldn’t move on without repaying this facility as 100% approval would be needed from their holders. The money was needed tomorrow (surely there is a Tomorrow Never Dies pun in here, shame it is a loan rather than a Bond)

In the end a solution was thrashed out, after the company's advisors proposed paying $1bn of the DIP into an escrow account until October 31, which will be released if unsecured creditors fail to present a challenge to the priming loan before that date.

The hearing went on well past our bedtime, but according to a Cineworld release this am, the court has granted “immediate access to up to approximately $785 million of an approximate $1.94 billion debtor-in-possession.”

We will be covering the Chapter 11 case as it progresses and wading through some of huge amounts of documentation which are put on the docket.

Probably the most interesting posting so far is the first day declaration from Israel Greidinger, the deputy CEO – which can be found here.

In it he lamented that it wasn’t able to achieve the same meme stock status as its main US rival.

“While Cineworld would, of course, have welcomed the liquidity of becoming a ‘meme stock’ like AMC, we were never so lucky!”

We also learned that the family business started with eggs not movies.

Israel’s grandfather Moshe Greidinger was meant to be growing the family’s egg import business, but in 1930 he opened the Ein Dor cinema in the Hadar neighborhood of Haifa, Israel. 

As his brother Mooky explained, “1929, the year of the Great Depression, was a great year for cinema. During a crisis, it’s not a bad idea to go to the cinema for a couple of hours and forget your troubles.”

From Cineworld’s peak valuation in April 2019 to the filing, the Greidinger family has lost more than $1bn, Israel pined, adding it is the overwhelming majority of their net worth. “It has been a painful one-two punch for Mooky and me to see the impact that Cineworld’s struggles have had on our shareholders and our approximately 30,000 employees and to watch the legacy of our grandfather and father so severely diminished by the effects of the pandemic.”

But arguably the problems for Cineworld began in 2018 when it bought Regal in the US and overstretched embarking on an ambitious spending plan to revamp the cinemas and take them upmarket. It couldn’t have planned for Covid, but its resilience would have surely been tested given the sharp increase in debt in any downturn.

It might have been even worse if it had gone ahead and consummated an agreed purchase of rival Cineplex in 2019. The Canadian chain successfully secured a $1bn ruling in the courts – this is one of the many reasons why Cineworld had to file for Chapter 11 – the claim now conveniently sits alongside unsecured creditors who are likely to get very little under the reorganisation plan.

The TLDR of Lycra’s Q2 earnings call appears to be, in JP Morgan we trust.

With the maturity of its €250m SSNs looming in May 2023, as reported by 9fin’s Ben Hoskin management told investors they are looking at either refinancing with new lenders, and/or extending the notes, “most likely” to coincide with the $690m SSNs due May-25.

The refinancing will either be a secured term loan or senior secured notes, with the “exact structure dependent on market conditions”. The refinancing of the notes will be in USD, to align with the company’s FX needs.

Lycra is also in “active discussions to extend the maturity of the existing RCF” which is due in February 2023.  J.P. Morgan is leading the refinancing effects for both the notes and the RCF. The RCF is a $100m facility that is fully drawn. When pressed on whether the facility is adequate, management said they will be reviewing its size as part of the refinancing.

The aim is for the refinancing to be completed in Q4, which, as one analyst pointed out, is only weeks away. Aside from the colour above – disclosed in the prepared remarks – management wouldn’t get drawn into questions on a potential restructuring in the form of A&E and/or debt-for-equity swap, these were repeatedly batted away with the oft-heard generic statement “we’re exploring all options”.

Management acknowledged the refinancing is going to be tough, but they are confident in the ability of J.P. Morgan to find a solution and the support of the new shareholders, who were creditors of previous shareholder Ruyi Textile. For more on the Change of Control see here.

The market appears less confident. Following the release of results the paper was four-to-five points softer in secondary, with both tranches still firmly in distressed territory. The June 2023 bonds dipped below 80, yesterday.

Oh, and what about the Q2 numbers, how were they? In a word – Ugly.

Higher prices weren’t adequate to offset intense raw material and energy inflation, putting pressure on margins with more pain to come in Q3. Compounding matters, China’s zero-covid policy and a weaker spandex market is putting severe pressure on volumes. This led to some production curtailment – mainly at Asian assets – in order to avoid further unwanted inventory build, with the company’s global capacity utilisation 9% lower versus Q2 21.

It was an interesting week for earnings reports from some of the names on our watchlist.

Raffinerie Heide the German oil refinery, had a stellar Q2 22 pushing its EBITDA generation and liquidity through the roof almost doubling to €200.1m. 9fin’s Denitsa Stoyanova says: “Judging by the forward reference margin curve, the positive trend is set to continue helping the refiner address its upcoming €250m November 2022 bond maturity. Management appears to be set on repaying the bond recognising the bond market remains closed for most issuers. An alternative option will be a combination of part cash repayment and part refinancing with a credit facility.”

HSE24, the Germany-based television sales business continues to battle diminishing consumer confidence, supply chain hurdles, logistics setbacks and the ongoing effects of a coronavirus outbreak in its warehouses. A sharp drop in Q2 earnings and an uncertain outlook has seen its bonds drop 10 points into distressed territory since their release on 29 August.

On its earnings call on 6 September, 9fin’s Michal Skypala reported that investors were keen for forward guidance, but they got little from management, save from reassurance that free cash flow would turn positive once more in the second half.

Could there be light at the end of the tunnel for Standard Profil, the beleaguered German automotive seals supplier? The car chip shortage is easing, raw materials cost inflation is mostly passed through, and OEM production schedules are robust. Management expects that with profits once again on the rise, it can turn a corner and start deleveraging as soon as Q3 22.

Germany-based filter tow manufacturer Cerdia produced a steady set of Q2 results despite sanctions effects, writes 9fin’s Ben Hoskin. A production site in Russia has fallen under EU sanctions, hampering volumes, with demand resilient otherwise. A price surcharge implemented in April in response to soaring input costs helped margins, but wasn’t quite enough to fully offset inflationary pressures. Cash flow remained strong despite the sanctions and certain one-off items in the first half, but the company still prudently drew down a €65m revolver in full in July to combat uncertainty in the German energy picture.

Aggregate Holdings announced this morning that it closed the sale of QH Core and has signed an agreement for the sale of QH Spring, two segments of its landmark Quartier Heidestrasse project. The gross purchase price is €456m, which the company says implies a premium to book value and will be used to reduce debt. But a big chunk is non-cash with Vivion using €219m of its 5.5% 2024 Aggregate Bonds as part payment. More from us next week.

Plenty of economists chatter this week about Liz Truss’ plans for the UK economy.

The FT wins the pun of the week award – Death Cab for QT – on the appetite to buy the splurge of government debt issuance funding her investment in growth. Who will buy Bailey’s bonds?

The front cover of the Economist certainly has an uplifting image – Can Liz Truss Fix Britain? It suggests the new prime minister (9fin’s Owen Sanderson says subprime minister is more appropriate) must eschew pantomime radicalism if she is to succeed.

Man Institute writes that global levels of distressed debt already rival those seen during the GFC.

“Fuelled by the latter stages of a forty-year bond bull market and turbocharged by Covid-induced borrowing, the global debt burden as a percent of GDP is now larger than ever before and appears vulnerable to a shift in the interest rate regime, at the same time it faces other, idiosyncratic stressors. The result has been a significant spike in distressed debt, led by emerging markets (EM) and EM sovereigns in particular.”

Man has a scary statistic or two in their report. EM distressed is now 80% of the total up from 10% at the time of the GFC. It adds:

“We now also view the contagion is beginning to envelop otherwise creditworthy EM corporates, and could spread beyond EM to infect DM, with European credit being particularly vulnerable. In our view, we may be on the cusp of a distressed debt super cycle – but unlike in 2008, the crisis is likely to originate from EM, not DM.”

And finally, thanks for all your kind messages and condolences, it has certainly been of a great help in such a difficult time.

The loss of Brighton’s Graham Potter who passed yesterday – to Chelsea – has hit hard.

From my viewpoint high up in the Upper West Stand Potterball was such a delight and he gave us so many fond memories. We may never see his type again at the Amex. Bill Shankly was right.

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