150. The firms paying off their pandemic debt

9 September 2021 (pre-recorded 7 September 2021)

Below is a transcript of the episode, modified for your reading pleasure. Please check the corresponding audio before quoting in print, as it may contain small errors. Please remember we’ve been discussing individual companies to bring investing to life for you. It’s not a recommendation to buy or sell. The fund may or may not still hold these companies at your time of listening. For more information on the people and ideas in the episode, see the links at the bottom of the post.

[INTRODUCTION]

Sam Slator (SS): I’m Sam Slator from FundCalibre and today I’ve been joined by Lesley Dunn, co-manager of the Baillie Gifford Strategic Bond fund. Hi Lesley.

Lesley Dunn (LD): Hi Sam, nice to be here.  

[INTERVIEW]

[0:12]

SS: So, perhaps we can start, there’s been general talk about economic recovery and company earnings have been pretty positive recently, which has been great news for the price of shares, et cetera. What are you seeing as a bond manager though? Are companies really in good shape and recovering from lockdown?

LD: Yeah, so I would say that clearly there are companies in some very exposed COVID sectors that have had, and continue to have, a particularly difficult time. But in general companies are recovering as economies reopen and that’s allowing them to function in an increasingly normal fashion. Leverage metrics remain elevated, and cash balances – because companies drew down so much liquidity during the crisis – are really flattering net-debt figures somewhat. Debt levels are definitely higher than they were pre-crisis, but we expect fundamentals will improve significantly from here.

That’s on the basis that we’re assuming that companies will be able to pass on higher costs and that demand is maintained, and this will flow through into improved credit metrics, meaning that credit losses from fallen angels and investment grades and from defaults in high yield will remain low.

There’s currently, I would say, really little dispersion in terms of spreads based on either credit quality or fundamentals with economies reopening. And the lifting of restrictions is really allowing a rising tide to lift all boats if you like. We think that’s probably likely to remain the case into the end of this year, and even the beginning of next year. And that’s when we expect the dispersions in spreads to become more apparent as we see differentiated performance between companies as growth starts to normalise.

And I think what’s really interesting from here, from a credit perspective, is really what companies choose to do with the cash that they have on their balance sheets. So, we continue to hold the view that whilst there has been clear fundamental deterioration, companies will actually choose to delever, as and when they’re able to do so, as opposed to choosing to run more structurally higher leverage. So yeah, companies are definitely moving in the right direction and becoming stronger again.

[2:17]

SS: So I suppose that leads on to a couple of questions. You said there that the level of debt’s gone up, does that mean that companies had to issue new debt during lockdowns just to sort of see them through it? And when you say that it sort of, that where they’re recovering, if they’re going to then use the money they’ve got on their balance sheets to reduce that debt, what actually happens if I’m invested in a bond then, what happens to that bond please?

LD: Yeah, absolutely. During the crisis sort of in the immediate aftermath of that, we saw significant issuance, both in investment grade and high yield. And if we just think about investment grade for a minute, these businesses are technically very highly rated by the rating agencies. They’ve got very strong balance sheets, they’ve got good credit metrics, but they were facing an unprecedented short-term challenge. And ultimately the market was open to provide them with liquidity. I think the first round choice that they had was to draw down on the revolvers, but they then came to the market to borrow money from us to further bolster their liquidity and strengthen their balance sheets. And what they were effectively doing was building up somewhat of a war chest when the uncertainty was at its highest. I think it will come as no surprise given what happened to yields during the crisis that this came at a particular cost for them, especially covid related sectors.

So a good example is booking.com, which was a name that we held in the Strategic Bond fund. So pre-crisis, booking, which is an online travel agency business, was a net-cash company. So it had more cash on its balance sheet than it had debt. And the yield on those bonds was close to about 2%, but this all effectively changed overnight. You know, COVID caused that business to have a revenue line go to zero and they were in a very difficult position, not knowing how long this was going to continue for. So in April 2020, they issued the bond with a coupon of four and five eighths. So, the cost of their debt almost more than doubled overnight because of the COVID crisis. The term of the issuance wasn’t notably short-term. And that was a 10-year bond. They were borrowing for the length of time that they would normally borrow for, but they were doing at a significantly higher level. And that was just to get them through the first stage of the crisis, which was very much focused on liquidity.

And if you fast forward around 18 months to where we are today, the yield on that bond is now back down at about 2% again. So companies could definitely access liquidity, but they just paid a higher price to borrow. And the markets were really open to these types of businesses because we had confidence given by the support of central banks to keep the markets functioning and to keep the flow of capital through the economy and provide these businesses with liquidity. And very quickly, after the crisis first struck, the new issue market was functioning really well. And we were seeing oversubscribed books and final pricing that was inside the initial price talk on the deal when it was squashed announced, and that has really continued into this year – the issue markets remains very strong, companies have access to liquidity, year-to-date issuance has been higher than last year’s full total, and we still have a number of years to run.

[5:29]

SS: So if they had issued that 10 year bond, for example, and they decided they actually wanted to pay down the debt, because now the situation is a lot better and they don’t need to have it, could booking come to you for example, and say, you know you’ve got this 10 year bond, actually, we’d like to give you your money back now, can that happen? Or how does it work exactly?

LD: That can happen. It would be very expensive for them to do so. The reason for that being that most investment grade bonds are issued with a final maturity, and they have no option to call the bonds earlier than that. In high yield, that is very difficult, we typically see a final maturity, but with a shorter call feature. Booking did issue some bonds with a call, which they have subsequently bought back. But their initial bond that they did was what we call a billet bond, that is no option to buy it back prior to maturity without paying a very hefty cost to investors. So I think it just goes to show or to evidence how extreme the liquidity crunch was for some of these businesses that they were willing to issue into a market at that level.

[6:35]

SS: And you’ve talked there about high yield and investment grade corporate bonds. So the two areas that your fund invests in, which of those two areas are you finding the most opportunities at the moment?

LD: So currently we’re expecting better returns from high yield than from investment grade, spreads and yields in both markets, so both in investment grade and high yield are low. We think that the investment grade market is a policy tool for central banks, which is really keeping a lid on spend levels in that market. Whereas in high yield, it doesn’t have the same direct support, but the low level of defaults during the crisis surprised most people to the upside. And there was significant significantly fewer defaults actually materialised than people expected when we were in the depths of the problems that we had. Our view is that defaults will continue to run at very low levels, which means that even at the tight levels we’re seeing in the market, that high yield spreads are currently amply compensating for credit losses. The strategic asset allocation in our strategic bond fund is 70% investment grade and 30% high yield and the reason for that is that that’s proven to be optimal from a risk/return perspective, but we can vary the allocation up to 50% in high yield. And we’ve been running very close to that maximum allocation in high yield since the depths of the crisis.

More recently, as that risk/reward has become more balanced as spreads in the market continue to tighten and there’s an acceptance that we’re not completely out of the woods in terms of the crisis just yet, we’ve begun to reduce that possession somewhat, but we remain overweight high yield. So 43% of the fund is invested in that asset class. And I think what’s important for us generally, but very specifically at the moment given where spreads and yields are, is to focus on bond selection, which is very central to our philosophy and process. So in addition to looking for investments that generate income, we’re looking to identify companies that have the potential to generate a capital return. And we’re finding more of those opportunities on balanced and high yield at the moment than in investment grade.

[8:48]

SS: Thinking about inflation. There’s a lot of talk that inflation around the globe is going to be transitory because it’s just that we came from such a low base last year. Here in the UK, I mean from personal experience, it seems to me that we might have a bit more inflation for a bit longer because of the Brexit effect. That’s just been delayed by the pandemic. What are your thoughts on the inflation outlook and how that might impact the bonds you’re invested in?

LD: Yeah. So as you say, inflation is a very topical area at the moment, and there are lots of competing views and interesting debates. Our central view over the long term remains that the factors that have kept inflation at a low level for several years are still present. So big trends like technology and what this has on the bargaining power of workers in terms of wages, the pandemic has undoubtedly caused some pressure to that view in the short to medium term. And as you rightly point out, these pressures are compounded in the UK as a result of Brexit. So that is one region where we think there is a particular risk of inflation being higher and sticker than certainly the central bank expects.

And the reasons for that are well understood – labour shortages or shortage of many components and goods. And some of this is due to the pandemic, you know, a number of foreign citizens went home during the crisis. There were rolling factory shut downs for many months, but also some of it is specific to Brexit. So the tighter restrictions on the free movement of people and the longer time and higher costs of port and border checks are definitely having an impact. And as you say, you can see this in everyday life. So these pressures are resulting in higher prices in many areas. The second-hand cars, rents, building materials, gas prices, it’s pretty broad based. And adding to that, job vacancies are at record highs, and it’s true that some workers will become available when furlough ends this month, but wages for some jobs probably need to rise in order to attract people to do them. And we’re starting to see some of this already.

So recent UK wage data showed that the average early earnings were up close to 9%. And once inflation starts to leak into the labour market, as appears to be the case, then consumers can afford higher prices and inflation expectations further out start to rise and compounding both of those points, accumulated household savings are very high. So I think they’re sitting at around £170 billion at the moment which if deployed could support the economy enormously through consumption. So when all this is combined with very lose monetary policy that we have from the central banks, then all the ingredients are there for higher and more persistent inflation, at least until the end of next year. But beyond that, we would expect UK inflation to return to more normalised levels.

[11:44]

SS: Okay. Perhaps we can end on a couple of your holdings. So I noticed that Netflix, the Netflix bond is actually your top holding, perhaps you can tell us a little bit about that. And maybe one other that our listeners may have heard of?

LD: Sure, so yeah, Netflix is the largest position in our fund, it’s 2.5%, and it’s quite an interesting one. So when Netflix first came to the European high yield market in 2017, it was very free cash cashflow negative. So it was burning close to $2 billion of cash per annum. And that’s a really difficult one for credit investors because we can’t actually participate in any of the growth upside. And as a tech company, it’s competitive position could be viewed us as quite fleeting, but we knew this business very well on the BG [Baillie Gifford] equity side having been investors for several years and we understood that producing original content, which is clearly what Netflix focuses on, is a very capital intensive endeavor so the business is going to be free cashflow negative, but we focused instead on the rate at which the business was growing, forecasting that the business would be free cashflow neutral and ultimately free cashflow positive in pretty short order.

And with that long-term view our analysis led us to think that Netflix was misrated. It was a single B business, it therefore fell into one of our key areas of focus in terms of inefficiency. And we believed that over time, Netflix’s competitive position would be strengthened and appreciated. I mean, that was combined with its improving balance sheet, the ratings books moved to upgrade and a rerating of the bond was very likely. The business has already seen several upgrades from where it started and that’s a high double B business. So it’s knocking on the door of investment grade. It has a huge market cap, you know, hundreds of billions of dollars. And with that competitive position and improving credit metrics, we think further updates into investment grade are very likely and therefore future bond price appreciation is very likely. And that’s why it remains one of our top picks.

[13:53]

Just in terms of some other names, our fund has lots of well-known names within it. So across varying sectors, so in the retail space we own Co-op and Tesco, we own AstraZeneca in healthcare, Apple, and Virgin Media in TMT [technology, media and telecoms], but equally there’s a lot of other companies in there that people might not have heard of. So we have ZhongAn, which is a Chinese-only insurance provider, Payment Sense, which is a company that provides payment terminals to small and medium businesses. And that’s clearly benefiting hugely during the pandemic in terms of the shift away from cash. I think what’s important, whether it’s a household name or not a household name, is that, the one thing all of the companies in our portfolio have in common is that they’re resilient businesses that we think have the ability to perform through an economic cycle. And that’s really important given our longer-term focus. We view all of our businesses through the lens of resilience and the output of that is that you get a portfolio of diverse idiosyncratic opportunities that looks to deliver capital appreciation as well as income.

SS: That’s brilliant, thank you very much.

LD: Thank you.

SS: And if you’d like to find out more about the Baillie Gifford Strategic Bond fund, please go to fundcalibre.com and don’t forget to subscribe to the Investing on the go podcast via your usual channel.