TwentyFour Asset Management
It has been another benign year for European High Yield default rates. Predicting where they go from here is tricky given the ever-present anchor provided by the ECB’s asset purchases, but what we can say with relative conviction is that we are past the cycle lows in terms of default rates and we expect a pick-up in 2020.
Where defaults get to exactly depends on a few things, especially the growth outlook for Europe, but we can certainly analyse where we think the problem areas could be, whether cracks are already starting to appear, and what investors might do to protect themselves.
Companies generally run into trouble in two ways; either an inability to refinance an upcoming maturity (be it a bond, term loan or revolving credit facility), or by running out of liquidity, and thus failing to pay debt interest or even pay for the ongoing operations of the company. The environment for refinancing has been almost perfect for opportunistic issuers over the last few years, with the maturity wall for European high yield looking relatively comfortable and the bulk of maturities not coming due until at least 2023.
Liquidity is therefore the most likely problem and is something to focus on closely – what do cash balances look like? How much of that cash is restricted? Does the borrower have access to any revolving credit facilities? Is this revolver committed, or can a bank ultimately decide not to let that company draw on the revolver if that company is under stress? These are all important questions to ask and need to be addressed after every quarter, particularly in those bonds rated single-B and below.
Most of the accidents in high yield will come in those companies rated CCC. The financial flexibility of these companies is obviously limited and the margin for error is small, sometimes extremely so. The average EBITDA margin, for example, in CCC companies in the European high yield universe is 6.9%, according to Fitch, compared to 14.1% for B- rated names and 19% for B rated names. Additionally, the average gross leverage of 8.0x for CCC names (it is around 4.9x for B- names), coupled with a free cash flow margin of around -2.5%, means that the average CCC name may not generate enough cash to sustain its already levered capital structure. Moody’s points out in the liquidity assessment of every company it rates that over 60% of CCC companies have a “weak” liquidity score, compared to just 4% in B- rated companies.
All told this leads to our cautious view on CCC bonds, something we have blogged on in the past. Although a relatively small proportion of the index at around 6%, this still equates to around €20bn of nominal debt. The average price of CCC bonds in the European high yield index is approximately 88.75 with an average yield-to-worst of 9.7%, so the market is already trading at a fairly steep discount to par and suggesting to companies that these bonds will be hard to refinance unless they pay a coupon of 10% plus. This is something that is ultimately unsustainable for most companies (remember the negative free cash flow margin we discussed earlier, in addition to an even larger interest bill), and why the worst rated bonds tend to be poorly sponsored towards the end of a cycle.
Back to our outlook for European high yield defaults in the year ahead, and while it’s hard to predict the precise rate, investors should not be surprised to see quite a jump, probably a doubling, in 2020. We don’t see that as a reason for panic, given Moody’s puts the current 12-month European high yield default rate at 1.2% and the historical average is 3.2%. But it is a reason to remain ultra-vigilant when looking at credits in the high yield universe.