Why healthcare and telecoms stand out in US high yield credit
Why healthcare and telecoms stand out in US high yield credit
Chris Lau and David Rowe discuss the US high yield credit market and why they see opportunities in some healthcare and telecoms bonds.
One of the key consequences of the increase in US rates has been the strong growth in yields offered by USD bonds. US high yield credit is no exception, with the yield of the ICE BofA US High Yield Index approaching 8.1%.1 Looking at the last 10 years, this level is quite attractive. However, a large component of the yield is simply coming from the risk-free rate.
Credit spreads are certainly less compelling. US high yield credit is trading at a historically tight level, but a closer look into this space reveals areas of opportunity. Strong demand from investors has supported valuations for bonds with higher ratings, leading to a meaningful tightening. Thus, we see limited potential for additional upside in generic BB credit.
The interesting exception to this 3-year tightness is the portion of the market with a lower rating. CCC-rated bonds, for example, show a bifurcation between potential upgrade candidates (those with no imminent default risk) and those with impending events that could very likely result in defaults. Across some B-rated and CCC-rated bonds we have found several attractive opportunities, specifically in the healthcare and telecommunications sectors.
Companies that have been or are inflecting from an operational perspective, and those that have highly valuable assets are especially interesting to us.
Credit spreads are certainly less compelling. US high yield credit is trading at a historically tight level, but a closer look into this space reveals areas of opportunity. Strong demand from investors has supported valuations for bonds with higher ratings, leading to a meaningful tightening. Thus, we see limited potential for additional upside in generic BB credit.
The interesting exception to this 3-year tightness is the portion of the market with a lower rating. CCC-rated bonds, for example, show a bifurcation between potential upgrade candidates (those with no imminent default risk) and those with impending events that could very likely result in defaults. Across some B-rated and CCC-rated bonds we have found several attractive opportunities, specifically in the healthcare and telecommunications sectors.
Companies that have been or are inflecting from an operational perspective, and those that have highly valuable assets are especially interesting to us.
US healthcare normalisation after COVID
It is well known that Covid severely disrupted the healthcare industry. Two areas of particular relevance are the increased expenditure on contract labour and the change in payer mix that resulted in reduced profitability. With both factors normalising and an increase in state supplemented healthcare programmes, we have anticipated a strong rebound for the sector. This continues to be the case today. This is evidenced by the US HY Healthcare Index delivering 300bps of outperformance YTD, on a total return basis, versus the broader high yield index, thanks to meaningful spread compression (see charts below).
US Cash Pay Healthcare HY vs. US HY Spread Differential
Source: Jupiter, Bloomberg. As of 31.05.2024
Another important observation is that in recent months individual hospitals have changed hands with many achieving considerable valuations, not currently reflected in the price of publicly traded assets. Hence, we believe that the market underappreciates and undervalues credits where operators own a large number of highly valuable hospital assets.
With the above considerations in mind, we see Community Health Systems as an attractive opportunity. Since the start of 2019 Community Health has pruned its portfolio of facilities. Despite this, net revenue per facility increased by +35% over the same period. The proceeds from these asset sales have mostly been used to pay down debt since Q1 2019. With a pipeline of additional disposals coming to act as a value recognition catalyst, the longer dated first lien notes (yield in excess of 10%) look attractive.
Prime Healthcare is another example of a company that shifted its focus to regain ownership of its real estate. The company has bought out nearly all its lease obligations over the last few years. Most recently, it disposed of a hospital in California that was contributing negative EBITDA to the overall business. Using the proceeds, the company repurchased an asset that generated meaningful EBITDA in 2023. We have held the senior secured notes for some time in several funds and see further upside potential as the company seeks to refinance and term out its maturity profile.
The US presidential vote is in November, and early indications suggest that unlike in previous elections, healthcare reform is less of an agenda item this time. Additionally, under the Biden administration, the Federal Trade Commissioner, Lina Kahn, has taken a stance that is somewhat against M&A and private equity investment. If Trump is elected, it is plausible that this approach will shift. We closely monitor these considerations as election day approaches.
With the above considerations in mind, we see Community Health Systems as an attractive opportunity. Since the start of 2019 Community Health has pruned its portfolio of facilities. Despite this, net revenue per facility increased by +35% over the same period. The proceeds from these asset sales have mostly been used to pay down debt since Q1 2019. With a pipeline of additional disposals coming to act as a value recognition catalyst, the longer dated first lien notes (yield in excess of 10%) look attractive.
Prime Healthcare is another example of a company that shifted its focus to regain ownership of its real estate. The company has bought out nearly all its lease obligations over the last few years. Most recently, it disposed of a hospital in California that was contributing negative EBITDA to the overall business. Using the proceeds, the company repurchased an asset that generated meaningful EBITDA in 2023. We have held the senior secured notes for some time in several funds and see further upside potential as the company seeks to refinance and term out its maturity profile.
The US presidential vote is in November, and early indications suggest that unlike in previous elections, healthcare reform is less of an agenda item this time. Additionally, under the Biden administration, the Federal Trade Commissioner, Lina Kahn, has taken a stance that is somewhat against M&A and private equity investment. If Trump is elected, it is plausible that this approach will shift. We closely monitor these considerations as election day approaches.
Telecommunication: higher rates and capex drives volatility
Telecommunication is another area of interest. While this is typically a more defensive sector there is some level of cyclicality. As the industry evolves there is a period (every 10 or so years) when the capital expenditure demands increase exponentially. Currently this is owed to the dynamic move to fibre from outdated cable and broadband infrastructure. This is a very costly process that companies must undergo to stay relevant. And, as with any shift in market positioning, there is the opportunity to profit from this change.
The rate hiking cycle coinciding with the capex investment cycle has placed substantial stress on US telco capital structures. That said, we don’t consider the industry to be permanently impaired. Subsequent to inflection in these cycles, we think there is material value in these assets. So, despite the market giving these companies at extremely low valuations, by historical standards, we think this represents a compelling opportunity.
The rate hiking cycle coinciding with the capex investment cycle has placed substantial stress on US telco capital structures. That said, we don’t consider the industry to be permanently impaired. Subsequent to inflection in these cycles, we think there is material value in these assets. So, despite the market giving these companies at extremely low valuations, by historical standards, we think this represents a compelling opportunity.
`Haves’ and `have nots’
Another key consideration in this sector is customer satisfaction scores; these play a vital role in the success of a company. In distinguishing between the ‘haves’ and ‘have nots’ within this sector, we believe NPS (Net Promoter Scores) and increasing fibre penetration rates allude to differentiated outcomes amongst operators.
Additionally, there has been an emergence of a new source of liquidity where fibre providers are able to securitise their mature fibre footprint at a relatively low cost of capital. This provides companies with significant runway to reach buildout targets that would otherwise be unattainable. We are closely monitoring a number of the issuers in the space for potential inclusion across some of our portfolios.
Additionally, there has been an emergence of a new source of liquidity where fibre providers are able to securitise their mature fibre footprint at a relatively low cost of capital. This provides companies with significant runway to reach buildout targets that would otherwise be unattainable. We are closely monitoring a number of the issuers in the space for potential inclusion across some of our portfolios.
1 Source: Bloomberg as of 10.06.2024
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