The second quarter of 2020 was remarkable in many ways, but the healing of the credit markets via the Federal Reserve’s corporate bond purchase announcement and subsequent execution ranks among the most noteworthy and impactful events. This event reinjected liquidity into the market by opening the new issue floodgates, first in investment grade and then high yield, enabling the companies most impacted by the COVID-19 shutdowns to raise much-needed capital. Amid record issuance, we saw a significant number of secured bonds come to market.
In non-distressed markets, issuers will often issue debt that is structurally or contractually senior to unsecured debt, with the market pricing risk based on an enterprise value assessment. What is rarer in the high-yield market is debt secured by discrete assets. The pandemic changed that as a number of airlines, retailers and cruise lines have been forced to mortgage the bulk of their encumbered asset base. As shown in this week’s chart, these bonds have performed well, a function of strong market technicals, the expectation that these companies may avoid bankruptcy or the perception that the collateral will cover the debt in the event of a filing. Maybe it’s a combination of all three. However, if the first two tailwinds fade, investors may be greatly disappointed if the third thesis is ever tested.
To highlight a few examples, the cruise collateral consists of new and midlife cruise ships; the airline collateral of slots, routes and gates; and the retail collateral of certain real estate, warehouse and distribution locations. The key question in my mind is what would cause a bankruptcy filing. If the answer is the pandemic, then I think most of these companies will have to restructure and the assets securing the bonds could be rejected. In a pandemic-driven default scenario, the buyers of these assets will be limited, the revenue associated with the assets de minimis and the negotiating leverage of the issuer will be weak, leading to greatly diminished value.
Key Takeaway
While I think a vaccine will ultimately arrive to avoid a draconian scenario, when accessing the value of the collateral, this small-probability event needs to be considered. It’s one thing to gain comfort from appraised values and low loan-to-value ratios on a spreadsheet; it’s another to try to realize that value in an environment like the one we experienced in March.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
Opinions and statements of financial market trends that are based on current market conditions constitute judgment of the author and are subject to change without notice. The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete. Statements that reflect projections or expectations of future financial or economic performance of the markets may be considered forward-looking statements. Actual results may differ significantly. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate.
Investing involves risk, including possible loss of principal. Past performance is no guarantee of future results. All information referenced in preparation of this material has been obtained from sources believed to be reliable, but accuracy and completeness are not guaranteed. There is no representation or warranty as to the accuracy of the information and Penn Mutual Asset Management shall have no liability for decisions based upon such information.
High-Yield bonds are subject to greater fluctuations in value and risk of loss of income and principal. Investing in higher yielding, lower rated corporate bonds have a greater risk of price fluctuations and loss of principal and income than U.S. Treasury bonds and bills. Government securities offer a higher degree of safety and are guaranteed as to the timely payment of principal and interest if held to maturity.
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