High-yield: Beware of Germans bearing PIKs

COPYING AND DISTRIBUTING ARE PROHIBITED WITHOUT PERMISSION OF THE PUBLISHER: SContreras@Euromoney.com

By:
Duncan Kerr
Published on:

Schaeffler sells largest payment-in-kind bond; Investors reiterate maxim – caveat emptor

Schaeffler’s sale of the largest ever payment-in-kind bond in July says as much about the company as it does about the state of the high-yield bond markets.

The family-owned German car component manufacturer has been cleaning up its capital structure since the start of the year, and this latest financing is probably the last step ahead of a possible public listing next year.

On the other side, Schaeffler’s €1.6 billion equivalent sale of PIK toggle bonds also points to ravenous investor appetite for high-yield bonds, particularly the riskiest type, despite the bond market tremors in June.

Steven Logan, head of European high yield at Scottish Widows Investment Partnership
Steven Logan, head of European high yield at Scottish Widows Investment Partnership
For some, this suggests that the high-yield bond market is overheating. But Steven Logan, head of European high yield at Scottish Widows Investment Partnership (Swip), is more phlegmatic. He says the market temperature is "no more than it has been in the last six months".

Flexibility

He adds: "This transaction does give the company a good degree of flexibility. It is highly levered, it’s got some covenants that are ratcheting tighter, and it probably could benefit from the optionality this type of transaction gives them in the documents.

"The bigger question is how these new bonds are going to trade because if the company underperforms, it could be forced to utilize the PIK option instead of paying a cash coupon."

Schaeffler operates in a highly cyclical industry, and if economic growth in Europe and other core export markets deteriorates this will adversely affect its ability to generate cash, potentially forcing it to use the PIK toggle option.

This option provides the issuing company with a choice in how to pay accrued interest for each interest period during the first years of the bonds. The company can pay interest completely in cash, or it can ‘pay in kind’ by adding the interest payment to the principal amount, or issuing new debt with a principal amount equal to the interest paid. Companies can also opt to pay half in cash and half in kind.

Schaeffler does plan to pay cash for life, but there are two specific circumstances where, under the terms of the structure, it can allow the interest to accrue on the principal: first, if there is less than €1 billion of liquidity at Schaeffler’s operating company, or less than 10% headroom under the opco’s maintenance covenants.

Although Schaeffler’s new bonds have performed well in the aftermarket – they have traded up to around 102 since pricing on July 18 – this could change dramatically.

"If the toggle does get triggered," says George Flynn, credit research analyst at ECM Asset Management, "you could potentially see some pretty bad price action in this."

Of equal concern, according to Konstantin Leidman, European and UK credit fund manager at Schroders, is what happens if market liquidity evaporates. "It’s not hard to guess what effect this will have on risky assets, whether that’s equities or subordinated credit transactions such as PIK toggle notes."

Both are risks some are nevertheless willing to take on.

Logan at Swip, which participated in the Schaeffler bonds, says: "You have to pick your PIK toggles carefully because we’ve seen how dire the outcomes can be when things don’t go particularly well. However, in our view this one has merit and stacks up."

He adds: "Net-net we are talking about a company with €2 billion of ebitda and, due to its stake in Continental, significant asset value."

For Flynn however, the Schaeffler transaction does highlight the extent to which "the power now seems to be with the issuers" and until "we get a sell-off or correction, it would be very hard for investors to push back".

On pricing alone this was evident. Schaeffler’s €800 million and $1 billion five-year bonds were sold to yield a record low for PIK bonds of 7% and 7.25%, respectively.

Other PIK toggle bonds sold earlier this year, by companies such as Kloeckner Pentaplast, Orange Switzerland, R&R Ice-Cream and Sunrise, paid higher yields, but there are important differences between most of these and Schaeffler’s bonds.

For example, Schaeffler is not using the proceeds to fund a dividend distribution, it is offering a stronger security package and intends to pay cash for life to investors.

Schaeffler also stands out for another compelling reason.

"As an investor, you are focused on when and how the company [Schaeffler] will de-lever, and that’s dependent on a further sale of Conti shares or an IPO," says Flynn.

He adds, however, that both of these options "require a reasonably steady and buoyant equity market" and in recent weeks "there has been some volatility there due to Fed tapering, as well as reduced GDP growth forecast numbers". For a highly leveraged cyclical company that rules out such options in the near term, but according to Leidman at Schroders that is not so much of a concern.

"If it’s unattractive now, that actually gives me confidence about the future," he says.

In the meantime, could Schaeffler’s deal spark a flurry of PIK issues?

"I don’t think there is going to be a rush of new PIK issuance," says Logan. "Most investors require cash bonds, and they have only limited appetite for PIK notes in portfolios."

Flynn adds: "These type of capital structures are pretty complex, with multiple levels of subordination. Schaeffler has the investor base there and ready to support it, and you may not get that with smaller issuers, particularly first-time issuers."