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Opportunities in the Fixed Income Crossover Space – RP Investment Advisors

Capitalize for KIDS Monthly Manager Insight – RP Investment Advisors, June 2017

What is the Crossover Sub-Sector?

  • Typical investor in investment grade bonds is constrained by an explicit set of investment restrictions and in contrast, high yield managers have more flexibility to invest in bonds of any rating but they typically focus on 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 and as a result, often fall between the cracks and are not analyzed by the majority of fixed income investors

A Growing Segment of the Bond Market

  • Crossover rated bonds have been a growing component of the bond market, particularly in the US
  • As interest rates have remained very low in the wake of the financial crisis that has driven a great deal of leveraged M&A whereby the acquirer is willing to lever up, be downgraded to HY and work its way back to IG over time
  • There are 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 Space Interesting for RPIA?

  • Relative to full IG-rated bonds, Crossover investors realize a higher spread / yield with a similar volatility profile to IG credits
  • 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, generally enters the index at a spread much wider than existing index-eligible comparables
  • Another interesting feature of these bonds is that they tend to have shorter maturity terms than IG bonds
    • Duration of BAML Crossover Index is 5.5 years vs. 7 years for BAML US Corporate Index
    • 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

crossover yield

Case Study: AERCAP

  • In 2014, AER acquired International Lease Finance Corporation from AIG and became the world’s largest aircraft leasing business
  • Publicly traded with $7Bn market cap, $41.4Bn total assets, with a fleet of 1,500 aircraft that it leases on a global basis to over 200 customers in 80 countries
    • More than $12Bn debt outstanding that is now IG rated at all 3 credit agencies
  • In the wake of the acquisition, debt/equity increased to over 4x and AER’s credit ratings became HY
  • Global aircraft leasing industry has very good fundamentals with high leasing utilization, low credit issues with airlines generating record profits, high passenger travel growth, and robust leasing spreads given low interest rates
  • Originally initiated a position in the financing used to acquire ILFC in Spring of 2014
  • Thesis was that although AER was not yet rated as such, AER was an IG quality credit offering yield and spreads that were very attractive relative to IG peers such as Air Lease and Aviation Capital
  • Management has delivered on their intention to drive retained earnings toward a deleveraging path and IG status: AER has driven its debt/equity ratio down to 2.7x in the most recent quarter
  • Company has a global platform with unmatched scale and geographic diversity of airlines that it leases its aircraft to for operations: fleet utilization of 99.7%
  • Global air travel growth has averaged annual growth of 5.5% since 2007
  • Global airlines have increased their use of leased aircraft from 21% in 1996 to 42% in 2016
  • Aircraft demand is growing aircraft lessors such as AER will play a crucial role in managing this growing area
  • AER has a robust leasing spread of 9.2% (the difference between the rate at which it leases its aircraft and its cost of funding)
  • Average remaining term of the leases is 6.5 years, providing stability and predictability of earnings
  • In March 2016, S&P gave AER a BBB- rating and 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
    • In April 2016, Fitch followed suit and led to a spread compression of almost 100 bps
      AER
  • At this juncture, believe AER’s spreads reflect full value and we have cycled capital from AER into wider spread aircraft leasing firms such as Avolon

RP Investment Advisors is an investment manager founded in 2009 by former senior executives of RBC Capital Markets, focused on providing solutions in the global fixed income markets.

Image Source: BAML, Capitalize for KIDS
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