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Five lessons for bond investors from the Virgin collapse

Virgin Australia was an Australian-based full-service airline providing both domestic and international operations. In the Australian domestic market, Virgin held the number two market share, with Qantas its main competitor. Prior to COVID-19, Virgin had an issuer rating of B+ and B2 by S&P and Moody’s respectively. Ratings are ranked from highest credit quality of AAA down to CCC and D for default.

Virgin was ground to a halt by the first wave of COVID-19. The airline requested financial support from the Australian Government and its shareholders, all to no avail. Then Virgin announced it would enter voluntary administration in April 2020. In August 2020, Virgin’s new owner, Bain Capital, confirmed that unsecured creditors - including bondholders – would receive between nine and 13 cents of the par value of their bonds.

Virgin traded under the code VAH before delisting.

Source: Market Index

In Australia, the most recent previous collapse was Ansett in 2001. The company went into liquidation with no cash at bank and Ansett Global Rewards frequent flyer points were worthless. Unlike Ansett, Virgin’s Velocity Frequent Flyer business was a separate entity and did not enter voluntary administration. Thus, the points were not worthless.

Lessons learned

1. Credit ratings do not always accurately predict default risk

Historically, Australian default statistics are much lower than global comparisons, partly due to our high-grade credit market. 

Per S&P’s latest annual global corporate default study, the B+ rating of Virgin implied a less than a 2% and 10% chance that Virgin would be downgraded to default over the next one and three years. The ratings of B+ and B2 were not downgraded until March 2020, after which the price of Virgin bonds had already fallen significantly. Consequently, the rating agencies may have underestimated the actual default risk once implications from COVID-19 on air travel were present in late 2019.

2. Debt structure matters just as much as the probability of a default

When assessing an expected loss on a bond, investors need to consider the probability of default as well as 'loss given default' (LGD). Investors can have different loss outcomes depending on whether their bonds are secured or not.

The debt structure of Virgin consisted of secured bank loans (secured by aircraft leases), unsecured loans, unsecured bonds (issued in AUD and USD), finance leases, letters of credit, and bank guarantees.

In this instance, priority creditors and employees were looked after first, thus diluting the overall recovery for bondholders to between nine and 13 cents in the $1.

3. Having a strong balance sheet can shield against low probability, high consequence events

Virgin went into COVID-19 with a weaker balance sheet and liquidity than Qantas, which made it financially more vulnerable. Once the airline was grounded, it was burning cash given its high operating leverage.

Unlike Qantas, Virgin had minimal cash on balance sheet and did not have the capacity to raise equity from its investor base, including foreign airlines who were themselves in trouble. Furthermore, unencumbered assets are generally only valuable when there is capacity to fly.

4. Cyclical credits can be incorrectly priced if based on forward-looking earnings

Virgin had consistently reported losses over the five fiscal years up until 2019. In October 2019, management provided commentary that earnings were expected to rebound over the next 12-24 months through productivity and cost base initiatives.

Using forward-looking earnings, Virgin had a stronger credit rating than the issuer rating of B+ and B2 implied by S&P and Moody’s respectively. In 2019, Virgin issued an ASX-listed 8% coupon 5-year AUD bond which fully priced this incremental improvement in credit fundamentals.

5. Relying on government support for an investment decision is fundamentally flawed

Many investors thought the Australian Government would come to the rescue and bail Virgin out. Hanging investment decisions on external support from a third-party can often end in tears.

What is more important for investors is to look for businesses that can absorb and withstand external shocks and are critical pieces of the economy. For investors, differentiating between essential and non-essential industries has become a key facet in this COVID-19 world.

Takeaways on the high-yield bond market

In this volatile environment, it pays to do the research and diversify a portfolio. A high-yield allocation remains valid for investors needing income, but watch for red flags. Over the past 10 years, the broader US high-yield asset class has delivered an annualised return of 7% against an equivalent investment-grade return of 4%. In addition, US high-yield has delivered a 15% return over the past year. This is based on data from the Bloomberg Barclays US corporate high-yield index as at 30 June 2021.

We expect the Australian high-yield market to continue to grow and inevitably there will be both good and bad high-yield credits due to a variety of reasons:

  • debt structure
  • strength of balance sheets
  • industry in which the company operates
  • covenants
  • whether the management is skilled and even trustworthy.

As an investor, a key priority is the management of idiosyncratic risk and ensuring an appropriate return on all risks.

Benefits of diversification

Owning a mixture of high-yield and investment-grade bonds in a diversified portfolio is critical to withstanding unforeseen exogeneous events. In a risk off environment, high-yield bonds have historically had a higher correlation to equity returns than their investment-grade bond counterparts offering less protection.

Furthermore, a large number of bonds in the portfolio can also help lower risk and stabilise returns, thus offsetting any loss of value that occurs from a loss on a catastrophic holding.

In the past, this portfolio diversification has been more difficult for some retail or non-professional investors, with most fixed income securities classified as ‘wholesale only’. However, it is possible now for more investors to access over-the-counter (OTC) wholesale fixed income securities which can enable greater diversification.

Let’s use Virgin as an example to illustrate this point:

  • Imagine an investor had an equally-weighted bond portfolio of five names, including a Virgin bond six months prior to the collapse at close to par. If the recovery on the Virgin bonds ended up at 10 cents in the $1, the investor would have lost 18% of their capital (that is, 20% of the portfolio was in Virgin and only 2% was recovered).
  • In the current environment, achieving a return of 18% on the remaining bonds in the portfolio to offset this loss would be almost impossible.
  • On the flip side, imagine an investor owned an equally-weighted bond portfolio of 20 names. In this instance, let’s assume they bought Virgin six months prior to the collapse, also at par. If the recovery on the Virgin bonds ended up being 10 cents, they would have lost 4.5% of their capital.
  • While 4.5% is still a heavy loss, there is a good chance this loss would have been covered by income on the remaining bonds in the portfolio.

 

Matthew Macreadie is a BondIncome Credit Strategist at Cashwerkz, a sponsor of Firstlinks. This article is general information and does not consider the circumstances of any investor. Please consider financial advice for your personal circumstances.

For more articles and papers from BondIncome, please click here.

 

7 Comments
Owen
July 31, 2021

For retail investors, investing in an ETF of investment grade corporate bonds rather than an "equally rated bond portfolio of 20 names" , would seem to be a lot simpler.
Otherwise, thanks for the article.

Peter
July 29, 2021

Ownership matters.
As a big time loser in Virgin, my lesson was that holding an airline debt where its shareholders were almost exclusively other airlines was a risk few appreciated… until an event that struck at the airline industry occurred.
In the high yield space we understand the secured banker position and assess risk after their position is factored. I, for one, never considered the possibility that major shareholders would walk away.
In the event they had no sensible slternstive.
Next time…

Anthony zantis
July 29, 2021

Virgin did not collapse, it still exists as a quality viable Australian Airline and business.

Ansett did collapse, which is why they no longer exist - since 2001.

Please don’t be like every other media reporting outlet, dramatising for headline grabs. It detracts from your credibility as a reputable organisation and information source. Be factual and report accordingly with integrity.

JC
July 30, 2021

Tell that to Virgin Australia share holders....

C
August 01, 2021

you are kidding , right ? where is their share price ?.......

David
August 04, 2021

They collapsed. I sold my shares for 5 cents each with a huge loss before they went under. There is now a new Virgin. Facts. This article is factual and has integrity.

Jonathan Rochford
July 29, 2021

A great wrap-up of what went wrong Michael. The ratings agencies relied too much on the owners to provide additional capital to an unprofitable businesses, in what is a notoriously cyclical industry. There was a clear warning that the Virgin bonds were poor value before they listed. https://www.narrowroadcapital.com/memos/credit-snapshots-november-2019/

 

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