11 June 2018, 16:00 GMT
Bolstered by a dearth of issuance
Lower rated credits, which tend to exhibit positive correlation to economic growth and inflation, have strongly outperformed their higher quality, more interest rate sensitive cohorts this year. This is a natural reaction to a strong economy, gently increasing government bond yields and healthy earnings generation. Despite a steady stream of investor outflows since the second half of 2017, HY returns have also been bolstered by a dearth of issuance.
This source of strength masks a growing number of underlying weaknesses, including but not limited to increasingly creditor negative documentation and creatively generated financial projections. With an excess of liquidity relative to allocation opportunities, investors have begrudgingly overlooked stretched metrics for newly levered entities navigating their way through the capital markets pipeline.
Market on notice for jumbo financing
Danger perennially lurks beneath the surface in HY when market participants exhibit a combination of complacency and resignation. The benign negative net supply dynamic is set for a challenge, potentially as early as Tuesday 12 June, the date expected to yield a final ruling in the long drawn out AT&T - Time Warner acquisition dispute. While a favourable ruling would not produce immediate HY issuance from the entity in question, the precedent that it may set with positive implications for Sprint - T Mobile USA deal approval should put the market on notice for a jumbo financing package in the not too distant future.
That may be the best case scenario for telecom companies struggling to spark revenue and earnings growth in the face of disruptive challenges to their existing business models. Not to mention that mass market consumers in developed markets continue to face disappointing marginal disposable income growth and are therefore resistant to price increases for goods and services. Indeed, the sales pitch for the debt financing the deal will draw heavily upon hopes that industry consolidation can improve pricing power and enable investment in new technologies that may command an additional premium. Many investors will buy into this vision but will clearly also demand a substantial new issue premium for promised yet unguaranteed execution of these plans.
Source: Chart shows spread between the ICE BofA Merrill Lynch US High Yield Index and the ICE BofA Merrill Lynch US High Yield Telecommunications Index. Source: Bloomberg, Fidelity International, June 2018
Wider premium for HY telecoms
One of the negative currents churning below the surface in HY is the burgeoning spread investors require to own telecom company debt. Indubitably, anticipation of jumbo supply plays a role here, but so too do deteriorating revenue growth prospects, increasing pressure on enterprise value multiples across a sector laden with ‘melting ice cubes’.
Further complicating the picture, telecom debt is already one of the largest market capitalisation sectors and is by definition widely held. There are selected reasons for creditors to be constructive on certain stories in the sector, whether that is ample cash flows, new technologies or sufficient capital allocation flexibility making debt service and reduction manageable. Expect markets to require an even wider premium to warehouse the risks.
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