Wednesday 06 September 2017 by Bonnie Corbett Trade opportunities

Yield hungry? Have your cake and eat it

This year, credit spreads across the rating spectrum have continued to tighten significantly and spreads between rating bands have compressed. This is normal behaviour in a positive credit environment. However, given the lengthy credit cycle many investors are questioning whether now is the time to move towards a more defensive portfolio 

eatcake

As credit spreads have compressed – no more so than in sub investment grade bonds – investors are being rewarded less in terms of yield for taking on additional risk. Figure 1 shows the movement of credit spreads of BBB, BB and B rated securities across the maturity spectrum since the start of the year until the end of August. Clearly, there has been a significant reduction in the yield that investors are happy to accept as they move up the risk spectrum into lower rated credits.


Source: Bloomberg
Figure 1

To put it simply, earning a return for each level of risk has become more difficult.

Investors have two options:

  1. They can either chase yield and move into lower rated credits and accept higher risk
  2. Accept a lower expected return for the same level of risk.            

We’ve been recommending investors move to higher rated bonds and sacrifice yield for higher credit quality, but if you like the first option, to have your cake and eat it too, Figure 2 highlights potential sources of value. It plots the current yield curves for different rating bands, and also a selection of bonds that appear to be good relative value if looking purely at their respective ratings and ignoring all other relevant credit factors.

We believe these bonds could be used in conjunction with investment grade and government securities to increase yield across a diversified portfolio. See Jonathan Sheridan’s article from last week here.

Note there is very little additional incentive for extending the maturity date with BBB rated bonds, but BB and single B rated bond yield curves do better. We show four bonds in the “BB” range and their respective yields above the BB curve highlighted in red. 


Source: Bloomberg, FIIG Securities; Pricing as of 31 August 2017
Figure 2
Note: Yields are calculated using indicative mid-prices

Ensco USD 5.20% 15 March 2025 senior unsecured notes

Ensco’s March 2025 senior unsecured notes are currently rated BB/B1 (S&P/Moody’s) but those ratings are on review for downgrade with both agencies. These notes have a high chance of seeing its rating cut, so while the bond has the highest yield above the BB spread curve with an indicative YTW of approximately 9.66% (calculated using an indicative mid-price of 76.525), it may be an unfair comparison.

Ensco is a leading provider of offshore contract drilling services to the international oil and gas industry. The bonds have also been under pressure because the oil and gas sectors are cyclical by nature and have recently endured significant pricing pressures. Additionally, there is uncertainty surrounding Ensco’s acquisition of Atwood Oceanics announced in May 2017.

See the Ensco 2025 factsheet here.

Avon International Operations Inc. USD 7.875% 15 August 2022 senior secured notes

Avon’s August 2022 senior secured notes are currently rated BB-/Ba1/BB+ (S&P/Moody’s/Fitch) and are yielding approximately 6.13% (YTW, calculated using an indicative mid-price of 106.025). This is 124bps above the relative spread of BB rated credit and as such, some investors may see value in adding this security to their portfolio.

Avon has a strong competitive position and geographical diversity in the beauty industry globally. Notably, Avon has a current focus on volatile emerging markets in conjunction with a high exposure to foreign currency fluctuations and operates in an increasingly competitive market, which may be amplified should global tension continue. Avon also faces management uncertainty after the resignation of CEO Sheri McCoy, which was announced in August 2017 due to her failure to reverse declining revenues. Despite this, S&P estimates that in the event of default, the expected recovery on these notes is 90-100% of capital value.

See the Avon 2022 factsheet here.

Hertz Corporation USD 7.625% 1 June 2022 senior second priority secured notes

Hertz’s June 2022 senior second priority secured notes are currently rated BB-/B1 (S&P/Moody’s). Hertz is one of the largest worldwide airport vehicle rental companies and operates a global vehicle rental business through the Hertz, Dollar and Thrifty brands.

Hertz’s 2022 maturity notes are on the cusp of BB and B ratings and as such are yielding 222bps above the spread for BB rated securities and 156bps above the spread for B rated securities (based off an indicative mid-price of 101.65). Hertz faces significant competition risk, and by nature of the industry in which it operates, is required to combat cyclical and seasonal revenue fluctuations. The company’s operating performance is expected to remain weak over the coming 12 to 18 months as Hertz also faces intense pricing pressures in the second hand vehicle market. However, these notes are secured by a junior lien on the same assets that secure the revolving credit facility and term loan and as a result, in the event of default, the expected recovery on the notes is 70-90% of capital value.

See the Hertz 2022 factsheet here.

Transocean Inc USD 9.00% 15 July 2023 senior unsecured notes

Transocean’s July 2023 senior unsecured notes are currently rated BB-/B1/BB (S&P/Moody’s/Fitch) and similar to Ensco, operates as an international provider of offshore contract drilling services for oil and gas wells.

Transocean’s notes are yielding approximately 7.38% (YTW, calculated using an indicative mid-price of 108.475), close to 180bps above the relative spread of BB rated credit. The company is the largest in the world in terms of overall fleet size. However, Transocean’s revenues are dependent on the level of activity in the offshore oil and gas industry, which is affected significantly by volatile commodity prices. Expected recovery in demand for offshore contract drilling services is unlikely to occur before 2019.

See the Transocean 2023 factsheet here.


 

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