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Fixed income: Beware corona zombies

Glenn Freeman  |  22 May 2020Text size  Decrease  Increase  |  
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The threat of companies with mountainous debt and little hope of trading back to profitability is increasing and investors are being warned to take action.

The federal government's $200 billion bailout package of wage subsidies, asset write-offs and loan guarantees has done some heavy lifting for Australia's economy. But what happens when the stimulus ends in as little as six months’ time?

High debt levels on the books of Australian companies isn't new. But the reliance on debt deferrals and the flood of cheap cash that has flowed longer than it would have otherwise – thanks to government bailouts – is turbo-charging the problem.

"Things have snapped back really quickly, but they've snapped back on central bank support initiatives globally – this is what has driven the market bounce," says Likos, director of investment management at fixed income specialist BondAdviser.

The combination of loan deferrals from many financial institutions, government stimulus and listed-company equity raisings is bolstering the threat of an insolvency crisis. This comes on top of the earlier liquidity crisis – the concern that local companies wouldn't have enough cash on hand because credit facilities were rapidly drying up.

"To the point that you almost now have this FOMO (fear of missing out); being overweight in cash is now almost a consensus position," Likos says.

By the middle of April, ASX-listed companies had raised around $8 billion from investors, according to figures from Dealogic.

But Likos fears the situation will worsen once the credit tap is turned off

"When you come out the other side six or nine months from now, there's going to be more zombie companies around," Likos says.

"Whether you're an airline, a retailer, or a hotel, I think it's going to be pretty common that your average company is going to be sitting on more debt with a weaker earnings profile."

Government support initiatives, whether extended beyond September or not, will have to end, Likos says.

"As this process plays out, companies are all going to be chewing through cash, but what if you've shut your doors and your customers have dried up?"

How risky is your portfolio?

In the face of a looming insolvency crisis for Australian companies, Likos says investors should look carefully at their portfolios and assess how they're positioned on the capital structure.

Simplified capital structure

Capital structure

Source: Australian Securities and Investments Commission

At the bottom with the highest level of risk – but generally the greatest reward potential – are equities.

At the top are credit products including unsecured bonds, senior bonds and treasury notes.
Understanding where your assets lie on this continuum is perhaps the most fundamental aspect for debt investors.

And now is the time to review whether you're skewed to the bottom or to the top, to understand the risks and determine whether you can live with them or not.

Moving further up the capital structure, perhaps out of equities or hybrids into bonds, is a common response in risk-off environments. But this still leaves a lot of uncertainty with respect to hybrids in the near term.

The $345 million Challenger Capital Notes hybrid is a prime example. It was due to be called – its repayment date to investors – on 25 May. But on the back of very poor trading, the prudential regulator APRA has allowed it to be deferred for two years – essentially changing the rules for the asset manager.

Hybrid securities, which combine elements of both fixed interest and equities, sit just above equity within the capital structure. So in the event of a wind-up of a company, investors are more likely to get paid than those who hold stock, but less likely to get their cash back than those who hold bonds.

'Blood on the streets'

Though Likos barely dares mention it, he says there are client concerns in the local market that banks could stop paying coupons – the discretionary payments issuers pay to investors – if the economic situation deteriorates further.

"We don’t think that will happen, it’s a blood-on-the-streets-type scenario risk," Likos says.
"If it did, it would be absolutely devastating for the hybrid market, which could see hybrid price falls of over 30 per cent.”

This would affect more than $40 billion in total outstanding listed credit issuance, including hybrids, according to Morningstar and BondAdviser data.

Likos says a bank can cut an equity dividend paid to shareholders – as has happened in recent months – and make this up to shareholders in the future.

"But in hybrids, a lost coupon payment is a permanent loss of capital, you can’t make that up later."

It remains unclear when government stimulus will end. JobKeeper—which subsidises employees through cash payments to businesses—is due to end in September. Increases to JobSeeker payments for Australians actively seeking work should end around the same time.

But there's speculation the measures could stop sooner.

"Australians know there is no money tree. What we borrow today, we must repay in the future," said Josh Frydenberg in his latest budget update speech earlier this month.

"Temporary and targeted, the new spending measures were not designed to go forever but to build a bridge to the recovery phase."

is senior editor for Morningstar Australia

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