The heart of our credit analysis is an in-depth look at the fundamentals of specific companies and bonds, but that cannot be the starting point.
In the global high yield universe there are roughly 1,000 issuers, so before our analysts roll their sleeves up to examine the fine details we need to make sure that list is a more manageable size.
The process starts with thinking about which countries, industries and types of company are likely to perform best given the threats and opportunities we are facing. Only then are we in a position to identify a sub-set of bonds that are truly worth considering for the fund.
In October last year our UK economist, in spite of expecting the economy to remain stuck in first gear, was seeing stronger labour market data. This suggested a boost to UK household spending. When we make forecasts like this, we care most about identifying where our views differ from other investors. This helps determine the areas of the high-yield bond market where we will find the best opportunities.
If UK consumers were going to spend more than the market generally expected, how could we capitalise on this? The UK retail sector seemed a good place to start.
Thomas Cook Group (TCG) bonds were trading at roughly 60 per cent of par, which reflected the company’s well-publicised difficulties. TCG is one of the world’s largest leisure travel firms with a strong brand and leading market position – but the company faced several challenges, including uncertainty about UK economic growth, very poor visibility into future bookings, high levels of debt (not good for bondholders) and a structural shift away from store-based travel agents to internet bookings.
Nevertheless, we were reassured by management’s progress in addressing these challenges – cutting capacity and improving margins, bookings on an improving trend, non-core assets being sold to repay debt, an expansion of its online business and increased exposure to emerging markets where leisure travel demand was growing fast. On balance, this looked like a great investment opportunity.
In the second half of October, we bought a Thomas Cook Group bond with five years to maturity which paid a coupon of 7.75 per cent at a weighted average purchase price of just under 61p. Our dedicated credit analyst – influenced by our economist’s macro view – saw considerable upside potential and an easing of downside risks.
By the time TCG announced its full year results at the end of November, the firm’s summer 2012 had ended strongly while winter 12/13 sales were off to a good start – and having cut capacity, strong pricing was being maintained. The new CEO impressed us, wasting no time in leading the much-needed transformation of the group. In our view, downside risks had been much reduced for TCG bonds whereas our forecast of how well Thomas Cook bonds could perform had increased.
The company’s bonds are moving closer to fair value – about the time we start to think about taking profits and hunting out a new opportunity.
Martin Reeves is manager of the Legal & General High Income trust
