In a generally positive environment for corporate credit, the
recent performance of high-yield bonds in the telecom, media and
technology (TMT) sector offers a market contrast. Our Lead
Analyst for High-Yield TMT joins our Head of Corporate Credit
Research to explain the divergence.
----- Transcript -----
Andrew Sheets: Welcome to Thoughts on the
Market. I'm Andrew Sheets, Head of Corporate Credit Research for
Morgan Stanley.
David Hamburger: And I'm David Hamburger,
Head of US Sector Corporate Credit Research and Lead Analyst for
the high yield telecom, media, and technology sectors.
Andrew Sheets: And today on the podcast
we'll be discussing the contrast between strong overall markets
in credit and a whole lot of volatility in the high yield TMT
space.
It's Friday, May 31st at 10am in New York.
So, David, it's great to talk to you. You know, listeners have
probably been hearing about our views on overall markets and
credit markets for the 12 months ahead.
We have US growth at 2 percent. We have inflation coming down. We
had the Fed lowering interest rates. But there’s needless to say;
there's some pretty notable contrast between that sort of
backdrop and the backdrop we've had for credit year to date,
which has been pretty calm, pretty strong -- and what's been
going on in your sector.
So maybe before we get into the why -- let's talk about the what
and bring people up to speed on the saga that's been high yield
TMT year.
David Hamburger: Yeah. I'm here today to
disavow you of any notion that everything is fine and dandy in
the market today. So, if you look at the high yield
communications sector, it's trading about 325 basis points wide
of the overall high yield index. And just to give you that
magnitude of that -- the high yield index trading around 300
basis points -- we're talking about 625 basis points over. Now,
the high yield communication sector as well is trading about 275
basis points, wider than the next widest sector in the index.
And so, it's pretty astounding today, given the market backdrop,
how much underperformance we've seen in this sector.
Andrew Sheets: What's been causing this
just large divergence between high yield TMT and what seems like
a lot of other things?
David Hamburger: Yeah, I think there are
two forces at work here. One's kind of a broader set of issues
that I can outline for you. Really, I think it's a combination of
one, the maturation of the communications marketplace. Coming out
of COVID, we certainly had accelerated adoption of broadband and
wireless services. That in and of itself has created a lot of
intense competition.
And as such, we've seen a lot of technological advances that have
created some secular pressures on the space. As well, when you
pair that up with elevated financial leverage, all coming
together at a time when the marginal cost of capital for
companies has increased due to higher interest rates. Those are
really some of the underlying forces at work that have driven
underperformance in this sector.
But some companies have managed to navigate this environment. And
I would say by and large, it's those with really strong balance
sheets. But that has really cast a shadow on this sector -- is
the fundamental and financing issues.
When you think about the bloated balance sheets that some of the
other companies have had, they've been exploring a whole new set
of transactions and, evaluating different options for their
balance sheets. And that's probably the more sinister thing that
we've seen in the market of late.
Andrew Sheets: So, so tell me a little bit
more about this. You know, what are some of the types of things
that companies can do that often leave the bond holder unhappy?
David Hamburger: We all became all too
aware of what private equity sponsors might do back in the heyday
of LBOs, and we still live in that world today, and it's really
fairly well known.
You know, I've been in the credit markets for more than 20 years,
but I can't recall a time we've seen so many management teams and
controlling shareholders now that are at odds with their
creditors because of elevated leverage and the business risks
they face. So really, the prospect of real and expected liability
management has created a lot of dislocation across companies’
capital structures.
So, what have they done? We look and see companies that have been
exploring liability manage, taking advantage of weak protections
in certain credit documentation in their structure at the expense
of other creditors in the same capital structure. So, we have one
company where you see this dislocation in their term loans. They
have the same pool of collateral between two different term loans
with two different maturities. The later dated maturity is
trading higher than the nearer dated maturity, strictly or
solely because of the better protections in that documentation.
And the premise being, you can negotiate with that class of
creditors, give them an advantaged position in the capital
structure at the expense of other creditors -- in order to
somehow manage the balance sheet and manage those liabilities.
Andrew Sheets: And David, is it fair to say
that this is a direct outcrop of, you know -- a term some
people might have heard of -- of covenant light debt, where, you
know, usually debt has certain legal protections that mean that
the bondholder is more assured of getting paid back or not
being made a less well off than other lenders. But you know, we
did see some of that change during different, stronger market
conditions. Is that a partial explanation of what's going on?
David Hamburger: That's exactly right,
Andrew. We are seeing the result, if I might say, the hangover
from some of these covenant light deals that came to market over
the last few years; almost to the point of speak to some clients
and they will just want to know what is the vintage of that
secured debt issue that you're talking about because there were
certain years where they were far more flexible documentation and
protections. And now, given where the equity markets are trading
and the financing environment, you see a lot of those securities
trading at severe discounts to par, which is unusual because,
again, in my 20-year career, I've not often seen companies with
billion-dollar equity market caps and bonds trading in the 20,
30, or 40 cents on the dollar.
You would think that if a company had a substantial market cap,
that their bonds would be trading closer to par and would have
value. But what really the market's, I think, pricing in is this
transference of value from creditors to shareholders; and the
opportunity cost associated with these shareholders; or
controlling shareholders or management teams looking to capture
those discounts that they now see in their bonds; or in their
loans to the benefit of equity shareholders -- really puts all
constituents in the company's balance sheet, if you will, at odds
with one another.
Andrew Sheets: So, David, this is so
interesting because again, I think, you know, for a lot of
listeners, you can read the newspaper, you see the headlines, the
market looks very strong and stable. And yet, there's definitely
a tempest that's been brewing, you know, in your sector. For
people who are investing in high yield TMT, what are you think
the most important things that you're looking out for in your
credit coverage?
David Hamburger: Well, look, we're forced
to really dig in and scrutinize these credit docs and really
understand what protections are there, understanding how
companies might navigate through those protections in order to
prolong or preserve their equity value or the equity options in
their companies.
It's not like we're trying to be alarmists in saying this is a
canary in the coal mine, but it is certainly a cautionary tale
for any high yield investor to be well versed in those credit
documentation, understanding the protections in those debt
securities.
And we have seen bondholders and creditors, largely even in
loans, you know, get together in co-op agreements to push back on
some of these aggressive liability management transactions. And
that, I think, is really important in an environment where yields
have come back in and, you know, where people look at
opportunities and maybe we could, once again, see two things.
One, a reach for yield, where you're looking at sectors that have
underperformed. And secondly, should we get back into an
environment of covenant light docks once again? So, I don't want
to be talking about this again in a few years’ time. And it's not
something that the market has helped resolve rather than just
perpetuate.
Andrew Sheets: David, it's fascinating as
always. Thanks for taking the time to talk.
David Hamburger: Thank you Andrew. Glad to
be here.
Andrew Sheets: And thanks for listening. If
you enjoy the show, please leave us a review wherever you get
your podcast and share Thoughts on the Market with a friend or
colleague today.
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