After holding a largely positive view on corporate credit fundamentals throughout 2021, our Credit team has become moderately cautious, according to Audra Delport, Head of Corporate Credit Research, and Robin Usson, Senior Credit Analyst. The more conservative stance is due to expectations that:
1) Continuing supply chain issues and inflation will lead to moderating growth
In 2021 corporate earnings were shielded from negative supply-chain effects and inflationary pressures. As demand for goods and services remained strong, companies benefitted from pricing power (autos, healthcare, homebuilders) and inflation was mitigated with cost saving programs (retailers). Looking forward into 2022, however, extended inflationary pressures and supply chain issues could result in lower demand and dent the ability of corporates to implement additional measures. Resulting in moderating growth, potential for negative guidance revisions and margin pressure. US retail sales have already and unexpectedly declined 1.9% versus an expected decline of 0.1% in December 2021, as higher prices reduced spending. With Omicron only starting to flare up in China, “the world’s factory” known for its zero-tolerance strategy for fighting the pandemic, supply chain disruptions are likely to be extended, resulting in additional shortages and inflation. Toyota Motor’s operations at its factory in Tianjin, China already came to a halt in early January because of mass testing requirements imposed across the city. Sectors exhibiting less pricing power, such as auto parts suppliers, have already seen profit warnings and have been negatively impacted by their inability to pass-through higher costs to customers.
2) From Balance sheet to returning capital to shareholders; issuer behaviour remains rational
As EBITDA grew in 2021 from the low base of 2020 and companies focused on paying down debt, some of which was undertaken in 2020 to boost liquidity, leverage metrics, such as interest coverage and leverage continued to improve. As corporates shifted from balance sheet repair mode to a more confident financial position, we are now seeing issuers increasing their focus on returning capital to shareholders in the form of dividend increases and announcements of share repurchase programs. In some cyclical sectors, such as energy, because of high commodity prices and thus very strong cash flows leading to significant debt paydowns last year, leverage has declined to the levels below managements’ long-term targets, providing opportunity to accommodate more debt, to fund M&A or buybacks. However, so far, issue behaviour appears rational, return to shareholders remain balanced, focused on preserving current balance sheet strength and we haven’t seen aggressive equity-related initiatives that would be detrimental to bondholders.
3) Event risk is on the rise: EU TMT and UK Supermarket Leveraged buyouts (LBO) in focus – security selection and scenario analysis are key
As estimated by S&P Global, as of January 2021, US private equity dry powder (unspent cash that is available to invest) was at all time high of $1.9tn, with as much as $300B ready to be deployed in Europe1. In addition, combined with low borrowing costs and investors searching for yield, driving ample liquidity, we saw LBO’s come back in 2021, especially in European telecoms and the UK’s supermarkets. In European telecoms, private equity interest has been sparked by equity underperformance and low valuation multiples, as the sector undergoes a major upgrade cycle (that’s elevating capital expenditures and pressuring free cash flows) and is exposed to intense industry competition. While in UK supermarkets, LBO activity has been driven by predictable cash flows that have been boosted by the pandemic, opportunity to drive cost savings and efficiencies under PE ownership, the sector’s large property portfolios that can be borrowed against to obtain attractive financing terms as well as relative cheapness of UK equities. Elevated LBO activity presents quite a few opportunities for credit investors, including investing in securities that have widened out too much once the LBO news disseminate, after conducting scenario analysis and taking a view of how likely the LBO will take place. In addition, there is opportunity of entering credit default swap (CDS) contracts to capture negative spread movement or moving down the curve ahead of the anticipated announcements.
4) Ongoing crisis in Chinese Property presents credit opportunities
In the second half of 2021, the Chinese Property sector’s fundamentals deteriorated dramatically because of (i) the 3-Red-Line policy (“3RL”, a supply-side reform aimed at cutting excessive leverage) and (ii) the 2-Red-Line policy (“2RL”, a demand-side reform aimed at cutting ‘real estate’ systemic risk by limiting banks’ exposure to the property sector). This double whammy precipitated the demise of highly indebted issuers which needed to accelerate cash collection to cut debt at a time when mortgage approvals were significantly scaled back. As a result, the physical market dropped somewhere between ~15-20% YoY in H2 2021. Local governments have also tightened regulatory scrutiny on presale deposits triggering a liquidity crisis for the whole sector including better-capitalised developers (presales have been a major source of funding for Chinese Properties). This creates a conundrum for Chinese regulators: how to ensure social stability in the grand scheme of “Common Prosperity” while maintaining long-term goals for the sector (3RL & 2RL). Recent liquidity crises at better-capitalised developers could mark an inflection point for more regulatory loosening. Already, the Ministry of Housing and Urban Rural Development is said to be drafting new escrow rules, which could in our view, alleviate liquidity conditions onshore. More defaults will ensue, but eventually fundamentals should normalize in the second half of this year. Therefore, it is important to keep an eye on highly convex credit opportunities in this space.
5) Relative Value becomes more attractive
Despite spread widening in November 2021, relative value has become more attractive. Therefore, through our relative value and security selection lenses to assess higher event risk in corporates we see opportunities in 1) moving down the curve where appropriate 2) adding exposure in single Bs which have underperformed, via senior to sub or secured to unsecured switches or 3) opportunities in emerging markets, especially in Asia.