Where do fixed income investors go from here?
The primary market in Europe has understandably proved challenging for high yield issuers in 2022, with new issuance volume year-to-date down almost 80% on the same period in 2021. The issuers that have managed to print new deals have endured longer and more challenging roadshows, and have also ended up offering investors deep discounts to existing secondary levels to get involved.
One such issuer is 888 Holdings, with the UK gambling operator having sold €400m of five-year non-call two fixed rate notes and €300m of six-year non-call one floating rate notes on July 8, both issued at a cash price of around 85 (a 15 point discount to par) after an arduous two-week marketing process. The fixed rate tranche was priced with a coupon of 7.558%, which thanks to the hefty cash price discount translates to an all-in yield for investors of 11.5%; the all-in yield is the annual return investors expect from the interest on the notes plus the expected capital gain derived from the cash price discount, assuming the company repays the notes at par at maturity.
Another is BestSecret, which decided it was prudent to pay up in order to refinance an existing €260m bond set to mature in 2023. The B+ rated online fashion retailer issued a new €315m five-year bond at 600bp over Euribor, but again at a cash price of around 85 for an all-in yield of around 11%. For BestSecret, pricing at a discount meant it incurred larger than normal expenses in order to extend the maturity of its debt – it reported some €55m of transaction fees, expenses and costs related to the new deal, which is three to four times higher than usual. These elevated costs mean an increase in leverage for the company, but clearly BestSecret decided paying up now to remove its 2023 refinancing risk was the prudent course of action.
Thanks to the favourable market conditions of recent years, high yield borrowers have been able to term out their debt at relatively low cost, and are therefore not facing the level of refinancing risk they might otherwise have been now credit spreads have surged. Only 5% of the outstanding European high yield market matures over the next 12 months, and 8% by the end of 2023. However, issuers face contrasting fortunes and there will be those that decide increased leverage or higher debt servicing costs are a fair price for removing refinancing risk in the event that market conditions deteriorate further.
When pricing a deal in the current market, issuers (and the banks advising them) must strike the right balance between baking in a higher cost of debt and offering an attractive discount to investors. With both 888 and BestSecret printing around 85, is that the right number?
The weighted average price of all the bonds included in the ICE BofA European High Yield index was 85.6 at the end of June. The average spread on the index peaked at 659bp in early July but has now dipped back to around 590bp, which means the weighted average cash price has also improved slightly to 88.75 today. In normal times, investors would expect this weighted average cash price to be much closer to par; at the beginning of the year it was 101.3.
When the sector as a whole is trading below par, the bar for investing in new issue opportunities tends to be much higher as investors tend to focus more on pull-to-par when looking at relative value, and the effect of pull-to-par is stronger at the short end of the curve. The ICE BofA European High Yield index currently has a duration of around 3.4 years. New issues such as those from 888 and BestSecret, priced at a similar discount to the overall market, offer better yields but potentially higher volatility since they are longer dated.
In periods of stress, it is normal to see this degree of cash price discount in high yield. One of the reasons H1 2022 was so challenging for investors everywhere was that stocks and bonds fell in unison; the S&P 500 is down around 15% year-to-date, while the index level performance of high yield is down around 11.4%. Where fixed income investors have the advantage is their high yield bonds have a set maturity date, meaning that assuming the issuer doesn’t default, they can expect the bond’s cash price to climb steadily back towards par as the maturity date approaches. That provides some comfort to those who are sitting on mark-to-market losses having bought in before this year’s sell-off, as well as to those looking to build some potentially significant performance into their portfolios by buying in at lower cash prices today.
We expect the high yield primary market to normalise once investors stop having to battle outflows and the economic outlook becomes more favourable, and roll-down over the next year should prove a powerful force to bring the weighted average price of the market up. For now, 85 is the new par.