To the uninitiated, credit ratings assigned by rating agencies may appear to be a continuum from AAA to C. But not to readers of the Vernimmen, who know that in the minds of all players involved, there is a big difference between ratings from AAA to BBB- (investment grade) and ratings of BB+ and below (below investment grade or high yield).

Lenders divide the world in two: the world of leverage and the world of investment grade or high grade. The rules, codes and players in these worlds are very different. Financial institutions, starting with banks and debt funds, are structured with separate teams dedicated to each segment.

It should be noted at the outset that the boundary between leverage and investment grade rarely matches with the theoretical boundary between BBB- and BB+. In the pre-crisis market (which was characterised by significant liquidity on the markets and therefore a trading capacity favourable to borrowers), the boundary was in the region of BB^[1]. In the course of March/April 2020 the boundary was closer to BBB (issuers with BBB- and below, with a few exceptions, have no access to the market).

This means that outside of crisis periods, many companies rated BB+ or even BB, although actually below investment grade, issue bonds on the markets as if they were investment grade (this is the case, for example, of Spie, Elis or Nexans). We talk about cross-over (their rating straddles the investment grade and non-investment grade worlds), but in reality, their bond documentation^[2] is largely comparable to that of a company rated BBB.

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Investment grade^[3] bond documentation is fairly simple and not very restrictive, with no covenants^[4]. The process to place the paper is also very simple and takes place in a few hours^[5] for an issuer known to the market on the basis of a framework document updated every year (EMTN programme). Although management meets frequently with investors, it is rare, except for first-time issuers or in specific situations such as acquisition financing, for management to hold a roadshow for a specific transaction. Documentation is highly standardised. The main investor protection clauses are:

• Cross default: a default observed on another debt of the company leads to a default of this bond issue (and therefore triggering redemption).
• Pari passu: bondholders of the same seniority rank must be treated by the issuer in the same order of priority.
• Negative pledge: the company is prohibited from pledging all or part of its assets to other bondholders (which de facto excludes bank lenders), unless it shares these securities with all bondholders of the same rank or gives them securities of equivalent quality.
• Change of control: Investors can demand repayment at par in the event of a change of control. Some documentation only opens this capacity if the change of control results in a downgrade of the borrower's speculative grade rating.

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The world of leverage is significantly more complex. The documentation is more constraining and there is much more of it. It includes a detailed description of the industry in which the company operates, its strategy and its financial performance. High Yield bonds are not issued under an EMTN programme, so the prospectuses include all the documentation individually.

The issue process is also a different kettle of fish. It is spread over several days or even weeks, with roadshows in different cities: London, Paris, Amsterdam, etc. and in New York, Boston, etc. if the issue is open to US investors (in Reg-S or 144A format^[6]). Investors are very sophisticated and carry out a real credit analysis before making an investment decision. The process is very similar to that of an IPO (especially if it is a first-time issue).

Documentation includes covenants and often collateral (shares in group subsidiaries). These are referred to as Senior Secured Notes (SSN) for secured issues and Senior Notes or Senior Unsecured Notes (SUN) for unsecured issues.

Investors will often get their hands on some of the company's assets. The structuring of the issue will depend on the assets available when the new issue is set up (bond investors do not share their collateral with other lenders). For example, Casino offered to give the high-yield bond investors of its last issue a large part of its real estate assets as security^[7].

It should be emphasised that the documentation is not intended to constrain the company in its day-to-day operations. Accordingly, in the world of leverage, covenants are "incurrence covenants", i.e. the limit ratios are not tested periodically, but only if certain events occur (acquisition, issue of new debt, etc.). Non-compliance with covenants does not lead to a default, but simply to the inability of the company to take the targeted action. Investors are therefore not directly protected by these covenants from a deterioration in the company's operating performance. Deterioration in performance only results in a very significant limitation on what the company can do. Default only occurs if the company can no longer honour its commitments.

The main covenants of a high yield issue are:

• Limiting the increase in indebtedness by means of financial ratios.
• Restricting certain payments (dividends, share buybacks, redemption of subordinated debt, etc.).
• Limiting certain asset disposals.
• Supervising transactions with sister companies or shareholders.
• Change of control, it should be noted that repayment is made at 101% of par and not at par as in investment grade documentation.
• Limiting acquisitions and mergers.
• Collateral taken on certain assets or at least the negative pledge.
• Managing dividends paid by subsidiaries.
• Managing guarantees given to other lenders.

All of these limitations are subject to lengthy negotiations on their scope and the exemptions provided for contractually.

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In markets that are particularly attractive for borrowers, a new type of documentation has emerged, accessible to the highest rated leverage borrowers, referred to as cov-lite (for Covenant Light). In this documentation, some of the covenants limiting indebtedness or restricting payments, limiting asset sales and transactions with the group are absent.

The breakdown between the different lenders is more complex than in the investment grade world (where lenders are often pari passu, i.e. at the same rank). A specific contract (intercreditor agreement, ICA) defines the relationships between the different lenders.

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Companies that have issued in investment grade format, but whose rating has deteriorated and need to issue in leverage format, are rather poetically referred to as fallen angels.

A company constrained by a leverage environment will sometimes experience this situation as necessarily temporary (following a bad economic situation or an exceptional acquisition); its objective will then be to improve its rating, or even to return to the investment grade universe. Investors are well aware of this fact and leave the door open to early redemption. Given the significant amount of work involved in making the investment decision, investors nevertheless define a minimum period (known as the "non-call" period) at the end of which the bond may be redeemed early, subject to a predefined early redemption penalty that decreases over time. These provisions are specific to the leverage universe. Indeed, for investment grade bonds, repayment is made at maturity^[8] and an issuer wishing to repay before maturity will have to carry out a bond tender offer^[9]; but the result is often less than optimal^[10].

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There is also a third world in bond issues, that of the "unrated". Some companies have deliberately chosen not to be rated by rating agencies. The reasons can be various: cost, low frequency of need for and/or access to financing that does not require a rating, pressure to follow certain rules of financial orthodoxy, etc. These companies (Bureau Véritas, Eurofins, Air France, Lagardère, Bolloré, Vilmorin, etc.) can nevertheless access the listed bond market. Investors will make their analysis and assign them an implicit rating. The interest rate paid will be slightly higher than that of the same rated company, as investors are often more constrained to invest in this segment and therefore demand a premium to compensate for the lack of rating. The majority of transactions are for maturities of less than 8 years.

The market windows during which unrated companies can issue are narrower. Investors prefer, when the market is turbulent, to have the buffer of rating agencies that have done extensive due diligence on the borrower. Companies that have made this choice nevertheless belong to the cross-over or investment grade world. Indeed, a group whose financial characteristics clearly link it to the non-investment grade world will not be able to issue on the markets without being rated.

Since mid-March 2020, the high-yield and non-rated markets have been totally closed, while the investment grade market has remained continuously (or almost) open with very high issue volumes.

If as of April 18 the MSCI world index, which reflects the evolution of stock markets worldwide, is down 17% from its December 31, 2019 level, marking a 22% rebound from its 2020 low, all stocks are far from having evolved in parallel, as shown in the graph above.

Thus, it seems to us that, so far, the financial market has experienced a sudden movement of asset repricing, rather than a panic movement that would have seen all values fall by more or less the same percentage.

Thus, the L'Oréal share behaves almost like the short-term bond of a highly rated issuer (AA, Sanofi), while the Europcar high-yield bond (B-) behaves like the share of a cyclical group (ArcelorMittal) with a fall in value of around 50%.

With Simon Gueguen, lecturer-researcher at CY Cergy Paris University

The collapse of Lehman Brothers in September 2008 remains to date the biggest bankruptcy in history (over $700bn in assets). It led to a global crisis in the interbank market, resulting in a contraction in the supply of credit. The banking crisis spread to borrowers. However, this contraction in supply was accompanied by reallocation, so that not all borrowers suffered equally. That is demonstrated by a recently published study[1] based on a detailed credit database on the Belgian market.

As in other countries, the Belgian interbank market saw a collapse (in this case a halving) of its volumes in the year following the bankruptcy. For this market, De Joghe et al have a complete credit register of the loans granted by banks before the crisis and in the years following it. In total, this includes more than 160,000 bank-business combinations. The reallocation effects measured are significant, leading the authors to conclude that some borrowers are "more equal than others" in the face of the crisis.

First, banks concentrated their focus on sectors in which they had a strong market share. For companies in these sectors, the negative impact of the crisis remains significant but is reduced by 22% (for a standard deviation of market share). In these sectors, the bank's bargaining power enables it to obtain higher interest rates (at equivalent risk). In a situation of credit scarcity, banks naturally cut the most profitable sectors last.

Second, they focussed on sectors in which they were specialised. In other words, their sectoral specialisation increased. The effect is less pronounced than the first but is still significant: the negative impact of the crisis is mitigated by 8% for a standard deviation in terms of specialisation. While market share is a source of bargaining power, specialisation (the share of a sector in the bank's total credit allocation) provides greater knowledge of the sector and the possibility of better identifying the companies to be financed. This effect is comparable to "relationship lending" discussed in the June issue of this newsletter. Sound knowledge of a particular borrower or of a sector of the economy in general encourages more credit because information asymmetries are reduced.

Thirdly, they shifted to less risky businesses. The race for quality is a classic phenomenon in the event of a crisis, and it is also observed for bank lending. The decline in the negative impact of the crisis is around 10% for a standard deviation in terms of borrower's risk (different measures of risk lead to the same result). An increase in risk aversion and/or the cost of risk for banks may explain the race for quality.

The study also shows that these reallocation effects persisted at least two years after the Lehman bankruptcy. In terms of timing, the most immediate reallocation shock was that which shifted credit towards sectors with large market shares. Since this was also the most pronounced effect, the lesson is clear: the priority for banks after Lehman's failure was to cut credit to firms in sectors where they did not have strong market power.

According to De Joghe et al, these results should prompt regulators to consider that there are positive aspects to the concentration and specialisation of credit institutions during crises. By increasing the ability of banks to extract income and to be selective when responding to requests for financing, these characteristics help to mitigate the effects of the crisis for the borrowers concerned.

^[1] O. DE JOGHE, H. DEWACHTER, K. MULIER and S. ONGENA (2020), Some borrowers are more equal than others: bank funding shocks and credit reallocation, Review of Finance, vol.24-1, pages 1 to 43.

When calculating your own TSR as a shareholder, you only have to take into account the cash flows you have received or disbursed, i.e. the purchase price and the sale price of the share, and any dividends paid in the meantime, but not share buybacks since you have not received them.

If you now want to do the computations at the level of a company, you can do the same for a share over a certain period of time. Alternatively, you could take the market capitalization, beginning of period, end of period, all dividends paid, and the amount of any share buybacks (which offsets the decrease in the final market capitalization from the beginning, since there are fewer shares outstanding and therefore a lower market capitalization at a constant share price). The result is much the same, since academic research has shown that share buybacks do not lead to a rise in share prices, contrary to widespread popular belief[1]

[1] For more on this point, see Chapter 37 of the Vernimmen.

Regularly on the Vernimmen.com Facebook page[1] we publish comments on financial news that we deem to be of interest.

Another negative price 

After negative share values during M&A transactions (such as the sale by Auchan of its Italian assets in 2019 for 2.5 years of losses), which is always hard for the layman to imagine, negative interest rates that were long thought impossible, here are now negative raw material prices.

The price of oil in the United States on April 20 was - $37 a barrel. Why what seems to be a market aberration? Because stopping and restarting a well is expensive, storage capacities are limited and saturated and because consumption has fallen sharply due to the health crisis, not to mention the market share wars.

Of course, this will not help the energy transition, but this low oil price is still good news for the European economies which are highly importing. If it could help the recovery a little bit...

Should companies applying for state financial support be prohibited from paying dividends or doing share buybacks?

It should be remembered that dividends in well-managed companies correspond to liquid assets that the company does not need to use in its business once it has reached a financial structure that corresponds to its objective. 

If, as a result of the sanitary crisis we are experiencing, a company has liquidity needs, it has to be consistent and eliminate or sharply reduce the dividends paid, which are in no way an eternal commitment set in stone, but a discretionary cash outflow.

Then, and only then, can the company turn to the public authorities for help. By ceasing to pay dividends, it will thus strengthen its solvency (or avoid weakening it) before increasing its liquidity and indebtedness thanks to the Public Authorities.[2]

It therefore seems to us financially (and politically) appropriate for the Public Authorities to make their financial assistance conditional on the cessation of dividend payments and share buybacks.

The dividend is neither an idol nor a taboo!

While we have never been for or against dividends, we are against their sacredness. And we are currently witnessing their re-sacralization. 

In the previous post, we welcomed companies that were cutting or sharply reducing their dividends because they suddenly had unexpected cash requirements due to the health crisis. And this is perfectly rational and logical, because the dividend is an excess of cash that is not useful to the company. Just as paying a dividend is not value-creating, stopping paying one for good reasons (because the company needs it in its business) is not value-destroying.

The position of AFEP (which groups together 110 of the largest private companies in France) advising its members who have opted for short-time working for part of their workforce to reduce their dividend to be paid in 2020 by 20% is difficult to understand. Either the large group has the necessary cash flow, without penalizing its operating activities, to pay a dividend that reflects its distribution policy and 2019 results, and in this case we see no reason why it would reduce it by 20%, as if it were a symbol to be addressed to public opinion. Either it cannot afford it, which is implied by his recourse to partial unemployment financed by the State, which allows it to avoid cash outlays, and in this case, we do not understand why a reduction of 20% and not 100%.

It is also hard to understand the rumour that a large group is thinking cutting its dividend when it is only marginally affected by the health crisis. Out of solidarity, there is a whisper of solidarity. But out of solidarity with whom? Abolishing the dividend will not increase the resources of hospitals, but will reduce the tax revenues of States, which are in great need of them at the moment.

It is also hard to understand the rumour that one other large group across the Rhine wants to maintain its dividend when its business is obviously significantly affected.

If there is a single dividend fetish, it is that the liquidity of the listed company must take precedence over that of the shareholders. Indeed, if the shareholder of the listed company needs liquidity, he or she can always sell the few percentages of his or her portfolio (which the dividend yield of large groups represents on average), whereas it is obviously almost impossible to carry out capital increases at the moment. 

This rule of common sense should, if necessary, simplify the debates within the boards of directors, which naturally need time, as we all do, to reach the best decision.

If turnover falls by 10% as a result of the coronavirus crisis, how much will profits fall?

This is a question that is easy to answer ... to a certain extent.

In each edition of Vernimmen we give a breakdown of the fixed and variable costs estimated by Exane for the main European listed companies. With an operating leverage of 2.7 estimated for 2019, a 10% drop in sales translates, on average, into a 27% drop in operating income and probably a little more for net income due to the fixed nature of financial expenses. 

That said, like the slope of a tangent to a hyperbola, operating leverage becomes distorted and increases the closer one gets to breakeven. For example, with the 10% drop in sales, operating leverage is no longer 2.7, but 3.2. A further 10% drop in sales would this time lead to a 32% drop in operating income. This is in line with the first break-even law, which states that the closer you are to break-even, the greater the sensitivity of earnings to a change in business.

However, many companies have higher operating leverage than listed companies because their margins are lower than those of the tenors of the stock market, which averaged an operating margin of 15.1%.

A doubly intelligent deal

On March 10, in a climate of rising tensions, a listed company, Digigram, for whom this status had become a handicap, synthetically sold its listing to a financial group wishing to be listed in order to offer liquidity to its shareholders and raise funds to develop its business in its sector adored by stock market investors, green energy.

The transaction had been prepared for a long time. Digigram contributed all its assets and liabilities to a wholly-owned subsidiary. This subsidiary was then acquired by Digigram's management and main shareholders, who financed themselves by selling their Digigram shares, which had become a pure shell, to Evergreen which thus took control of it. In a short while, after the minority shareholders of Digigram have paid the same price, Evergreen will be absorbed by Digigram and will thus be listed, which is a performance in the current market. . 

As for the new Digigram, which has become unlisted, nothing has changed for it from an operational point of view except that it can raise equity capital without having to pay 25% of the funds raised (sic) in various fees. And that changes everything!

Like what goes (the Stock Exchange) to some (groups) is really not made for others (SMEs). In short, in this field too, everyone must find the right shoe for him or her[3].