24.11.17

Snapshots caught up with his dad for Thanksgiving lunch yesterday.

We talked about grandad who came to Newcastle in the 1950s as a Commonwealth immigrant and registered as a peddler. This involved selling household goods out of a suitcase on credit. The credit aspect was appealing because collections meant an opportunity for him to sell more goods. Losses given default were 100% and so it must have been emotionally fraught. The cost of collections was relatively low at the price of a return bus ticket.  There was limited bank or bond market credit available for aggressive expansion and grandad eventually sold his business for an arbitrary discount to book value of remaining collections.  How times have changed for the second generation credit trader!

HY and TMT jitters

Speaking of change, there has been a large year end rotation out of high yield and into investment grade. The outflows have coincided with weakness in the TMT sector. This weakness started with the failed merger of Sprint and T-Mobile in the US. This occurred during an intense price war in the wireless market and a structural change in content consumption from cable to streaming. The weakness then spilled over to Europe when investors started to question the intercompany financial arrangements that underpin Altice’s recently acquired Euro 50bn debt load.

For the moment the high yield weakness can be described as idiosyncratic and not systemic to the high yield market but we are monitoring events closely.

Outlook for returns

The reason we continue to remain cautious about the high yield market is valuations.  The Bank of America European High Yield Index is trading at a very low spread of 219bps despite the telecom sell-off.  The equivalent duration risk free German Government Bond yield is at -50bps.  A simple analysis of total returns back to 1998 suggests that there is only a slim chance for positive returns from the spread component or the government bond component.  There is a correspondingly high chance of negative returns in the year ahead.  Of course this is for the broad market and idiosyncratic opportunities will always be available for active managers.

Hidden leverage

We almost fell out of our swivel chair when we read that investors were taking risk to zero-recovery index tranches. What really shocked us was that the use of zero-recovery was described as being easy to explain to investors and easy for dealers to hedge.  The article did not mention that zero-recovery is a way to leverage your credit exposure with the terms of that leverage being difficult to ascertain.

Snapshots is not shy about leverage.  In fact we welcome it when it is carefully structured, managed and explained.  This takes toil and sweat to achieve.  Unfortunately and fortunately the world has plenty of people that aren’t willing to do this work and opportunities are plentiful in the alternative credit space for the hard working peddler.

Asif Godall
Co-Chief Investment Officer