Contemplating a bruising debt for equity swap is not a position that most bond investors want to find themselves in – but it is where investors in UK mobile phone retailer Phones 4U found themselves in at the end of this week.
| Overvaluation is not |
the same thing as a bubble. Things aren’t cheap any more in credit, they are fair value
The firm entered administration on Monday under PwC as all of its main mobile-phone suppliers had cancelled their contracts.
Phones 4U has roughly £760 million debt outstanding, £430 million 9.5% senior bonds due April 2018, £205 million 10% payment-in-kind (PIK) notes due April 2019 and a £125 million revolving credit facility that matures in March 2017.
The senior bondholders are now understood to have hired law firm Brown Rudnick to represent them in restructuring negotiations. By Thursday, the senior notes were trading at around 22 while the PIK notes were deemed essentially worthless.
The situation at Phones 4U adds grist to the mill of critics that have long-argued that discipline in the leveraged finance market is breaking down, given the huge volumes of money now hunting for yield within it.
The Phones 4U PIK was only issued in September last year and increased the firm’s leverage to seven-times ebitda. The proceeds were used to repay private equity firm BC Partners’ investment in the firm in full via a dividend recapitalization. The deal was led by Goldman Sachs.
The fact BC Partners was cashing out of Phones 4U ahead of negotiations with its main suppliers – Vodafone and EE – should probably have led prospective buyers of a PIK toggle note to pause for thought, but the Phones 4U PIK deal last September was far from unusual.
According to Dealogic, by Monday $8.2 billion-worth of PIK notes had been issued globally year-to-date via 23 deals. This compares with $15.3 billion-worth of issuance through 39 deals in 2013. The lion’s share of this market has been in the US this year, however, with only three such trades in Europe so far.
Recently, frozen-food retailer Findus raised €200 million for a dividend recap via a PIK note in August. The bonds, rated CC, were issued to pay down private-equity owners Lion Capital, JPMorgan and Highbridge Capital Management’s investment in the business. Findus underwent a debt restructuring in 2012 and was mired in scandal last year when some of its meat products were found to contain 100% horsemeat.
PIK toggles have always been viewed as a product of market excess, and their revival last year highlighted the extent to which investor demand has made financing available at the lower end of the credit-quality spectrum at very attractive terms.
Phones 4U should serve as a cautionary tale for high-yield investors – although it faces specific difficulties.
“The new issue market is a mixed range of credit quality, including some issues at the lower end of the quality scale,” points out Dagmar Kent Kershaw, head of credit fund management at Intermediate Capital Group (ICG) in London. “There was specific idiosyncratic credit risk aligned to Phones 4U that was related to the business model rather than necessarily the financing structure.
“Even a lowly levered corporate would be in trouble if it saw all its suppliers cancel their contracts.”
This is true, although the burden of debt repayment has weighed heavily on the company’s commercial flexibility. And the episode highlights just how risky instruments at the lower end of the credit spectrum can be.
|Retail: It’s the credit, stupid|
“There is a question as to whether or not the market is being excessive in the pricing of CCCs,” admits Christian Roth, head of global credit at Morgan Stanley Investment Management. “Spreads in this part of the market are below the historical default rate. The low interest-rate environment has been very beneficial to the bottom end of the sub-investment grade market.”
Roth argues, however, that frothiness in parts of the high-yield market does not indicate that investors should be concerned about the broader market.
“Overvaluation is not the same thing as a bubble,” he tells Euromoney. “Things aren’t cheap any more in credit, they are fair value. The credit markets care about defaults, which don’t happen outside a recession. The average loss from default on investment grade bonds is around 15 basis points, but the investment grade spread is around 100bp so the risk premium is not unreasonable.
“In high yield the spread is 400bp while historic loss is around 200bp. That 2% risk premium is only a little lower than average. There are pockets of the market which are expensive – covenant-lite loans and dividend recaps, for example. However, fundamentals are great and valuations are OK so the high-yield market is in good shape.”
However, a high-profile corporate failure like Phones 4U does focus the market’s attention on the level of risk investors have been prepared to take.
“When investors get burned and see a sudden, big price drop on a single credit, it does add to a feeling of slight nervousness in the market,” says ICG’s Kent Kershaw. “Phones 4U has created some market noise.”
However, Michael Kushma, head of global fixed income at Morgan Stanley Investment Management, advocates calm. With defaults very sticky at around 2%, there is little cause for concern.
“The high-yield market blows up when there is a recession or inflation goes up,” he says. “The probability of either at the moment is close to zero. Central banks are more afraid of downside risks, so the policy response is in your favour.”
However, investors holding triple-C or lower-rated paper that has refinanced the investment of private-equity sponsors in the credit would be well-advised to pay close attention.