George Flynn

Author Archives: George Flynn

17th September 2019

HY: Comfortably Numb (Free Content)

“May you live in interesting times”…

In my last note, I suggested a rotation from more expensive BBs into Bs as a means of reducing systematic risk and in preparation for a squeeze in yields as we enter the year-end period. YTD performance and valuations all point to caution as we enter the home straight. Q3 earnings will be critical in determining who is on the right side of the “Earnings Recession” debate. Over the next few notes, I plan on identifying those safe places to hide as well as (try) to develop a valuation framework for the asset class.

The old Chinese curse (May you live in interesting times) is certainly applicable to credit investors.  Last week’s power moves by Draghi have yet to sink in and, added to that, rising oil prices are increasing concerns of constraining sluggish growth. 

Systematic drivers (read rates, and a declining but stable economic background) could see spread compression increase. In an intensified hunt for yield, I wonder just how much incremental QE directly supports credit fundamentals. 

Clearly, easy money and low lending rates have made for low defaults. But given the amount of cash already in the system, the marginal benefit is likely to have diminishing returns. “Zombie” companies that should have gone to the grave long ago are still with us.

They have been operating in an ‘easy money’ environment for some time and natural selection has yet to pick them off. Unless they refinance at lower rates risk it is hard to see how fundamentals will improve significantly for such companies. The one thing they do have is time.

I wanted to (at least start) to get a sense for this. The above chart shows the number of 5% plus moves by month of the Pan European High Yield Index, plotted against the 10 Yr Bund Yield. 

It hopefully shows Systematic vs. Idiosyncratic risks. What’s more, you tend to see a decline in the idiosyncratic moves after a dose of yield compression. However – fundamentals will prevail. 

So, it looks like the cost of getting it wrong will increase while at the same time spreads can compress further if our view of IG/ HY compression takes hold.

Fundamentals look to have softened slightly and a continuation into Q3 could put that cat amongst the pigeons – Especially ahead of QE restarting.

We analysed the fundamentals of 300+ issuers and calculated several metrics – leverage, coverage and cash flow.  The number of issuers was roughly 73% of the Pan Euro High Yield Index. Outliers were removed and then the straight average was calculated.

Ideally, in the future, this can be done on an issuer weighted basis as well as digging into the trends seen in specific issuers. High Yield is seeing an increase in data providers and leveraging them for screens and other studies will hopefully deliver more insight.

The table below shows that leverage has increased on average since 2016, with Energy and Transportation showing a decline in leverage at the aggregate level Q2 ’19 vs. FY 18.

Rating-wise, the story is the same. BBs edging higher vs. Q4 ’18 +11% vs. Bs +2%. Which suggests some slippage in quality, plus the influence of new issues.

We use Funds from Operations to look at both the ability of Issuers to pay back debt and in terms of interest coverage. YTD and YoY there is little to cheer about with FFO down across the board. Consumer-facing and cyclical sectors down the most. Ratings-wise, BBs show a steeper decline YTD than Bs but fare much better on YoY and comparison against FY16.

Interest cover at the aggregate level looks relatively healthy, with any “zombies” lost in the mix.  Most segments have seen a decline based on recent history and point to a softening YTD and YoY.

Overall, the moves are not huge – but they are significant. A further decline would represent reasons for increased caution. Overall, the softness does look to be cyclical. Clearly, we have to be mindful of mix when extrapolating to the wider market.

There is an ever-growing list of “known knowns“  to contend with– distorted relative value, aggressive deals with weak covenants, additional financial stimulus, declining margins of error, geopolitics and a softening economy. The key is picking your spots into Q3.

“Complacency” is something that one does not often associate with the High Yield market where it pays to be a skeptic. 

Whilst “Animal Spirits” may not be rampant, there are signs of frothiness. The recent Pinewood Studio is a case in point. Split rated BBB/BB the business managed to print a £550mm deal of which £280mm (51%) was a dividend. 

The deal printed at 3.25%, and after tax that is roughly 2.8%. The cost of equity on the Euro Stoxx Real estate constituents is 6.6%. Pinewood managed to pay itself a dividend at a cost of 2.8%. The flip side is that debt investors are the ones effectively covering the additional risk – it is a zero-sum game.  Pushing back on primary is going to become more and more important in sustaining that margin for error. 

Fundamentals, though, are not flashing red yet, so well-rated dividend deals are a sign of the times rather than a sign of the end of times.  

We remain comfortably numb awaiting our next dose from Dr Draghi, but positioning needs to stack up.  Credit selection remains the number one priority with a view to managing downside. October looks to be a cash-rich month in terms of coupons and redemptions – some of the supply we are seeing now is pre-financing that but technicals look to be supportive near term. QE will drive compression between IG and High Yield, the risk is the fundamentals continue to slip and stimulus fails to keep a lid on volatility. 

Next time, I plan on looking at curves and convexity. You can follow me on twitter @EuroYield.

3rd September 2019

2B or Not 2B (Free Content)

Finding value in the high yield market…

Just how much have rates driven returns in the quality end of high yield?  How much do spread returns in the Investment grade market explain returns in the BB space? Are BB’s cheap? Where could spreads go?

There has been much talk about the proportion of negatively yielding debt – even in European High Yield. Hopes are for the ECB to step in with a yield crushing solution in the coming weeks. Meanwhile, economic data has been softening, especially when you look at Germany and China.

Year to date BBs have outperformed single Bs by 192bps when looking at the Bloomberg Barclays High Yield Eur Index returning a not too shabby 9.84%. The BBB Euro Corporate AGG as returned a whopping 8.84% year to date, also outshining single Bs.

The Bloomberg Barclays Bundesrepublik Deutschland index has returned a 9.41% YTD. Who cares about credit risk??

Figure 1: Selected Stats for Eur Bloomberg Barclays Indices
Source: Bloomberg,

Well – you should – especially if you are sitting on a decent year to date return. BBs are synonymous with quality, liquidity and low defaults. And yet we have seen Casino, Steinhoff, Dia and GE, to name a few, all nosedive in rating and price – credit risk is real. Liquidity is increasingly difficult to source, and gap risk has increased significantly over the past 12 months. If the name of the game is riding yields until they are negative then BBs certainly benefit from higher rate sensitivity, but from a credit standpoint are we doubling down?  Calculating the R Squared of Excess Returns against Total returns for the BBB/BB/B corporate indices tells us just how much spread performance drives returns.

Figure 2: R Squared of Excess and Total Returns and Return Summary for Eur Bloomberg Barclays Indices
Source: Bloomberg,

On average 2010-2018 spread looks to explain 13.44% of IG returns, for BBs and Bs the numbers are 29.62% and 34.4% respectively. The LTM figures are much higher 29.61%, 35.92% and 45.65% for BBBs, BBs and Bs respectively This is mainly a function of including 2018’s sell-off. Looking at the Bar chart you can see that spread has a larger influence on returns in times of stress – 2011, 2015,2018.

So, having enjoyed the ride is it time to take chips off the table? From a credit standpoint earnings have yet to take a turn for the worse. However, the “known” unknowns list is long now. Trump’s ability to send Xover wider one day and tighter the next is a prime example. Systematic factors likely demand caution, with idiosyncratic risk, the risk at the heart of the High Yield market yet to be influenced by the overall economy.

The linkage between rating buckets when it comes to spread performance is significant.  Regressing weekly Excess returns of BBBs and BBs yields an R squared of 87%, and with BBs and Bs the figure is slightly lower at 80% reflecting the step up in default risk. Doing the same exercise on a total return basis the R squared regressing BBBs against BBs is much lower 37.5% compared to 77.8% for BBs vs. Bs.

Figure 3: R Squared between Rating Buckets
Source: Bloomberg,

The inference is that credit risk explains a large part in the return of BBs vs. BBBs.  A key technical, demand from the “Investment Grade tourist”, is unlikely to endure in the context of spread underperformance. The Mean weekly return for BBs and BBBs 2010- to date are c. 33 and 17bps respectively, and BB excess return volatility is roughly 3x that of BBBs.

Looking at the spread ratio of BBs to BBBs it is hard to argue that BBs are cheap. The Ratio has averaged 1.97x since 2011 and currently sits at 1.7x. In the Dec-18 Sell off the ratio blew out to 2.56x. For context, this is roughly a 200bp widening relative to the BB index’s FY18 starting spread of 148. BBB spreads started the year at 68bps and ended at 148.

Figure 4: Ratio of Swap OAS for BB and BBB Eur Bloomberg Barclays Indices
Source: Bloomberg,

So relative to BBBs, BBs look relatively rich and certainly the downside volatility appears to be significant enough to perhaps take some chips off the table.

When it comes to BBs vs Single Bs the decision to take chips off the table come down to your willingness to take more credit risk. Doing a similar exercise with Bs and BBs the average weekly excess returns 2011- to date are similar +33bps vs. +35bps. Volatility of returns is also closer (but not insignificant) with Bs having a volatility roughly 1.6x that of BBs.

Figure 5: Ratio of Swap OAS for B and BB Eur Bloomberg Barclays Indices
Source: Bloomberg,

Looking at the spread ratio Single Bs vs. BBs the current value of 1.82x is practically the same as the 2011- to date average of 1.81x. Here the relationship looks fairly valued.

Credit selection is a somewhat consensus mantra. Given the margin for error at current spreads this makes perfect sense. Being overweight in the current environment assumes The ECB’s “Bazooka 3.0” will drive spreads tighter and yields lower, with the softness macro being more of an issue come 2020.

With 3 months to year-end and a significant YTD return and increasing uncertainty, taking some risk off is extremely tempting.

The CreditMarketDaily view is that we see further compression in High Yield vs. IG. Taking profits in BBs to rotate into Bs with positive credit momentum is a way to position for near term central bank action. Deep value – if your remit allows- is also a way to position for upside, given the nature of special situations they reduce your overall correlation with the wider market.       

An underweight vs. the benchmark assumes that “Bazooka 3.0” does not cure all and that the cyclical decline worsens ahead of expectations. Given the risk-on – risk-off volatility maintaining a neutral position locks in returns and allows for some upside assuming credit selection is good.

Below is a spread summary covering November 2010 to date for the Bloomberg Barclays indices discussed. “Distance from the wides” shows how far current levels spreads are from the wides of the range.

A friend of mine likens the High Yield Market to an elastic band – the more it is stretched the more violent the snap back. If you were holding that elastic band right now, I suspect you would be holding it as far from your face as you can manage. It might not be fully stretched yet, but it has the potential to deliver a sting. Credit selection and an avoidance of outright beta should lessen it should we get the snap.

A tightening to the lows would result in an additional 2.4%,1.93% and 2.86% for the BBB, BB and B indices respectively. What gets us there is probably a combination of ECB not disappointing, continued corporate strength, Orderly Brexit and China trade tensions easing.

Impossible? No. Improbable? Maybe. Likely? You Hope.

Figure 6: Spread Summary Eur Bloomberg Barclays Indices
Source: Bloomberg,