RP Investment Advisors (“RPIA”) is an investment manager focused on providing solutions in the global fixed income markets. Article by RP Investment Advisor via Capitalize For Kids
Founded in 2009 by former senior executives of RBC Capital Markets, RPIA manages money on behalf of pensions, foundations, endowments, and private wealth clients. RPIA is focused on generating positive, absolute returns from the global fixed income markets irrespective of the direction of interest rates or macro trends.
One important area of the fixed income market through which RPIA has achieved strong returns is the Crossover sub-space. Crossover bonds are a niche part of the market that is under-analyzed and where active managers with flexible mandates can uncover real value. Through in-depth credit analysis the team has uncovered crossover investments that offer attractive relative value with a strong catalyst for capital appreciation.
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What is the Crossover Sub-Sector?
In broad terms, the global universe of bond investors is bifurcated between investment grade (“IG”) investors and high yield (“HY”) managers. Bond market investors pay very close attention to the credit ratings assigned to issuers by Moody’s, S&P and Fitch rating agencies. The typical investor in IG bonds (for example, an insurance company) is constrained in their investment choices by an explicit set of investment restrictions that typically mean they can only invest in bonds that are sufficiently rated to be in the IG credit indices. In contrast, HY managers have more flexibility to invest in bonds of any rating, but given their target return they typically focus on lower rated HY securities that generate equity-like returns.
Crossover bonds are corporate bonds that have both an IG rating and an HY rating. This puts these securities in a grey area somewhere between the IG universe and the HY universe. As a result, Crossover securities often fall between the cracks and are not analyzed by the majority of fixed income investors.
IG managers are prohibited from buying the securities because of their mandates, while HY investors don’t tend to focus on these securities because they are targeting a higher return and must focus on higher yielding and riskier securities. RPIA managed funds have more flexible investment mandates that permit them to invest in Crossover credits in order to take advantage of these market inefficiencies.
A growing segment of the bond market
In recent years Crossover rated bonds have been a growing component of the corporate bond market, particularly in the US. In the wake of the 2008 financial crisis many issuers were downgraded to HY. Over time, as such firms improve their credit profiles they are migrating back to IG ratings. In addition, as interest rates have remained very low in the wake of the financial crisis this has driven a great deal of leveraged M&A transactions whereby the acquirer is willing to lever up, be downgraded to HY and work its way back to IG over time.
Specifically, there are currently more than 4,500 Crossover rated securities outstanding in the US market, which is an increase of more than 100% since 2007.
Why is the cross over space interesting for RPIA?
The Crossover space has been an important area of focus and return generation for RPIA funds. Firstly, relative to full IG-rated bonds, Crossover investors often realize a higher spread / yield with a similar volatility profile to IG credits. Figure 1 above shows where Crossover bonds sit on the risk-return frontier versus a range of other investments – highlighting the attractive risk-to-return characteristics of these securities.
Secondly, if an investor is able to successfully identify the Crossover-rated companies which are on a positive ratings trajectory to become fully IG-rated overtime then there exists a strong potential catalyst for capital appreciation. When a Crossover bond becomes an IG index constituent, it generally enters the index at a spread much wider than existing index-eligible comparables. This drives investor buying which drives credit spread compression. Our research team has been very focused on Crossover bonds that have a high degree of likelihood of being upgraded to IG over time.
Another interesting feature of these bonds is that they tend to have shorter maturity terms (less credit duration) than IG bonds. For instance, the credit duration of the BAML Crossover index is 5.5 years versus 7 years for the BAML US Corporate Index. The ability to invest in a security whose rating is on a positive ratings trajectory, with a wider spread/bigger yield and in a shorter credit duration format is a significant competitive advantage for RPIA.
A Case Study: AERCAP
One Crossover credit that has been an important investment for RPIA over time is AerCap (“AER”). In 2014 AER acquired International Lease Finance Corporation (“ILFC”) from AIG, and in so doing AER became the world’s largest independent aircraft leasing company. The company is publicly traded with a USD $7bn market capitalization, $41.4bn of total assets, with a fleet of over 1,500 aircraft (owned and on order) that it leases on a global basis to over 200 customers in 80 countries. AerCap has more than $12bn of public debt outstanding in the USD market that is now rated IG at all three credit rating agencies and is part of the broad IG index.
Additional Spread from Crossover Risk
When one looks at the additional spread investors get paid for assuming crossover risk, we believe this looks attractive relative to the modest increase in credit loss rates.
A Smart way to solve the “problem” of Fixed Income returns
Investors in IG fixed income face the challenge of low all-in yields as a result of low government yields and tight corporate spreads. There are a number of ways of approaching this challenge of enhancing the yield of a fixed income portfolio:
- Extend average term / duration of assets;
- Give up liquidity by moving from public debt into private debt;
- Compromise on credit quality by investing in more risky HY rateddebt;
- Moving into Crossover rated securities
The chart below graphically illustrates these options. We believe that it makes the most sense for investors to boost their portfolio yield by investing in crossover-rated securities rather than extending credit duration / term, giving up liquidity, or moving down the credit spectrum into more speculative HY bonds.
In the wake of the acquisition of ILFC, AerCap’s leverage levels increased to fund the acquisition. Specifically, AER’s debt / equity ratio increased to over 4x and that resulted in the rating agencies moving AER’s credit ratings to HY.
The global aircraft leasing industry has had very good fundamentals, with high aircraft leasing utilization rates, low credit issues with airlines generating record profits, high passenger travel growth in markets such as Asia, and robust leasing spreads given low interest rates. The view of our research team was that AER generates a robust return on its capital and through retained earnings it would drive leverage down in a reasonable time frame and regain its IG status. As a result, RPIA originally initiated a position in the financing used to acquire ILFC in the spring of 2014. Our perspective was that, although not yet rated as such, AerCap was an IG quality credit offering yield and spreads that were very attractive relative to IG peers such as Air Lease and Aviation Capital.
Over time, the management of AerCap has delivered on their intention to drive retained earnings toward a deleveraging path and IG status. Specifically, AER has driven its debt/equity ratio down to 2.7X on an adjusted basis in the most recent quarter. The firm has a global platform with unmatched scale, and geographic diversity of airlines that it leases its aircraft to for operations. The fleet utilization is 99.7%, meaning just 0.3% of aircraft are not presently being leased out to airlines. Global air travel (revenue passenger growth) has averaged annual growth of 5.5% since 2007, and in 2016 total passengers were 3.8 billion. Global airlines have increased their use of leased aircraft from 21% in 1996 to 42% in 2016, and aircraft globally are predicted to grow from 22,510 in 2015 to 45,240 in 2035. Therefore, it is clear that aircraft demand is growing and aircraft lessors such as AER will play a crucial role in managing this growing area.
Moreover, AER has a very robust leasing spread of 9.2% (the difference between the rate at which it leases its aircraft and its cost of funding). The average remaining term of the leases is 6.5 years, providing stability and predictability of earnings. These factors combine to provide AER with a stable and strong profitability profile where it can generate a high ROE and drive leverage levels to a conservative end point. In addition, AER has $9.5 billion of availability liquidity, and with estimated cash flow of $3.3 billion it has 1.6x coverage of expected debt maturities and capex.
Given these robust operational trends and business model, in March of 2016 S&P gave Aercap a BBB- rating in recognition of solid progress on two key debt metrics on which they base their ratings, namely FFO-to-debt and debt-to-cap. Although Moody’s and Fitch both still rated the issuer BB we were convinced that the balance sheet fundamentals of the business were sufficiently strong that it was only a matter of time before the other agencies followed suit. In April of 2016, Fitch followed suit and upgraded AER to IG which led to a spread compression of almost 100bps. This sharp move reflected the fact that with 2 of 3 agencies rating the securities IG, the bonds were included in the Bloomberg / Barclays Index. Finally, Moody’s upgraded Aercap in February of 2017 citing the company’s strengthened competitive positioning and expectations around continued profitability and cash flows compared to peers.
The chart below illustrates the spread compression that we saw in a specific AER bond as a result of this ratings action and index inclusion.
At this juncture, we believe AerCap’s spreads reflect full value and we have cycled capital from AER into wider spread aircraft leasing firms such as Avolon, the third largest global aircraft firm that recently brought a high yield unsecured debt offering to market to fund its acquisition of CIT’s aircraft leasing unit. Avolon has IG credit metrics and a young aircraft fleet focused on more easily marketable narrow-body aircraft that can be leased with ease on a global basis. We believe that over time Avolon will be rated IG and its spreads will continue to narrow toward its investment grade peers. As a result, we have shifted much of our exposure in the aircraft leasing sector to Avolon and will continue to research investment opportunities in this sector where Crossover credits can offer robust investment opportunities.
Article by RP Investment Advisor, Capitalize For Kids