Fixed Income Boutique
We hope you found a moment between the changing of the year to relax and reflect on 2020 – also finding some positives between all the happenings – and you now look forward with curiosity to what may come in 2021.
We expect a promising year for corporate credit and believe that 2021 will prove to be the sweet spot for this asset class (as previously stated in our advent calendar and outlook).
To kick-off 2021 together, we would like to take you on a tour – a tour in the Swiss mountains – because fresh air and outdoor exercise is a great way to calm the mind, find focus, and reduce stress. ‘Mens sana in corpore sano’ like the Romans said – ‘a healthy mind in a healthy body,’ which is a requirement to excel in any endeavor.
The reason for our mountain tour is that we discovered various similarities between mountaineering and credit analysis, which we will now illustrate to you.
For a successful tour in the mountains, preparation and experience is key. You need to be aware of the weather forecast, examine the terrain, and define your route. Mountaineering grading systems provide a measure of the level of difficulty of a given mountain ascent. Similarly, bond analysts need to be familiar with the key drivers of their industry and be up to date with current credit-spread drivers. Rating agencies provide a ‘grading system’ and help investors determine the risk associated with investing in a specific company by rating a debtor’s ability to pay back debt. However, focusing on ratings only is not enough and opportunities need to be sourced proactively. This is even more important in an environment with a strong consensus view. Here, credit selection is key and it is through credit selection that we aim to generate alpha.
The Covid-induced selloff left certain industries more vulnerable than others – for example, the aerospace sub-sector. There are names within this industry that we would not feel comfortable with currently but there are also opportunities that arise in names that are oversold, unloved, rated low investment grade or just not well known.
A recent example where we could build on our experience was the new bond issue of MTU Aero Engines in June 2020. MTU Aero Engines is a leading aircraft engine manufacturer and maintenance company headquartered in Germany. MTU was absent from the bond market over the last three years, but having followed the company for over 10 years and having been invested in their bonds previously, we were well acquainted with the characteristics of the company. On the back of our experience and preparedness, we could get comfortable relatively quickly with the issuer and the terms of the deal.
We understand why some market participants may have skipped this bond. As an aircraft engine manufacturing and maintenance company, MTU is exposed to air travel in a broader sense and hence considered a “COVID-19 sensitive” business, which was also reflected in the stock price that declined by over 45% from pre-COVID-19 levels. According to the International Air Transport Association (IATA), the pandemic is widely perceived to have pushed back plans for new aircraft programs by several years, creating record losses of ca. 150 billion US dollars in 2020/21 for the overall sub-sector.
In addition, the rating agency Moody’s rated the new bond at Baa3 with a negative outlook – the brink of becoming sub-investment grade. Against this, we drew our confidence in particular from the revenue visibility through the large order backlog (equivalent to around four years of production based on 2019 revenues), the strong balance sheet and a longstanding, and in our view, a very capable management team.
As outlined in our previous Viewpoints (see here and here), our base case in June was that a vaccine would come, affecting sectors such as travel and help them recover over the medium term. With respect to the rating downgrade risk to sub-investment grade, we saw MTU’s efforts to bolster its liquidity position through this bond issuance as a key mitigator to the main risk factors cited by Moody’s, which could potentially precipitate a rating downgrade.
A mountaineer can eliminate certain risks by thorough preparation (e.g. avoiding bad weather and unsuitable route choices) and a credit analyst can exclude certain risks by conscientious research (e.g. modelling rating changes, assessing deteriorating fundamentals and a firm’s ability to generate cash). However, not all risks can be eliminated. For example, a mountaineer cannot, with 100% certainty, prevent a rockfall, just like an analyst may not be able to predict a case of fraud especially if it was undetected by auditors or part of public information. However, an analyst can evaluate whether the expected returns will compensate for the known risks. In the example of MTU Aero Engines, we deemed that the coupon of 3% for this issue is an attractive compensation for the main risks we identified, namely a more prolonged impact of COVID-19 on commercial air traffic activity, which, through lower earnings, would eventually lead to a deterioration in credit metrics and eventually a rating downgrade.
After a successful climb, the mountaineer experiences a rush and satisfaction on top of the mountain since the primary goal is reached. As investors, we also feel this satisfaction when the price of the bond in the secondary market climbs to new highs as it confirms our initial view. In the case of MTU, the bond price climbed strongly on the back of the vaccine news in early November 2020. Since issuance at the end of June 2020, the MTU bond has delivered a total return (price return and coupon income) of approximately 11% until year-end 2020, well ahead of the Euro IG index, which returned approx. 3.9% over the same period.
Remember that reaching the mountaintop is only half of the journey, you still have to climb back down – which in many cases is more challenging and energy-sapping than the way up. Batteries are half-empty by then and mountaineers have to stay disciplined in order to avoid any accident on the way down. The same is valid for credit analysts, where continuous monitoring of a credit (e.g. changes in management, strategy, regulatory changes, deterioration in fundamentals) are an essential part of our daily work.
An integral part of our credit analysis are ESG-factors. We use a risk approach, based on controversy findings and determine potential detrimental credit impacts resulting from these factors. At heart, a true mountaineer will likewise pay attention to their surroundings and avoid littering, for example.
In the case of MTU, there are no controversies flagged at any of the ESG research data providers we work with and we are not aware of any cases that could impact the credit in a significant way resulting from environmental, social or governance factors as per time of writing.
We hope that you enjoyed our tour in the Swiss mountains and gained an insight to our way of generating alpha. Credit selection is our key performance driver and main source of alpha generation. An active credit selection style provides value and comfort by letting experienced credit analysts take care of the credit selection and pick names that can weather a storm and more than compensate for the risk taken.