Fixed Income Boutique

Swooping in on rising stars

Viewpoint

Following our recent article “Hunting from on high”, we received several questions from our readers’ on how they can benefit from market inefficiencies related to rating moves. In order to bring everybody onto the same page, we’ll now show, with a specific example, how we go about capitalizing on market inefficiencies.

As many investors are forced to stick to their narrow investments baskets (such as bonds with an investment-grade rating only), mispricings will occur. These types of mispricings are common in so called “rising stars” (rating-upgrade candidates from the BB category to BBB). We attempt to identify these rising stars and invest before the crowd, thus benefitting from the resulting spread tightening. So, let’s take a look at how this works in action.

One of the many issuers we follow is ArcelorMittal, the world’s largest steel company. The company was in trouble at the end of 2015 when commodity prices (including steel) fell. This caused company earnings and free cash flow to plunge and the leverage ratio (net debt versus EBITDA) to surge to extreme levels. As a result, investors started to panic and credit spreads of Arcelor bonds jumped to levels above 1 000 basis points.

However, at the time, the company was committed to supporting their credit profile with a focus on cost reduction, sale of non-core activities, and raising fresh equity capital. Following these developments closely we were confident of Arcelor’s ability to bolster their credit rating and reduce leverage. Our view was that Arcelor would deliver on these ambitious plans. In line with our expectations, the company reduced leverage during 2016 (even to lower levels than previously). Therefore, for us, the likelihood of Arcelor becoming a “rising star” was high.

Even so, it took the rating agencies (in this case Standard & Poor’s) until mid-2017 to recognize Arcelor’s efforts and upgrade their credit rating by one notch to BB+, and until Feb 2018 for the upgrade to BBB- (investment grade). However, most of Arcelor’s spread compression took place before the upgrades (see chart below).

2018-11-23_vp_fi_swooping-in-on_chart1

There are two important lessons in this example:

  1. To benefit from an improving credit story, it pays to get in early, as most of the spread compression takes place before the upgrade. Don’t wait for the rating agencies and don’t follow the crowd, which only buys after the upgrade.
  2. Exploiting market inefficiencies actively, by performing in-house credit analysis adds value in order to spot these opportunities.

As we stated in our previous article (Hunting from on high), we like to take an eagle’s eye view: spotting opportunities from on high and investing where we see value that will benefit our investors.