Investors in travel and airline stocks are right to feel nervous after Thomas Cook’s recent share price collapse and disappointing results from airlines easyJet and Ryanair.
Thomas Cook’s bondholders will share that anxiety, with its euro-denominated bonds hitting a record low on Monday. The travel firm’s case is an extreme one as Thomas Cook is fighting for survival and its bonds are rated “junk”, but the example shows that the travel sector is not often a happy hunting ground for income investors.
Thomas Cook bonds have been downgraded by the main credit rating agencies this year following a number of profit warnings. Analyst Citigroup is recommending that bondholders swap £1 billion of debt for equity to keep Thomas Cook alive. This would wipe out equity shareholders because the shares are diluted in order to fund repaying the debt, explains Mark Benbow, a fixed-income manager at Kames Capital.
Bondholders may favour this idea as the value of their investments have plunged. The company’s 2023 bond, for example, launched with a par value of €100 but that has since fallen by more than 60%. This means someone who invested €1,000 at launch would now have just €394 left.
Exchanging the bonds at 50% of their par value in shares would mean bondholders will retain some of their investment rather than losing the lot.
At the heart of Thomas Cook’s problems is its debt position – net debt was £886 million in the first half of 2018 but this had jumped to £1.24 billion.
“Thomas Cook has got into trouble not because it has any near-term maturities that need refinancing, but because it needs banking lines to fund large working capital outflows in the first quarter of each year,” Benbow says. “Companies often default not because they aren’t making any money, but because they lose access to liquidity, which is needed to invest in the business.”
If Thomas Cook is to secure any further credit from banks it will likely be on the condition of a drastic restructuring of the company, such as selling of its airline business.
At issue Thomas Cook’s 2023 maturity bond had a coupon of 4% But due to the sharp fall in the price of the bonds, the yield on the 2023 issue is now an incredible 42%, reflecting the risk investors are attaching to the company.
Standard & Poor's on Thursday lowered its credit rating for Thomas Cook from B-, which means the bonds are "highly speculative" to CCC+, which signifies "substantial risks". Another two downgrades would take the bonds into default territory. The bonds were also put on a "negative outlook" by S&P, which warned of the danger that "Thomas Cook's performance could continue to deteriorate". Fitch Ratings also downgraded the bonds from B+ to CCC.
One could argue that its shareholders have had a rougher ride than bondholders though: shares were trading at 100p in 2016 and this week fell to a lowly 8.5p. We featured Thomas Cook as one of the biggest share price fallers of 2018 after it lost 80% of its value – at the time, shares were 32p.
According to Morningstar data, the fund with the highest exposure to Thomas Cook in our coverage is the one-star rated SLI UK Equity Recovery fund, whose portfolio has more than 4% invested in the travel firm.
Ryanair, easyJet and Tui
While Thomas Cook’s bonds are at the most risky end of the spectrum, those of Ryanair, for example, are considered a safer bet, according to ratings agencies.
Ryanair’s bond is rated BBB+ with S&P and Fitch, which means it is investment grade, with a stable outlook. At BBB+, the bonds are at the lower end of the investment grade though.
Ryanair's €750 million bond, which matures in August 2023, has a coupon of 1.125%, although the yield is currently much lower. The bond is also classed as senior debt, which means that in the event of the company going bankrupt, the bond’s owners rank above other bondholders and shareholders.
Ryanair is also an interesting case in that it doesn’t pay a regular dividend, so those looking to gain an income while investing in the airline’s prospects can either buy its bond, or a bond fund that holds them – or hold out for the prospect of a special dividend, which was last paid in 2015. Including special dividends, the stock yields more than 4%, similar to easyJet.
Ryanair has largely been seen by investors as a pure growth stock in recent years, with shares rising from €3.39 in 2010 to €18.5 in 2017. They have tailed off over the past year as a combination of factors, including Brexit, rising oil prices and weak consumer sentiment, have led to a re-rating of travel sector shares.
At last month's Morningstar Investment Conference, Columbia Threadneedle manager David Dudding identified Ryanair as one of a select band of companies with economic "moats", or competitive advantages. Dudding is the manager of Bronze-rated Threadneedle European Select. Morningstar analyst Mathieu Caquineau says: "The fund has displayed below-average volatility compared with peers thanks to the team’s preference for established franchise companies with low levels of debt as these stocks tend to exhibit lower share-price volatility."
Tui Has Junk Bonds Too
Germany’s Tui is one of Thomas Cook’s biggest listed rivals in the UK and has held its position in the FTSE 100 while its competitor slipped down the rankings into the FTSE 350.
Tui has not escaped the travel sector’s woes as it was put on “negative outlook” by ratings agencies S&P and Moody’s in April 2019. Still, Tui’s bonds are rated more highly those of Thomas Cook at BB, which means they are “speculative” rather than “highly speculative”, but still considered “junk” or “high yield” – that is to say non-investment grade. Tui has one bond available, with a coupon of 2.25%, with a maturity of October 2021.
Moody’s noted when it altered the credit outlook for Tui in April: “Though the long-term prospects for the travel industry remain favourable, the near-term market outlook is becoming increasingly challenging and is prone to disruptions, underpinned by Tui's two profit warnings in 2019.
“While the group's good overall liquidity position helps in dealing with headwinds, it will become weaker this year dragged down by one-off costs associated with the recently announced grounding of Boeing 737 Max 8.”
Benbow argues that Tui is in a better financial position than Thomas Cook, but that doesn't necessarily make its bonds attractive to investors.
easyJet’s shares, meanwhile, have not been immune to the weakness in the travel sector, falling from a record high of around £17 to just above £10 today. The company made a pre-tax loss of £272 million in the first half, but Graham Spooner, investment research analyst at The Share Centre, maintains his buy recommendation based on easyJet’s strong balance sheet and “attractive dividend yield” of more than 4%.
EasyJet makes up nearly 3% of the portfolio in the three-star rated Invesco UK Companies fund. Five-star rated BlackRock UK Equity has 1% of its portfolio invested in the budget airline, according to Morningstar data.
EasyJet’s €500 million bond matures in 2023 with a fixed coupon of 1.75%, higher than that of Ryanair and Tui but significantly lower than Thomas Cook. The easyJet bond is currently trading above its issue price, which means that anyone who bought the bond at issue and holds it to maturity will lock in a profit.
Around 1% of iShares UK Dividend ETF (IUKD) is invested in Tui. Morningstar gives this ETF a one-star rating. Analyst Dimitar Boyadzhiev says of the ETF and of income investing in general: "Investors can benefit from owning dividend-paying stocks but chasing yield can be dangerous. The highest-yielding stocks could be under financial distress and more likely to cut their dividends than their lower-yielding counterparts."
Kames’ Benbow argues that ultimately, income seekers should avoid the cyclical travel sector and seek out different sectors where companies are better capitalised, for example utilities.
