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Thursday, 15 November 2018

Investors reach for yield instead of brakes

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Investors drove past warning signs and straight on to the yield of two large junk bond sales separately financing the buyouts of Refinitiv and Akzo Nobel.

Both deals were inundated by investor demand despite analyst warnings that bonds for both deals have some of the worst bondholder protections since the financial crisis.

Private equity firm Blackstone - which is buying a 55% stake in Thomson Reuters’ Financial & Risk business that will be renamed Refinitiv when the deal closes - managed to sell the bonds at much lower yields than first targeted. 

It was also able to secure unprecedented flexibility to protect its returns if its business plan - which involves dramatic cost cuts of US$650m in the first few years - does not turn out as expected.

Books on the €6.5bn-equivalent debt package financing the buyout of Akzo Nobel’s specialty chemicals business by private equity firm Carlyle and Singaporean wealth fund GIC was also oversubscribed, a banker close to the deal told IFR on Tuesday.

Analysts at Moody’s and research firm Covenant Review warned that Akzo deal contains off-market, complex terms allowing the company to pay dividends using asset sales proceeds, even when in default. 

But strong market conditions, a good economy and limited high-yield supply lured many investors to both trades.

“Among the rationales for investors is confidence in the economy - it’s looking good right now, it’s looking good next year, and the belief that they can sell before the quality of the debt deteriorates,” Christina Padgett, a senior vice-president at Moody’s, told IFR.

“So if you are just thinking about the next year or two, some investors will get comfortable given a need for yield.”

Moody’s is forecasting a decline in the US speculative-grade default rate to 2.2% over the next year from 3.4% now.

But investors do face potential risks in giving up structural protections, and one of those is the ability of private equity firms to move assets out of the reach of creditors.

“The time to negotiate for better protections is before deals are priced,” Anthony Canale, global head of research at Covenant Review, told IFR.

“But investors don’t always fully appreciate the importance of doing that because covenant protections are just one element of the overall analysis while making a decision to purchase bonds.”

PetSmart and Neiman Marcus are two buyouts since the financial crisis that have run into difficulties.

Neiman Marcus bonds dropped more than eight points on Tuesday after the company said it was spinning off the MyTheresa Unrestricted Subsidiaries.

“You want to ensure that you are compensated for looser covenants,” one New York-based portfolio manager who bought the Refinitiv bonds told IFR.

“But you also have to be realistic that if the business is trending in the wrong direction and the debt has loose covenants, that will be used against you. Retail is pretty problematic, but PetSmart and Neiman Marcus are both good examples of why covenants matter.”

 

YIELD NOT ALWAYS ENOUGH

For some, the Refinitiv deal made investment sense as a rally in US junk bonds fuels a hunt for yield.

Average high-yield spreads are 29bp tighter so far this year, and Triple C a massive 181bp tighter in the year up to Monday, according to ICE BAML data.

High-yield has been one of the best performing asset classes. Average total returns for US high-yield are 2.315% so far this year, compared to negative 2.268% for average US investment-grade bonds.

Even though the final yields on the Refinitiv bonds were up to 100bp tighter than initial levels first marketed, the portfolio manager said it still offered a decent premium to similar rated credits like Bausch Health (formerly Valeant).

Refinitiv’s US$1.575bn unsecured bonds, maturing May 2026 and rated Caa2/B-/B+, priced at par to yield 8.25% compared to IPTs of low 9% area. A recently issued 8.5% 2027 bond sold by Bausch, rated Caa1/B-, is currently yielding about 7.3%.

The portfolio manager is now turning his attention to Akzo, which he said was a “best in class in the chemicals sector”.

“Chemicals as a sector tends to be cyclical, but this is a conglomerate. It’s a very diversified business.”

But others had reservations. Another investor steered clear of the Refinitiv deal.

“Refinitiv and Akzo are interesting bookends in looking at this market as they share features in terms of aggressive covenant packages,” said one high-yield investor.

But what has been lost, he said, are challenges to the business for Refinitiv in particular.

“It got to the point where the only thing I liked about the (Refinitiv) deal was the yield. And I’ve learned after 25 years in this business, that’s not enough.”

Among his concerns were business challenges that the Refinitiv business has already faced from competitors like Bloomberg and FactSet. But Blackstone’s ambitious cost-savings target also made him leery.

“When you look at the investment thesis of the sponsor, it’s very much about achieving cost synergies,” said the investor.

“The synergies they forecast are based on their story that they know how to do this better as sponsors than the corporate parent.”

Padgett at Moody’s said the worry was more long-term and how recovery rates will be impacted when the economy turns and businesses suffer. The agency warned last month that average first-lien term loan recoveries are expected to tumble to 61% from an average of 77% historically. 

She warned that we’re in a new paradigm, and that loan investors could bear the brunt of potential losses.

“There is little historical precedent for speculative grade issuers with such weak covenants and owned by private equity,” Padgett told IFR.

“But it doesn’t bode well for recovery. We haven’t seen the ability to move collateral around as much as these covenants allow before.”

 

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