After years of unprecedented monetary stimulus, central banks are edging towards increasing interest rates from their historically low levels, with the US Federal Reserve (Fed) set to hike around the middle of next year, for the first time in almost a decade. No two cycles are precisely alike, but even so, in looking forward to the central bank tightening to come, it is useful to consider the experience of past hiking cycles. The chart below shows US short rates, together with the tightening which was priced at the start of each of the last four Fed tightening cycles, shown with dashed lines. We can see that historically the Fed has hiked by a little more than the market had expected, on average: when the Fed gets going, it has tended to keep going.
Easing and Hiking Cycles in USD Futures
However, that has not generally been the case for other central banks, like the European Central Bank, Bank of England, Reserve Bank of Australia and Bank of Canada, which have tended to hike by less than had been expected at the start of their tightening cycles. For example, the chart below shows UK short rates, alongside the tightening which was priced at the start of past Bank of England tightening cycles.
Easing and Hiking Cycles in GBP Futures
Why is it that the Fed has historically followed through on tightening, but other central banks often have not? Part of the reason is idiosyncratic: for example, the ECB hiked in July 2008 (ahead of the Lehman crisis) and April 2011 (as the Euro area crisis was building), and so ended up swiftly reversing both moves. But it is also partly because the US economy is so large and does not rely much on net trade for growth. That means the Fed is much more the master of its own destiny than the central banks of smaller and more open economies, whose growth outlook can be buffeted more easily by events elsewhere, and who may see monetary conditions tighten materially through a stronger exchange rate when they start hiking. It is in that light that we believe the Fed can indeed start tightening next year, even as the ECB is likely to continue to ease.
Last weekend European high yield investors woke up to find that the owners of UK mobile handset retailer Phones4U had halted trading and called in bankruptcy administrators. A household name on the UK high street with over £1bn in annual turnover was unable to continue as a going concern after mobile network operators Vodafone and EE both announced that they would terminate their relationship with the retailer effectively leaving the business with nothing to sell. On 1 September Phones4U’s two high yield bond issues experienced one of the largest one-day falls in the European HY market’s history. Why then was the market not pricing in these risks the day before the company’s senior secured notes dropped from 102.5 to 38? The most likely explanation is twofold – complacency and the call feature.
The Phones4U seven-year non-call three 9.50% 2018 notes were issued in 2011 when both rate curves and credit spreads were a good deal higher. In April of this year the notes became callable at the option of the issuer. With its 9.5% coupon looking extremely high at a time when similarly rated European credits were yielding 4.9%, many investors just assumed that the company would redeem the bonds at their 104.75 call price before the end of the year. This prevailing wisdom made the bond a popular holding in short duration high yield funds and among those investors looking for some ‘safe carry’. What could go wrong? If you had paid attention to a litany of troubling events, the answer was, “A lot, in fact.”
Last September, BC Partners, the company’s equity sponsors re-leveraged the business and de-risked their investment by paying themselves a dividend with the proceeds of a £200m payment-in-kind (PIK) note. Shortly thereafter, the company reported disappointing results and revealed that UK mobile operator O2 would no longer sell its handset contracts through Phones4U. In May this year Carphone Warehouse, the company’s only competitor, announced that it would merge with the UK’s largest electronics retailer Dixons with the latter rejecting a counter-offer from Phones4U. Following this, the papers reported that BC Partners had written down the value of its equity stake by more than 80% to just £7m. Despite each of these clear warning signs, secured noteholders could have exited their position for as much as 102.5 right up until the 29th of August. On Monday the 1st of September the bid had dropped to 62. Two weeks later it was 18.5 as EE followed Vodafone in terminating its relationship with Phones4U.
Those of us who avoided the name cannot claim to have known that the company’s demise would come so swiftly and suddenly. However it was not difficult for watchful eyes to infer that both the business model and balance sheet were highly vulnerable such that clipping carry in anticipation of an upcoming call was poor compensation for the risk of no call at all. Phones4U serves as a timely reminder that even in low default environments, fundamentals do matter.