COMMENT-Phones 4U debacle needs to be a wake-up call

Fri Sep 5, 2014 6:12am EDT

LONDON, Sept 5 (IFR) - Whatever happened to bond investors being the smartest guys in the room?

The logic behind the adage is simple: while every man and his dog can take a punt on stocks, the world of fixed income is largely open only to professional investors with expensive qualifications.

So this week how exactly did an institutionally-held corporate bond plummet 74 points in a single day?

Phones 4U's £205m payment-in-kind toggle note began Monday bid at a cash price of 87. But after the UK phone retailer announced that Vodafone would not be renewing its network agreement the notes plunged to just 30 in less than two hours.

Management hurriedly arranged a conference call for midday to reassure bondholders. Instead, after hanging up their phones, investors hit the sell button even more vigorously and the notes were soon as low as 13.

On the call management said they were "completely and utterly surprised" by Vodafone's decision. Yet if Phones 4U was so dependent on a single contract, why was the market marking the PIK as high as 87 to begin with?

The first canary in the mineshaft stopped chirping in January when the company was dumped by network operator O2. The following month, rival Carphone Warehouse began exploring a merger with Dixons, a firm slap in the face for Phones 4U given its retail partnership with the electronic goods retailer.

Most stunningly though, news broke in May that private equity owner BC Partners had written down the value of its stake in the company by a whopping 86% to just EUR7.7m.

BC Partners, of course, used the PIK along with £25m of the company's cash to fund a £223m dividend. The private equity firm reportedly put in less than £200m of its own cash when it bought the business in 2011.

"This was a classic suckers market; the only ones who prepared themselves for this were BC Partners," said one investor.

So how did investors get caught out so badly?

The answer lies in the collective delusion gripping the bond market: relative value.

At one point in May, Phones 4U's senior secured notes were bid at a 6.5% yield while the PIK was at 12.5%, an incredible subordination premium given the leverage differential was not huge.

This is the siren call of relative value.

Banks happily peddled this line. In early April, with the PIK bid at 94.5 to yield 11.47%, Barclay's research team wrote: "at current levels investors are adequately compensated for the execution risk given Phones4u's solid cash flow generation."

There's been an "if you like that, you'll love this" approach in credit for far too long now.

Like bank bonds? You'll love AT1!

Like corporate bonds? You'll love hybrids!

Like high-yield bonds? You'll love PIKs!

The fact is, a 600bp subordination premium counts for nothing when a business gets wiped out. Credit investors need to remember why they were hired: to do credit work. (Reporting by Robert Smith, editing by Alex Chambers, Julian Baker)