Fallen angel bonds, high yield bonds originally issued with investment grade credit ratings, are generally known for offering potential value. A big source of this value has been the tendency of fallen angels to be oversold, to below what may be considered fair value, leading up to their downgrade to high yield.
However, a less obvious source of value for fallen angels can arise when the underlying corporation engages in a bond buyback, typically in the form of a public tender. Bond buybacks are a form of “liability management” that can help companies tidy up their balance sheets, improve their credit standings and ratings, and attract and retain investors. Companies use buybacks either to retire debt at a discount or to reduce costs simply by buying back a higher yielding bond and then issuing a new bond at a lower interest rate.
How Buybacks Add Value
Companies typically establish a tender offer price that is a premium to a bond's current price in order to entice investors to sell. As of June 30th, 11 fallen angel companies had issued tender offers year to date, boosting their bonds' prices by 5%, on average, between the day prior to and the day after the tender offer. Mainly from basic industry and energy sector issuers, five of the 11 firms were 2016 fallen angel entrants: Ensco, Encana, Noble Holdings, Anglo American Capital, and Southwestern Energy Company.
As shown in the bar chart below, bonds with tender offers contributed +243 basis points (bps) to the 16.18% year-to-date return of the BofA Merrill Lynch US Fallen Angel High Yield Index (H0FA), as of June 30th. By contrast, the BofA Merrill Lynch US High Yield Index (H0A0) returned 9.32%, of which just +57 bps can be attributed to bonds with tender offers in 2016.
YTD Return Contribution from Bonds with Tender Offers
As of June 30, 2016
Source: FactSet. Past performance is no guarantee of future performance. Contribution is presented for the BofA Merrill Lynch US Fallen Angel High Yield Index (H0FA) versus BofA Merrill Lynch US High Yield Index (H0A0) for the broad high yield bond market. Figures are gross of fees, non-transaction based and therefore estimates only.
A greater proportion of the H0FA Index than the H0A0 Index has been impacted by bond buybacks. As of June 30th, 10.5% of the H0FA index's market value was comprised of bonds that had issued tender offers year to date, versus the broad high yield bond market's 3.3% (H0A0). One major difference for fallen angel investors is that the debt issued to finance buybacks does not qualify for the H0FA index, since the new bonds would typically be issued as high yield. As such, fallen angel investors are not financing the buyback by buying new debt.
Companies recognize the value in buying back bonds for a variety of reasons; for investors it signals both the companies' willingness and ability to meet their debt obligations. For fallen angels, bond buybacks have served as another source of value so far this year. We believe bond buybacks offer another compelling reason for investors to look at the potential of this asset class.
Source: FactSet. Data as of June 30, 2016. Past performance is no guarantee of future performance. Contribution is presented for the BofA Merrill Lynch US Fallen Angel High Yield Index (H0FA) versus BofA Merrill Lynch US High Yield Index (H0A0) for the broad high yield bond market. Figures are gross of fees, non-transaction based and therefore estimates only.
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