While a very tolerant and forgiving market has allowed many of these companies to extend their loans/bonds, the massive leverage (interest payments) plus capital expenditures don’t allow most of these companies to generate the substantial free cash flow necessary to de-lever. So the sponsors are left with the greater fool game. Maybe equity market players will allow these companies to go public, creating funds for debt reduction (though we didn’t see meaningful delevering in the case of Caesar’s IPO last year), or perhaps their private equity sponsors can sell them to another private equity shop? This sounds like a hope certificate versus an investment strategy.
Just how prevalent are these bonds in the market? Well, with high debt levels come numerous tranches issued, and therefore these become a component in the major high yield indexes. In looking at the largest passive high yield ETF, the iShares iBoxx $ High Yield Corporate Bond ETF (ticker HYG), nearly 7.5% of this portfolio, or almost $1.2 billion, is invested in just these large LBOs that we have listed.3 There are certainly some tranches within each of these structures that will be money good, even in the event of a bankruptcy filing. However, our opinion is that many of them will be impaired or worth less than par in a restructuring or further exchanges. In our experience net leverage above 5x some rational level of EBITDA is generally a recipe for problems.
As we talked about in our recent blog (“Risk Management: The Ability to Say No”), the challenge with portfolios holding these LBOs, or any credit with a capital structure that does not work or has deteriorating fundamentals, is that the passive funds, such as HYG, cannot sell questionable bonds. Again, to no fault of their own, but by their mere structure, they own what fits their policy statement, viable credits or not. It isn’t until after an official default that the credit is removed from the index and subsequently from the funds that track the index.4
As we have noted before, with the ability to analyze a credit’s fundamentals and avoid these sorts of high levered names, investors are better able to manage the risk within their portfolio. With active management, not only can you avoid certain securities, but you can make sure you are getting paid for whatever credit risk you are taking on. This involves determining the appropriate price/yield based on the company’s fundamentals. With passive funds, when your mandate is to just hold what is in an index, how can you determine if you are being properly paid/generating an appropriate yield for the level of risk you are assuming without considering fundamentals and price? You can’t.