Exploring Factors Behind TMT Bond Underperformance and Management of Liabilities

In a generally positive environment for corporate credit, the recent performance of high-yield bonds in the telecom, media and technology (TMT) sector offers a market contrast. Our Lead Analyst for High-Yield TMT joins our Head of Corporate Credit Research to explain the divergence.

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Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Head of Corporate Credit Research for Morgan Stanley.

David Hamburger: And I'm David Hamburger, Head of US Sector Corporate Credit Research and Lead Analyst for the high yield telecom, media, and technology sectors.

Andrew Sheets: And today on the podcast we'll be discussing the contrast between strong overall markets in credit and a whole lot of volatility in the high yield TMT space.

It's Friday, May 31st at 10am in New York.

So, David, it's great to talk to you. You know, listeners have probably been hearing about our views on overall markets and credit markets for the 12 months ahead.

We have US growth at 2 percent. We have inflation coming down. We had the Fed lowering interest rates. But there’s needless to say; there's some pretty notable contrast between that sort of backdrop and the backdrop we've had for credit year to date, which has been pretty calm, pretty strong -- and what's been going on in your sector.

So maybe before we get into the why -- let's talk about the what and bring people up to speed on the saga that's been high yield TMT year.

David Hamburger: Yeah. I'm here today to disavow you of any notion that everything is fine and dandy in the market today. So, if you look at the high yield communications sector, it's trading about 325 basis points wide of the overall high yield index. And just to give you that magnitude of that -- the high yield index trading around 300 basis points -- we're talking about 625 basis points over. Now, the high yield communication sector as well is trading about 275 basis points, wider than the next widest sector in the index.

And so, it's pretty astounding today, given the market backdrop, how much underperformance we've seen in this sector.

Andrew Sheets: What's been causing this just large divergence between high yield TMT and what seems like a lot of other things?

David Hamburger: Yeah, I think there are two forces at work here. One's kind of a broader set of issues that I can outline for you. Really, I think it's a combination of one, the maturation of the communications marketplace. Coming out of COVID, we certainly had accelerated adoption of broadband and wireless services. That in and of itself has created a lot of intense competition.

And as such, we've seen a lot of technological advances that have created some secular pressures on the space. As well, when you pair that up with elevated financial leverage, all coming together at a time when the marginal cost of capital for companies has increased due to higher interest rates. Those are really some of the underlying forces at work that have driven underperformance in this sector.

But some companies have managed to navigate this environment. And I would say by and large, it's those with really strong balance sheets. But that has really cast a shadow on this sector -- is the fundamental and financing issues.

When you think about the bloated balance sheets that some of the other companies have had, they've been exploring a whole new set of transactions and, evaluating different options for their balance sheets. And that's probably the more sinister thing that we've seen in the market of late.

Andrew Sheets: So, so tell me a little bit more about this. You know, what are some of the types of things that companies can do that often leave the bond holder unhappy?

David Hamburger:  We all became all too aware of what private equity sponsors might do back in the heyday of LBOs, and we still live in that world today, and it's really fairly well known.

You know, I've been in the credit markets for more than 20 years, but I can't recall a time we've seen so many management teams and controlling shareholders now that are at odds with their creditors because of elevated leverage and the business risks they face. So really, the prospect of real and expected liability management has created a lot of dislocation across companies’ capital structures.

So, what have they done? We look and see companies that have been exploring liability manage, taking advantage of weak protections in certain credit documentation in their structure at the expense of other creditors in the same capital structure. So, we have one company where you see this dislocation in their term loans. They have the same pool of collateral between two different term loans with two different maturities. The later dated maturity is trading higher than the nearer dated maturity, strictly or solely because of the better protections in that documentation. And the premise being, you can negotiate with that class of creditors, give them an advantaged position in the capital structure at the expense of other creditors -- in order to somehow manage the balance sheet and manage those liabilities.

Andrew Sheets: And David, is it fair to say that this is a direct outcrop of, you know -- a term some people might have heard of -- of covenant light debt, where, you know, usually debt has certain legal protections that mean that the bondholder is more assured of getting paid back or not being made a less well off than other lenders. But you know, we did see some of that change during different, stronger market conditions. Is that a partial explanation of what's going on?

David Hamburger: That's exactly right, Andrew. We are seeing the result, if I might say, the hangover from some of these covenant light deals that came to market over the last few years; almost to the point of speak to some clients and they will just want to know what is the vintage of that secured debt issue that you're talking about because there were certain years where they were far more flexible documentation and protections. And now, given where the equity markets are trading and the financing environment, you see a lot of those securities trading at severe discounts to par, which is unusual because, again, in my 20-year career, I've not often seen companies with billion-dollar equity market caps and bonds trading in the 20, 30, or 40 cents on the dollar.

You would think that if a company had a substantial market cap, that their bonds would be trading closer to par and would have value. But what really the market's, I think, pricing in is this transference of value from creditors to shareholders; and the opportunity cost associated with these shareholders; or controlling shareholders or management teams looking to capture those discounts that they now see in their bonds; or in their loans to the benefit of equity shareholders -- really puts all constituents in the company's balance sheet, if you will, at odds with one another.

Andrew Sheets: So, David, this is so interesting because again, I think, you know, for a lot of listeners, you can read the newspaper, you see the headlines, the market looks very strong and stable. And yet, there's definitely a tempest that's been brewing, you know, in your sector. For people who are investing in high yield TMT, what are you think the most important things that you're looking out for in your credit coverage?

David Hamburger: Well, look, we're forced to really dig in and scrutinize these credit docs and really understand what protections are there, understanding how companies might navigate through those protections in order to prolong or preserve their equity value or the equity options in their companies.

It's not like we're trying to be alarmists in saying this is a canary in the coal mine, but it is certainly a cautionary tale for any high yield investor to be well versed in those credit documentation, understanding the protections in those debt securities.

And we have seen bondholders and creditors, largely even in loans, you know, get together in co-op agreements to push back on some of these aggressive liability management transactions. And that, I think, is really important in an environment where yields have come back in and, you know, where people look at opportunities and maybe we could, once again, see two things. One, a reach for yield, where you're looking at sectors that have underperformed. And secondly, should we get back into an environment of covenant light docks once again? So, I don't want to be talking about this again in a few years’ time. And it's not something that the market has helped resolve rather than just perpetuate.

Andrew Sheets: David, it's fascinating as always. Thanks for taking the time to talk.

David Hamburger: Thank you Andrew. Glad to be here.

Andrew Sheets: And thanks for listening. If you enjoy the show, please leave us a review wherever you get your podcast and share Thoughts on the Market with a friend or colleague today.