Lessons from the Virgin Collapse: Why it Pays to do Your Research and Diversify Your Portfolio
Overview
Virgin (ASX: VAH AU) 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 being 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.
As COVID-19 exacerbated, Virgin was grounded to a halt. The airline requested financial support from the Australian government and its shareholders, all to no avail. Once these options had been exhausted, 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.
In the Australian airline market, the most recent collapse was that of Ansett in 2001. The company went into liquidation with no cash at bank and members of Ansett Global Rewards were advised that their 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 as in the case of the Ansett collapse.
Lessons Learned
1. Credit ratings do not always accurately predict default risk
Prior to COVID-19, Virgin had an issuer rating of B+ and B2 by S&P and Moody’s respectively. 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 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 bond price had already fallen significantly. Consequently, the rating agencies may have underestimated the actual default risk once implications from COVID-19 on air travel were well and truly 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 of the par value of their bonds.
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 its nearest competitor (Qantas), which made it financially more vulnerable. Once the airline was grounded, it was significantly 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. 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 past 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
In this volatile environment, it pays to do the research and diversify one’s portfolio. Undoubtedly, having a high-yield allocation remains important, but it is worthwhile to examine holdings to ensure there are no red flags. Over the past ten 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 June 30 2021.
We expect the Australian high-yield market to continue to grow, and inevitably there will be both good and bad high-yield credits. This could be due to a variety of reasons: debt structure, balance sheets, the industry in which the company operates, covenants, or even whether the management is trustworthy. As an investor, a key priority is the management of idiosyncratic risk and ensuring an appropriate return on any and all risk.
A diversified portfolio is also of critical importance at this juncture. Owning a mixture of high-yield and investment-grade bonds can be good armour to have equipped, should unforeseen exogeneous events occur. 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, having 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 catastrophic holding. In the past, this has been difficult for some retail or non-professional investors, with most fixed income securities classified as ‘wholesale only’. However, it is possible now for these investors to access over the counter (OTC) wholesale fixed income securities which can enable this important facet of diversification to take place.
Let’s use Virgin as an example to illustrate this point:
- Imagine an investor had an equally-weighted bond portfolio of five names. Assume said investor bought Virgin six months prior to the collapse at close to par. If the recovery on the Virgin bonds ended up being 10 cents, the investor would have lost 18% of their capital.
- In the current environment, achieving a return of 18% on the remaining bonds in the portfolio to offset this loss would be incredibly difficult.
- 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, at close to par. If the recovery on the Virgin bonds ended up being 10 cents, they would have permanently lost 4% of their capital.
- Now 4% is still a heavy loss, but there is a good chance this loss would have been neutralised by the remaining bonds in the portfolio.
About Matthew Macreadie
Matthew’s current responsibilities include providing credit commentary/views on the bond market and specific issuers, with the aim of aiding investors to make better risk-return decisions.
Prior to joining Income Asset Management, Matthew spent eight years working as a Credit Portfolio Manager at Aberdeen Standard, where he was responsible for the credit portfolio construction and security selection across a wide range of financial and non-financial sectors.
Matthew began his career at KPMG working in Auditing and Assurance within the consumer and industrials group. Matthew holds a Masters of Applied Finance from Macquarie University and a Bachelor of Commerce from UNSW.
