Hello, and welcome to The Credit Edge, a weekly markets podcast. My name is James Crumbie. I'm a senior editor at Bloomberg. This week, we're very pleased to have on the show Lisa Lee, who covers credit markets for Bloomberg News and is based in London. How are you, Lisa.
Fine?
Thank you, James, and thank you for so much for having me.
We're also delighted to welcome Stephan Kohochef, who focuses on shipping at Bloomberg Intelligence, also in London.
Hi, James, thanks for having me.
We'll be coming back to Stefan to talk about how container shipping is starting to fall apart after a major boom during the pandemic when we were all cooped up at home ordering stuff online. So do stay with us. But first, Lisa Lee with Bloomberg News, there's a lot going on right now with clos. You've been all over that story and that's some you know, for those who don't know, that's collateralized loan obligations. So let's start with the elephant in the room. What is a colo and why do we care?
So?
Colos are vehicles that buy leverage loans, and leverage loans are debts of junk rated companies that are floating rate, and they buy them and they repackage them and sell them as bond of different ratings that range from triple A, which is the safest all the way down to what's called colo equity. And there are big buyer in the leverage loan market and fuel issues for private equity deals and also for just like names like Burger King and names that you might know Flora in the UK.
So they buy loans, repackage them, sell them onto different investors. Is that yes, okay? So are they anything like the CDOs which blew up the financial system in two thousand and eight.
They're similar in that the way they securitize their assets very similar to CDOs. That's why they have a very similar name. Different about a CDO and the clo iss what goes into the securitized vehicle. These are corporate debt and considered a lot more safer than some of the dicey junk mortgage backed derivatives that were that caused the
financial crisis. So even though these are junk rated debt and more likely to go bankrupt than say your Apple or your Microsoft, they're still historically only about four percent defaults. Bankruptcies are fairly low and recoveries have been fairly high, so they're considered a lot safer, and very few clos have gone bussed, even during the financial crisis.
So you're writing right now that resets, why are they happening right now?
And what?
Just tell us what they are?
Okay, So resets are a type of refinancing that sort of became in vogue around twenty seventeen twenty eighteen, And what they do is they extend the life of a clo. Colo is supposed to be a finite vehicle that after a number of years, you sell the loans and you return cash to all the investors. Well, a reset, sort of like what you would consider a refinancing of a higher bond or an ig bond, extends the maturity and
also sets the bond pricing at a different level. And they've been pretty much dead in the water for the last past over a year since the war in Ukraine, just because it just didn't make sense anymore. But they've started to come back, and we've saw two regular traditional clos do these resets, and it's a real indication that markets are starting to heal from f a year of really painful of returns and eels.
So an investor who is you know, has owns a piece of this thing, this structure that repackages leverage loans from companies. They are essentially being told that they need to hold on to them for longer. Will they get paid more for doing that?
No, they actually get paid less. So that is the issues in the COLO. They take all the interest payments that a leverage loan makes and they press them into a different investors, so triple a investor will get a lot less than say a single be investor and an equity investor. And what a reset does is they take away the yield, some of the yield that bond investor gets and increase the returns of equity investors. So why
would a bond investor play along? Well, you have to look at the prevailing issuance and the yield that you can get in the market right now. What they can either say yes, will take a lower interest payment, or you can get out and you can try to find another deal that pays similar there and they really can't. So you have the option to roll, option to leave. Some do leave and try to put their money in different areas, but that is why they would take the lower interest rate.
So rates globally have gone up quite a bit. You can get an investment grade bond for five percent yield right now, which is, you know, much more than junk was yielding even a year ago. Why do you go into clasteralize loan obligations? I mean, do you get paid significantly more or is it just a diversification or is it what's the benefit?
You do get paid more than a corporate bond. So yes, everything has gone up. But so you look at a comparable triple A of a CLO and you look at a triple A IG bond, they've both gone up, but a CLO has gone up even further. They're floating rate for one so based off so for a youur bore and so far is past five percent right now. And on top of that you get a spread. Now, the reason why they pay more is because of the complexity.
You know what you're getting with an Apple bond, just the debt of Apple here, it's a pool of one hundred, two hundred, three hundred leverage loans and because of that you do get an extra spread. So if you're interested in a triple A with high yield.
Then you go into a CLO complexity. That's that's always been a problem in the past. You know, the most complex, least transparent markets to where they trable usually starts. How worried should we be about this kind of structured product right now? Is there trouble brewing with all of this repackaging of risky loans, and particularly at the time when you know the economy is slowing, rates are going up, these companies are going to be struggling to pay back at some point right.
It's interesting you mentioned that, James, because in the past, no less than the Treasury Secretary Janet Yellen, the Bank of England, the IMF has highlighted and flagged COLO as a possible area of systemic risk. And that not only that a problem in the leverage loan a CLO market could also transfer on and and destabilize the financial system. So it is an area of risk. So regulators are tracking it very carefully. They have so far performed well.
But if defaults spike up much higher and recoveries which is what investors get when a loan goes into bankruptcy, is significantly lower, then they could be an area of worry. As of yet, there is no hint that it's problems are happening, but it might. We never know.
We never know.
And the flip side, of course, is that you've mentioned the regulators and they're constantly throwing stones at this market and saying, you know, it's going to blow up, it's going to get us into trouble. But it never it never has.
Oh, it never has. That's the thing. So you have history, but you know history can only point to a future, and so for so much the market is constantly changing and evolving. So history is a good guy, but it is not a perfect eye.
So leverage loans on the on the underlying side, you mentioned a bit about defaults. I still think that we're underestimating them, given you know, the pressures from lower earnings and much much higher rates. You know, rates just jumped faster and more than anyone was expecting. That has to lead to some problems, right, I mean we have to think about losses and leverage loans at some point.
Yeah. So bankruptcys have hit a more than a decade high right now, and we're seeing more companies go and all companies that like sort of what we used to call zombie companies have layered on dead and use debt to keep going. They're probably gonna go bus is their time to actually sort of flush out the system. But still defaults are way below historical norms, so it's anticipated and we'll oh very much depend on the course of
trajectory of the economy. There's a lot of people who think now that the US is going to avoid a big recession. If we do that, then there's gonna be less stress. If we have a protracted recession because of raid hikes and the economy contracts, and we will have a much bigger problem. So it's very much dependent on the Federal reserve, inflation and whether we go into a recession or not, both in Europe and in the US.
So just to go back to this sort of one key subject of CLO resets, as you say, it kind of shows that credit conditions are getting easier.
You know.
On the one hand, I'd be interested in your thoughts on whether this is a global phenomenon, I mean beyond just you know, the US, is it happening elsewhere? And then secondly, is it an all clear signal? Should we just breathe a big sigh of relief that the credit markets aren't going to blow up and everything's just going to get better from here.
So the anticipation is it's happened in the US and then it probably will happen in Europe about six months time. So these CLO resets have what's called a non call to protect bond investors, So you can't do these resets for a period of time, usually a year and in Europe a year and a half. And so for the for the type of deal that makes sense to do a reset, you'll probably see them later in Europe. And
that's the point that it's healed from last year. So the second half of last year things were tighter and worse and things have improved, but it's not healed from the beginning of last year or pre Ukraine attack, I mean an attack on Ukraine, or before the raid hikes and before inflation really soared. So no, there's still a ways to go, and it might be a while before we get to that period where money as easy and
credit condition as easy as it works before. But perhaps you could say it maybe those conditions were too easy, in which we shouldn't go back to them.
But in terms of what this signals. I mean, it's not an all clear. We're not out of the woods.
Are Oh absolutely not. It's not absolutely not an all clear signal. It's just a hint that some things are improving.
So too early to break out the champagne way too early. So before we talked to Stefan Kobchev of Bloomberg Intelligence, what's the next big story to watch here on your beat, Lisa, I mean to expect a big revival in leverage loan issuance in September. Is there going to be some other big trend that you're looking at?
So we are hearing from PE sources and from M and A bankers that a small pipeline is developing, so we might see more M and A issuance coming up. And the lever's landmark is very much driven by M and A and LBO issuance. But as of VIAT the pipeline, it's July now, and for for the pipeline to see a big issue in boost in September, it already already
needs to be here. So I don't think we're going to see a big issuance burst in September, but perhaps later in the year we might see a moderate pickup great stuff.
Lisa Lee from Bloomberg News, thank you so much for joining us.
Thank you.
You can read all of Lisa's scoops on the Bloomberg terminal and of course at Bloomberg dot com. So, as I mentioned earlier, shipping is a massive global business that's done very well over the last few years, but it's really hitting a wall right now, and to walk us through it, we're very pleased to have with us Stefan Kochef, who covers the sector for Bloomberg Intelligence based in London. How's it going, Stefan?
Very well, Jane, thank you. So what's the.
Latest from container shipping company, Stefan? How are they doing well?
Container shipping companies have in the last three years. So during the pandemic, people shifted from spending from services to buying more goods online, So a big increase in demand for container shipping during the pandemic, which led to container shipping companies charging five to six times more for bringing a container box from China to let's say Long Beach
in the US or Rotterdam here in Europe. So if you fast forward to today, if freight rates are down and are nearing pre pandemic levels, and looks like metrics in the sector are set to deteriorate very quickly in the coming quarters. So historically this has been a very hotil cyclical and competitive industry, and we believe this deteriorating outlook may not be fully reflected yet in the bond markets that we follow.
So how come companies were able to charge six times the pre pandemic prices and that sounds inflationary? Can you break that down for us?
Sure? Very inflation indeed, well on the supply side only it's mainly about supplying demound to be honest. And the supply side of things, there is about six thousand container ships in the world, huge ships, by the way, the size of a skyscraper like the Empire State Building in New York, and it takes two to three years to build a new ship in order to add capacity, so
very inelastic fixed capacity in the short term. And then at the same time, on the demand side of the equation, during the pandemic, suddenly all of us wanted to have a new chair for our work from home setup, or an extra monitor, maybe toys for our kids. And beyond supplying demand, there was also a degree of boord, congestion, worker shortages, COVID heartbreaks, etc. So if Ikea or Nike or anyone else wanted their goods delivered quickly from Asia to Europe or the US, they had to pay up
to secure capacity on the ships. So companies in the sector transporting these containers were able to charge five six times more during the pandemic, and some of the companies we followed have had record profits, you know in terms of EHBEIT down free cash flow in the last few years. But the good news is that we are now back
to pre pandemic levels. So to give you some numbers, shipping a forty food container from Asia to Europe cost about one thousand to two thousand dollars pre pandemic, and this went up to ten thousand dollars at the peak of the pandemic and is now down to about fifteen hundred dollars. But yes, companies in the sector do have very strong balance sheets after three years of record revenues.
So what are they doing with all the money? I mean, we're infecting a lot of m and A or some debt reduction.
There has been some m and A, but not the horizontal MNA. One could expect we have not seen major consolidation in the industry, and this can be explained by the fact that there are limited synergies in having more container ships. So basically, instead of you know, buying a competitor, you could just go and order more ships to be
built for you. So instead, container shipping companies with all the cash generated, they have been diversifying their revenue streams away from containers, so by buying logistical companies for last mad deliveries, or investing in planes to offer air cargo, buying some software companies, etc. But overall small ballt on acquisitions.
There has been some debt reduction and dividend distribution. But I think the key takeaways that shipping companies are well aware of the cyclicality of the industry and they want to be more prudent as the cycle is turning and outlook is already worsening quite quickly in the industry.
Let's talk a bit about what changed the me. Why are you more negative on the outlook generally for the industry.
Well, I think it's again going back to supply and demand. So the big driver for me is the demand side of the equation. High inflation rates macroeconomic volatility, I mean lower disposable incomes. These are worries for all of us these days. Equally, as economies have reopened, people want to travel again and go visit family members in other countries, maybe as opposed to buying yet another piece of furniture
for their living room. So weaker demand for finished goods is key, But the supply side of the equation is also normalizing. So what container shipping companies have done with some of the record profits from the pandemic is to go and order new ships, thus increasing the actual available capacity. And usually newer ships are bigger and are more cost efficient, so everybody needs those ships in a very competitive environment.
So overall, weaker demand for shipping services and increased supply of ships, and we already see a bit of a price war in the industry going on at the moment. So good news for us and consumers, and bad news for the companies in the sector.
We believe, okay, probably the big guys will be okay, but there must be some smaller companies that maybe weren't so ready for the downturn, and you know, our risk of distress or you know, even default in the worst case when do you expect that in this industry?
Yeah, James, you're right. The industry is extremely fragmented. So maybe the top three players have about fifteen percent market share each and then there's a huge tale of around fifty percent or half of the companies operating an industry have under one percent market share. So indeed, the smaller companies may be most at risk, so those ones may
feel the pain first. But that being said, even if the bigger players that you know investors are more familiar with, such as mrsk or Hapagloyd, maybe they're okay in the short term, but this doesn't mean that there won't be any volatility in terms of especially the bonds that we follow here on the credit side of our research analysis.
Are there any names particularly do you worry about any companies that are struggling techne hard.
Well, I think it's maybe it's important to mention the actual volatility of the industry. So one of the companies we we cover CMA CGM, a French container shipping company. They've had their rating credit ratings at S and T go from triple C plus to double B plus, so a six notch upgrade in the last ten years. Cycle so it looks like, you know, we are past the peak of the cycle and coming quickly in the opposite direction.
So we haven't seen any downgrades yet, but we've already seen earlier this week ZIM, which is a number number ten player in the industry, had you know, to lower its guidance for twenty twenty three, So you know, a few cracks appearing already, and even the bigger players won't be immune to to potential downgrades in outlook or maybe credit ratings. So yeah, more of a cautious stance on the whole industry.
I guess at this point, what are the takeaways more broadly speaking seven for the credit markets or even for the economy of what's gone well on him? It seems that there was an unusual event that really inflated pricing and gave these companies a massive windfall through the pandemic. But are we kind of normalizing now back to prayer trend?
Is it just getting that to where we were, or is you know, is there some of the some of the takeaway from from the post pandemic shipping story that you're looking at.
Well, I think we if one looks at the balance sheets and the financial statements of these companies today and they will be amazed at how, you know, how little debt they have and how great of a free cash flow they have generated in the last twelve months. But you know, looking at the annual report of twenty twenty two doesn't give you the forward looking chair, especially in the a cyclical industry such as the container shipping industry.
So I think then the key point is that historically, shipping credits have always traded at a premium to other industrial names, which is something we don't see yet in the credit markets. So for instance, Marska I was mentioning earlier, a Danish company currently is one of the tighter names in the triple B space, and a similar story for Hapagloid, the German container shipping company, one of them tighter names
in the double B euro credit space. So overall, I think credit valuations will be exposed to two weak or fundamentals, especially in the second half of this year and next year when we expect important deliveries of new ships, as it takes two to three years to actually build a new ship, so very interesting and potentially volatile times ahead for the industry.
So the premium shipping gets over industrials in credit markets that you think could be eroded, it could be lost.
Well, yeah, if we look back at at historical trends, I mean the shipping industry in terms of credit spreads, they have always traded at the premium, and now they're trading tighter than than the rest of the market. So it looks like, you know, it doesn't doesn't seem right, but then it is explained by the very strong balance sheet and the very strong cashboard generation in the in the last couple of years. But maybe it won't. It won't last.
So maybe instead of trading tight, they're going to be trading flat or maybe even wider to the to the industrial. Okay, interesting, Okay, So one one last question stevan view on ESG, which is the big hot topic at the moment. These big ships, they burn a ton of diesel to move all these heavy containers around. You know they must be polluting. What's the industry's answer to reducing CO two emissions?
Well, the shipping represents about three percent of worldwide CO two emissions, but it actually also transports about seventy to eighty percent of finished goods worldwide. So in terms of part ton of goods transported. It has actually a rather low COEO two emission if we look at other logistical companies. But the industry is still polluting a lot, obviously, and I think it all comes down to green fuel availability.
Let's say, when it comes to batteries, it's very easy to electrify a small scooter or even a car, but when it comes to a truck or something much heavier, you all of a sudden need bigger batteries and heavier batteries, and it's not yet a viable solution. The technology is not there in terms of batteries. And then if you look at you know, biomethan or biogas, which are very promising hydrogen as well, potentially, but we don't know yet which will be the green fuel of the future, especially
for those big, huge content inner ships. And also the shipping industry will have to compete with the aviation industry and tracking industry for those green fuels. But I think the what's great is that the industry has a clear standards, clear guidance to reduce greenhouse gas emissions to zero by twenty to fifty and we've already seen the bigger players out there ordering some dual fuel ships, meaning that those ships can run on traditional fuels and also biofuels, which
reduce you two emissions by around seventy percent currently. But yeah, so the industry is slowly but surely moving or sailing, i should say, towards a greener future.
Thanks very much. Stefan Kovichev of Bloomberg Intelligence.
Thank you, James.
You can read all of his great analysis on the Bloomberg Terminal to check it out and hope to see you back on the show soon. Stefan, thank you, and thanks again to Lisa Lee from Bloomberg News. Thank you so much for having me read all of her great credit scoops on the Terminal and at Bloomberg dot Com. I'm James Crumbie. It's been a pleasure having you join us again next week on the Credit Edge.