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High Yield correction - idiosyncratic risk and US tax reform

Photo: Shutterstock

Photo: Shutterstock

For the past months, High Yield (HY) debt continued to register very decent returns for investors. However, as I have opined in my previous writings, asset managers and investors alike have continued to question the sustainability of these returns given the fact that yields tightened albeit to record lows, but yes to extreme levels. This week, we witnessed the first notable sell-off since the beginning of the year.

Over the past week, in my view the main triggers for the said correction are both idiosyncratic risk and the debate on the US tax bill and how the latter can impact HY issuers. Let’s look at both arguments chronologically by looking initially at the market correction.

As many might be aware, we are in quarter three earnings season, in which both US and European HY major issuers are reporting their financial performances. In addition, over the past week we have also experienced specific negative news in the B rated segment in relation to both operational and capital structures. Few examples, which come into mind in Europe, are Astaldi, the Italian based Construction Company, which postponed its quarter three results by one week and is seeking a capital increase to strengthen its balance sheet, amid its exposure in Venezuela which the company has suffered a remarkable impairment, apart from its structural issues. In addition, Boparan, one of the UK’s largest food manufacturer reported very weak numbers that were also impacted by the recent sanitary issues faced by the company, which emerged as so serious, that the health and safety regulator ordered the temporary closure of one of the company’s plants in West Bromwich. These are amongst the other draggers for spreads to widen further in the B rated segment.

In the US, soft numbers were also reported by high weighting benchmarked names such as Sprint Communications, Community Health and Tenet Healthcare, which also contributed to the remarkable outflow from the iShares US HY ETF.

That said, apart from the soft numbers, another point that might have pinched US HY issuers is the US tax reform bill. Many market participants might not appreciate the fact that a reduction in tax might have a negative impact from a firm’s value perspective. The technical word in this regard is what we call ‘tax shield’. A simple definition of ‘tax shield’ would be a lower taxable income due to interest payments deducted prior to tax expense, thus increasing the firm’s value. With hindsight, companies should load their balance sheets with debt in order to benefit from the aforementioned. However, taking into consideration other factors such as bankruptcy costs, there is a limit on how much debt one could raise on its balance sheet.  

The main point is that a lower US tax rate might negatively affect HY issuers from a tax shield perspective. So yes, in my view the recent correction in US HY should also be attributed to the ongoing uncertainty of tax bill reform.

In all fairness, in my opinion, the recent correction is indeed offering opportunities to dip-in into good credit stories, which were irrationally pressured lower over the past days. My picks are currently industrials, which are offering good relative value when compared to other sectors, given the sustained positive global economic data. Take the opportunity on the dip by being selective; you will reap the benefits in the future. 

Disclaimer: This article was issued by Jordan Portelli, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article is being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri Investment Services Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.

 

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