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The double-edged sword of good covenants in corporate credit

In periods of market stress, strong bond and loan covenants protect debt investors from company actions that would be adverse to creditors’ interests…

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In periods of market stress, strong bond and loan covenants protect debt investors from company actions that would be adverse to creditors’ interests when it matters most. Yet, relative to their weaker covenant counterparts, bonds with strong covenants often see more pressure than would be expected or warranted in difficult market environments.

Flash back to 2019

Suppose I were to gift you $1 million of new issue bonds for one of two hypothetical travel companies – BOAT and SAIL:

1. BOAT 7.75% coupon, unsecured bonds, maturing 2029, priced at par

2. SAIL 7.75% coupon, unsecured bonds, maturing 2029, priced at par

Source: M&G, illustrative.

Both BOAT and SAIL have identical capital structures and enterprise values. Their only debt outstanding is the bonds shown above, each totalling $1 billion. Both companies are in the same business and have the same healthy profitability and liquidity.

The only differentiating feature is that the BOAT bonds’ covenants prohibit BOAT from raising any secured debt, whereas the SAIL bonds’ covenants allow SAIL to raise an incremental $500 million of

secured debt.

Which bond would you pick?

The choice here is straightforward: the BOAT bonds are the better choice because they have stronger covenants, limiting BOAT’s ability to take out debt that would rank higher than the BOAT 7.75% bonds due 2029.

Fast forward to today – If I gifted you another bond now, which would you pick?

Since the end of 2019, let’s assume both companies have been severely impacted by the pandemic, seeing two years of zero profitability and pushing both bond prices from par down to 70 cents on the dollar (or 15% yield).

Fortunately, with global travel normalizing, there is a light at the end of the tunnel. But there is one last hurdle: the recent pandemic-induced stress eroded both companies’ liquidity and both need a cash injection to bridge the gap until profitability fully recovers. Neither company can access the unsecured debt or equity markets given where their existing securities are trading. Accordingly, the two companies start exploring alternate paths:

  • SAIL, with flexibility under their debt documents (and a market receptive to lending only on a secured basis), hires bankers to help raise $500 million of secured (and priming) debt to raise their cash. Case closed, liquidity hurdle bridged.
  • BOAT, on the other hand, does not have the same flexibility as SAIL under its debt documents. Therefore, BOAT starts reaching out to creditors to negotiate some covenant relief and even goes as far as hiring bankruptcy advisors to prepare for a potential Chapter 11 reorganization. Enter market anxiety.

In this context, it’s helpful to imagine the relative market sentiment. SAIL gets maybe a few headlines regarding their debt raise and rating agencies stay at bay. Meanwhile, news articles on BOAT are discussing the need for a covenant waiver/distressed exchange/bankruptcy (with headlines probably in all caps), agencies are downgrading BOAT’s debt to CCC, it’s dropping out of indices, and clients are calling managers asking for updates. While BOAT is still the right choice, it’s now the contrarian choice and just became significantly more difficult against the backdrop of this negative narrative.

The moral here is that while we love and push for good covenants on new issuances, it’s easy to see how the same tight covenants can cause knee-jerk market reactions when fundamentals take a negative turn and debtors’ options are pushed to the threshold. In the example above, the SAIL unsecured bonds are now in a worse position as they sit below $500 million of secured debt, thereby increasing the 7.75% unsecured bond’s risk. In contrast, the BOAT bonds – despite facing a serious liquidity issue – are actually in a better position at the top of the capital structure, with correspondingly greater asset coverage and less risk.

Source: M&G, illustrative.

When things go wrong it is strong covenants that get us a seat at the table and allow us to protect our position – and, in instances like the above, potentially serve as identifiable pockets of investment opportunity with favourable risk/reward dynamics. This isn’t to say that covenants should be so tight that a company can’t manoeuvre, but there is definitely a reasonable medium. Fortunately, given market conditions right now, I would expect the negotiating leverage to start tipping more in favour of bond investors.

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Global Wages Take A Hit As Inflation Eats Into Paychecks

Global Wages Take A Hit As Inflation Eats Into Paychecks

The global inflation crisis paired with lackluster economic growth and an outlook…

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Global Wages Take A Hit As Inflation Eats Into Paychecks

The global inflation crisis paired with lackluster economic growth and an outlook clouded by uncertainties have led to a decline in real wages around the world, a new report published by the International Labour Organization (ILO) has found.

As Statista's Felix Richter reports, according to the 2022-23 Global Wage Report, global real monthly wages fell 0.9 percent this year on average, marking the first decline in real earnings at a global scale in the 21st century.

You will find more infographics at Statista

The multiple global crises we are facing have led to a decline in real wages.

"It has placed tens of millions of workers in a dire situation as they face increasing uncertainties,” ILO Director-General Gilbert F. Houngbo said in a statement, adding that “income inequality and poverty will rise if the purchasing power of the lowest paid is not maintained.”

While inflation rose faster in high-income countries, leading to above-average real wage declines in North America (minus 3.2 percent) and the European Union (minus 2.4 percent), the ILO finds that low-income earners are disproportionately affected by rising inflation. As lower-wage earners spend a larger share of their disposable income on essential goods and services, which generally see greater price increases than non-essential items, those who can least afford it suffer the biggest cost-of-living impact of rising prices.

“We must place particular attention to workers at the middle and lower end of the pay scale,” Rosalia Vazquez-Alvarez, one of the report’s authors said.

“Fighting against the deterioration of real wages can help maintain economic growth, which in turn can help to recover the employment levels observed before the pandemic. This can be an effective way to lessen the probability or depth of recessions in all countries and regions,” she said.

Tyler Durden Mon, 12/05/2022 - 20:00

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Metaverse comes in second place as Oxford’s word of the year

The term describing an internet-enabled virtual world lost to "goblin mode" in 2022 — "a type of behavior which is unapologetically self-indulgent, lazy,…

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The term describing an internet-enabled virtual world lost to "goblin mode" in 2022 — "a type of behavior which is unapologetically self-indulgent, lazy, slovenly, or greedy."

“Metaverse” has come in second to “goblin mode” as the Oxford University Press’ 2022 word of the year after the process was opened up to voters for the first time ever.

In a Dec. 4 announcement, Oxford Languages said the viral term “goblin mode” beat out “metaverse” and #IStandWith to become its 2022 word of the year. According to Oxford’s research, usage of the term metaverse “increased almost fourfold from the previous year in the Oxford Corpus,” driven in part by Facebook’s rebranding to Meta in October 2021.

Metaverse lost to goblin mode, which went viral in February, as it seemingly “captured the prevailing mood of individuals who rejected the idea of returning to ‘normal life’” following COVID-19 lockdowns being lifted in many areas. #IStandWith took third place in the contest, driven by social media hashtags including #IStandWithUkraine following Russia’s invasion of the country in February.

“As we grapple with relatively new concepts like hybrid working in the virtual reality space, metaverse is particularly pertinent to debates about the ethics and feasibility of an entirely online future," said Oxford Languages. "A worthy opponent to ‘goblin mode’, ‘metaverse’ gained voting traction with crypto communities and publications. We see the term continue to grow in use as more voices join the debate about the sustainability and viability of its future."

In the video pitch for ‘metaverse’ released in November, Oxford said the term dated back to “the science fiction novel Snow Crash by Neil Stephenson,” released in 1992.

More than 300,000 people cast votes between the three terms shortlisted by Oxford Languages.

Related: The metaverse is happening without Meta's permission

“NFT,” or nonfungible token, won Collins Dictionary’s contest for the word of 2021, while “vax” took first place as Oxford’s chosen word that the same year. The latest results seemingly represent a change in social media fervor around the crypto-related terms, which was reportedly falling in the first quarter of 2022.

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United Airlines stock has a 50% upside from here: Morgan Stanley

United Airlines Holdings Inc (NASDAQ: UAL) is keeping in the green on Monday in an otherwise down market after a Morgan Stanley analyst said 2023 could…

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United Airlines Holdings Inc (NASDAQ: UAL) is keeping in the green on Monday in an otherwise down market after a Morgan Stanley analyst said 2023 could be a “goldilocks” year for the air carrier.

United Airlines stock has upside to $67

Ravi Shanker sees upside in the airline holding company to $67 that translates to a near 50% premium on its current stock price.

He upgraded United Airlines stock to “overweight” this morning because he’s convinced that international travel will recover swiftly in 2023.

Earnings recovery post pandemic has kept pace with, if not led, peers and messaging has been very confident. We expect more normalised, just right conditions in 2023, stabilizing at level more favourable to earnings that market is pricing in.

Shanker expects continued leisure demand next year while business travel, he wrote, could exceed levels last seen before the COVID pandemic.

UAL has outperformed peers year-to-date

According to the Morgan Stanley analyst, prices will ease in 2023 as capacity returns. CASMxF trajectory was among other reasons cited for the bullish call.

United Airlines stock is roughly flat for the year at writing versus other major airline stocks in the red. Still, Shanker continues to see its current valuation as attractive. His note reads:

United Airlines Holdings Inc seems on track to exceed its 2023 guidance and to hit its 2026 guide issued eighteen months ago – something even the biggest UAL bulls may have considered difficult at the time.

In October, the Chicago-headquartered air carrier reported its financial results for the third quarter that handily topped Street estimates.

The post United Airlines stock has a 50% upside from here: Morgan Stanley appeared first on Invezz.

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