The recent issue of bonds by US pet store owner PetSmart highlights the risks inherent in the high yield bond universe, with many deals priced for perfection when they come to market, according to Kames Capital.
Whilst a growing number of companies around the globe have turned to the debt markets for finance in the era of record low rates (and correspondingly low financing costs) many of the bonds issued do not have attractive risk/reward profiles.
Jack Holmes, co-manager of Kames’ High Yield Global Bond fund, says the recent travails for PetSmart highlight some of the risks that can catch investors out.
“The company recently borrowed a grand total of $2bn in order to purchase Chewy, an online pet retailer,” Holmes says.
“Theoretically, buying a digital retailer to capture customers moving online makes sense. But PetSmart’s acquisition of Chewy is negative for one very important reason – once all the operating costs are factored in, Chewy doesn’t actually make any money from the sales it generates.”
Holmes says this is an example of how easy it is to overlook the fundamentals.
“While PetSmart’s physical stores have very healthy profit margins, Chewy’s are negative. In effect what PetSmart is doing in buying Chewy is gaining loss-making online sales as a way to offset the loss of profitable offline sales,” he says.
“While there is a chance that the business can cut costs and restore some of that ever-decreasing pie of profit, the odds are stacked against them.”
In comparison, one business the team did get excited about when it issued high yield bonds was Ocado, the online grocer.
“Ocado’s online grocery business is highly profitable, with better margins than all of the listed offline grocers and a very strong structural growth story. On top of its own online success, the business is well-positioned to benefit from other supermarkets attempting to move online through its platform-provision business – which effectively allows other retailers to establish an online business without the huge operational headache that starting from scratch would entail.”
Since coming to the market Ocado’s bonds have delivered a positive total return, while PetSmart’s have sunk sharply, delivering a sizeable negative return. Holmes says this highlights the necessity of detailed research and a focus on fundamentals.
“Overall this is a story of fundamentals. One company is trying to defend an offline retail empire by taking on more debt and buying a loss-making online retailer, while another company has a steady and sensible long-term plan to expand its already highly profitable business even further,” he says.