The end of the era of cheap capital should renew high yield investors’ forgotten focus on balance sheet sustainability, according to Aegon Asset Management.
Mark Benbow, high yield portfolio manager at Aegon AM, says the current backdrop of strong fundamentals and near-zero default rates masks a looming crisis for high yield issuers which rely on cheap funding but lack the balance sheet strength to cover a rise in interest costs.
“If we are truly entering a regime where cheap capital is being slowly removed, balance sheets suddenly become important,” he says. “One way to look at how manageable debt burdens are is to look at interest coverage. Companies in Europe with interest coverage below 1x are most at risk as central bank support is removed.
“Today, many businesses even with low funding costs still have poor interest coverage. Sell-side estimate around 10% of companies have less than 1x interest cover. High yield is a lender of last resort, which is a problem if you rely on this market for funding.”
Benbow highlights the recent news that pharmaceutical firm Covis Pharma’s syndication process had failed, resulting in a group of banks having to take the deal on their balance sheets. “This is probably the first time since the early days of Covid that a deal has been hung,” he says. “While one failed deal doesn’t make a trend, it’s clear the market is becoming more selective on the fear that the era of cheap capital is coming to an end.”
Benbow says increasing numbers of companies seeking funding are simply unattractive investment propositions, making it more important that investors take an active approach to security selection.
“Recently a company called Worldwide Flight Services (WFS) was in the market looking for funding,” he says. “The business makes money in air cargo handling. This is a very low margin, high fragmented and cyclical business. WFS is expected to burn free cash flow despite a positive fundamental backdrop and will struggle even more in an economic downturn. Stories such as this are a clear ‘avoid’, despite the offer of 7-8% yields.”
Given the risks, Benbow says it is important that investors do not leave their high yield exposure to passive funds which must own everything in the index.
“Passive investing is a fallacy within high yield,” he says. “Indices are based on the amount of debt outstanding, unlike equity indices which are market-cap weighted. As a result, passive investors inadvertently expose themselves to companies with more debt. This isn’t the basis for successful investing.
“You only need to look to how painful it has been for investors in structures such as Chinese real estate company Evergrande, which was a large part of the benchmark.”
Benbow says that, with the funding environment changing, investors should focus on companies with sustainable debt burdens and avoid those with weak balance sheets.
“When the cycle turns, those companies won’t be able to access the market and even if they can, it will be at very high rates which result in defaults or restructuring becoming almost a self-fulfilling prophecy,” he says. “Our focus therefore is on companies with strong cashflow generation, high barriers to entry and sustainable balance sheets.”
