Q3 2021 Commentary - A Change Is Gonna Come

October 29, 2021

Throughout history, pandemics have created structural changes: the fall of empires, the rise of Christianity, the collapse of economic systems, peace agreements among nations and societal introspection

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A Change is Gonna Come1

Throughout history, pandemics have created structural changes: the fall of empires, the rise of Christianity, the collapse of economic systems, peace agreements among nations and societal introspection.2 Similarly, COVID-19 has laid bare social and economic inequalities, exacerbated political tribalism and revealed global weakness such as the vulnerability of the international supply chain. COVID-19 has also accelerated technological change affecting the way we work, the way we think and our priorities.

We have been busy during this period of powerful change looking for mispriced investments and have found them in some interesting asset classes.

SPACs (for those interested in a basic primer on SPACs please see the appendix)

During the COVID-19 pandemic, Special Purpose Acquisition Companies (SPACs) have evolved from a backwater niche to a bona fide stand-alone asset class.3 We contend that SPACs purchased below trust value with the intent to hold them to liquidation or redeem upon a business combination (whichever happens sooner) are an attractive short-term fixed income alternative.

According to SPACinformer.com4, there are 461 SPACS with $134 billion of trust value seeking merger partners and 120 SPACs with $35 billion of capital with pending transactions at quarter-end.5

Special Purpose Acquisition Companies (SPACs) Trust Value ($millions) and Yield to Liquidation Date (%) - October 1, 20215

CB Graph

The subset of SPACS with a yield to liquidation greater than 2.0%, referenced in the chart above, is comprised of 229 companies with $53.6 billion of trust value. As a group these SPACS had a 2.4% yield to liquidation and time to liquidation of 1.1 years, which represents a 227-basis point spread to a comparable-maturity U.S. Treasury bond.5

Should a SPAC consummate a transaction substantially sooner than its liquidation date, the realized return will be significantly greater for investors that exercise the redemption right. For example, if all SPACs currently seeking targets closed transactions within the next six months, the yield to redemption date will be in excess of 4.0%. Additional upside may occur should the market become enthusiastic about an announced deal and drive the stock price above the trust value, allowing an exit through the sale of shares instead of redemption.

For example, in March of this year we purchased for the CrossingBridge Low Duration High Yield Fund, a position in Gores Guggenheim, which we exited in July.

Gores Guggenheim Inc. (GGPI, GGPIU)6 – On March 22, 2021, Gores Guggenheim, a SPAC, completed a $750 million IPO by issuing 75 million units, at $10.00 per unit, consisting of one share and 1/5 of a warrant with a strike price at $11.50 per share. Founded in 1987 and with experience in over 120 acquisitions, Gores has an excellent reputation that led us to believe that they would be successful in identifying a strong investment target and completing a business combination. Thus, with investment in SPACs a component of the strategy of the CrossingBridge Low Duration High Yield Fund, we participated in the SPAC’s IPO. In the weeks after the IPO, we sold a small portion of the position at a modest gain. With the units trading around the IPO price, minimal downside versus the liquidation price and optionality in the event that Gores announced an attractive acquisition, we retained the majority of the position. On July 8, there were rumors that Gores Guggenheim was going to merge with Polestar, the Volvo-backed electric vehicle producer, driving the unit price up above the trust value even though investors had no confirmation that a deal would actually occur or, if it did, whether the valuation would be attractive. Opportunistically, we sold more than half our position the next day and the balance the following week. Thereafter, the unit price fell back toward trust value, only briefly bouncing back toward the July high on September 27 when the deal with Polestar was officially announced. Subsequently, the unit price has fallen back below the prices at which we sold. Our belief is that many SPACs continue to be mis-priced and consequently represent a significant allocation in both funds.

CB Table

Investors desiring a stand-alone fund dedicated to pre-merger SPACs as an alternative to short-term fixed income allocations should consider our recently launched ETF, CrossingBridge Pre-Merger SPAC ETF (SPC).

ESG Fixed-Income Market

According to J.P. Morgan,7 European corporate debt issuers actively pursuing environmental, social and governance (ESG) principals are often rewarded with a lower cost of capital whereas the same phenomenon is not yet prevalent in the U.S. This appears, to us, to be another market mis-pricing and future opportunity.

 

Industrial BBB Credit Spreads vs. ESG Scores7

The graph above illustrates the difference in the pricing of ESG-sensitive credit in Europe versus the U.S. Credit spreads of BBB quality European credits narrow as ESG scores improve. This sharply contrasts with the U.S. where the credit spreads of BBB credits do not appear to be correlated to the ESG score, and counterintuitively, the credits with the best ESG scores in the U.S. yield 14 basis points more than those with lower scores. Although we respect the objectives of ESG-mindful companies and the discipline required to execute these elements, credit quality must also be taken into account when determining the appropriate spread.

Many consider the Nordic financial markets as leaders in adopting ESG principals and standardization as well as a model to observe investor behavior. As one of the largest U.S. investors in the Nordic corporate credit market, we have witnessed firsthand the tightening in credit spreads for ESG-friendly companies when investors emphasized adherence to ESG standards.

Leroy Seafood Group (LSG NO, LSGNO)8 – Founded in 1899 and publicly traded in Norway, Leroy Seafood Group is a leading farmer of salmon and trout and producer of wild-caught whitefish, primarily cod. The company’s fish farms are primarily located along the coast of Norway and Scotland, with value-added processing and distribution in nine other European countries, Asia and North America. The company holds the second largest salmon farming license in Norway and 30% of the total quota license for the Norwegian wild-catch whitefish trawler fleet. The company is benefitting from growing consumer interest in fresh salmon and cod throughout Europe. Demonstrating its alignment with the Green Bond Principals published by the International Capital Markets Association in June 2021, the company established its Green Finance Framework in August 2021 and received a certification of its dedication to sustainability from DNV Business Assurance Norway. With pro-forma net leverage less than 1.8x, a BBB rating from the Nordic Credit Rating Service and endorsement of the company’s dedication to “green” principals, the company, in September 2021, issued NOK 500 million of 3.35% senior unsecured bonds due 2031 to fund investment in new and ongoing “green” projects. At this yield, the bond provided a yield-to-maturity that was 200 basis points in excess of the Norwegian 10-year government bond and 80 basis points greater than a U.S. BBB corporate bond with, in our view, better credit quality. The CrossingBridge Responsible Credit Fund participated in this new issue.

ESG Global HY Issuance9

Globally, ESG equity funds have grown from $299 billion at the end of 2017 to approximately $1.6 trillion in August 202110, a cumulative annual growth rate of approximately 67%. However, the global fixed income market has been slower to adopt ESG strategies with assets growing from approximately $350 billion in early 2018 to an estimated $500 billion in early 2021 for a cumulative average growth rate of less than 13%.11 As shown above, growth of global high yield issuance of ESG bonds has been robust over the last two years, although the issuance amount has been quite small relative to the whole high yield market. Generally, the U.S. has lagged Europe in ESG adoption, and the ESG-friendly high yield debt market is even further behind and in early stages. We are hopeful that ESG standardization and independent scoring will encourage broader mindfulness among corporate issuers rather than simply be a catalyst for one-off “green” projects. Then, the market should boom.

Final Reflections

In 2012, Samuel K. Cohen, Professor of Medieval History at the University of Glasgow, wrote:

No matter how contentious the underlying social and political circumstances, how high the body counts, how gruesome the signs and symptoms, how fast or slow the spread or course of a disease, pandemics did not inevitably give rise to violence and hatred. In striking cases they in fact did the opposite, as witnessed with epidemics of unknown causes in antiquity, the Great Influenza of 1918–19 and yellow fever across numerous cities and regions in America and Europe. These epidemic crises unified communities, healing wounds cut deep by previous social, political, religious, racial and ethnic tensions and anxieties.12

Anticipating change and prepared to adapt,

David K. Sherman and the CrossingBridge Team

 

 

APPENDIX

A special purpose acquisition company (SPAC) is a company with no commercial operations that raises money from investors through an IPO for the sole purpose of acquiring an existing private operating business within a specific period of time (generally up to two years). SPACs are sometimes called ’blank check companies’ because, at the time of the IPO, investors do not know the business in which the sponsor will choose to invest, although the sponsor’s track record of investment in certain industries or stated areas of interest may provide an indication. IPO proceeds are be placed in a trust account, typically invested in U.S. government securities, money markets, and cash. This trust account is held for the benefit of the SPAC’s common shareholders until it is used to fund a successful business combination, or until it is returned to investors once the SPAC is liquidated because it failed to consummate a merger. A unique feature of SPACs is that SPAC common shareholders have the option to redeem their shares for their pro rata interest in the trust should the investor choose not to participate in the newly formed company. In many cases, the SPAC sponsor may overcollateralize the trust at the time of the IPO, meaning that there is more money in the trust than the IPO proceeds raised with the excess cash held for the benefit of SPAC common shareholders in the event of redemption or liquidation. If SPAC common shares are purchased at or below trust value, we believe the opportunity exists to earn an attractive yield to liquidation with minimal principal risk. As a result of the shareholder-friendly redemption feature of SPACs, should a SPAC successfully pursue a business combination, an investor’s realized rate of return will likely be higher due to the shortened maturity of the security. Furthermore, a SPAC pursuing a business combination that is positively received by the market may result in equity upside above the trust value.

SPACs are commonly issued at $10 per unit with a unit consisting of one share and a warrant or fraction of a warrant. The warrant allows its holder to purchase a specified amount of common stock at a specified price for a specified time; typically, the exercise price is $11.50 and the warrant has 5 years until expiration. On average, 55-60 days following the IPO, SPAC unit holders may elect to separate their units into shares and warrants that will trade as standalone securities. Some investors may sell the warrants to reduce their initial cost, thereby enhancing the yield to liquidation or yield to redemption. Other investors may choose to sell their SPAC common shares to create a portfolio of long-term, out-of-the-money options of future business combinations. And, some investors may choose to keep the units, or the combination of SPAC common shares and warrants, to replicate the characteristics of a convertible bond.

Following their IPOs, SPAC units typically trade below their trust value. In the speculative period between Labor Day 2020 and St. Patrick’s Day 2021, SPAC units often traded far in excess of trust value, but that enthusiasm has since diminished.

 

Endnotes:

1 The song was written and performed by American singer-songwriter Sam Cooke and released in February 1964 on the Ain’t That Good News album. Becoming an anthem of the Civil Rights movement, the song was selected by Rolling Stone magazine in September 2021 as #3 among the 500 Greatest Songs of All Time.

2 For those interested in learning more about these topics, we recommend Pandemics That Changed History, History.com, December 21, 2020 https://www.history.com/topics/middle-ages/pandemics-timeline

3 The SPAC market has grown from 59 SPACs raising $14.0 billion in 2019 to a cumulative 670 SPACs raising over $200 billion in 2020 and 2021 (year-to-date).4

4 SEC and company filings through 9/20/21

5 www.SPACinformer.com SPACinformer.com is owned by an affiliate of CrossingBridge Advisors LLC.

6 The position in the Gores Guggenheim SPAC represented a 0.16% position in the CrossingBridge Low Duration High Yield Fund as of 6/30/21 and a 0.00% position as of 9/30/21.

7 Oceans Apart – Assessing the ESG Cost of Debt in Global Credit, J.P. Morgan, June 9, 2021. ESG Score refer to a numerical measure of how an individual security is perceived to be performing on a wide range of environmental, social and governance (ESG) topics.

8 The position in the Leroy Seafood Group represented a 0.00% position in the CrossingBridge Responsible Credit Fund as of 6/30/21 and a 1.33% position as of 9/30/21.

9 The Sustainable Finance Movement, Deutsche Bank, June 7, 2021

10 ESG Matters – Quant Edge, Bank of America, May 4, 2021

11 ESG Integration for DM Corporate Credit Analysis, Morgan Stanley, August 16, 2021

12 Pandemics: waves of disease, waves of hate from the Plague of Athens to A.I.D.S., Samuel K. Cohn, https://www.ncbi.nlm.nih.gov/pmc/articles/PMC4422154/

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Definitions: The S&P 500, or simply the S&P, is a stock market index that measures the stock performance of 500 large companies listed on stock exchanges in the United States. The ICE BOFA INVESTMENT GRADE/Coporate Bond index tracks the performance of US dollar denominated investment grade rated corporate debt publically issued in the US domestic market. The ICE BOFA 1-3 Year Corporate Bond INDEX is a subset of the ICE BofA US Corporate Bond Index tracking the performance of US dollar denominated investment grade rated corporate debt publicly issued in the US domestic market. This subset includes all securities with a remaining term to maturity of less than 3 years.. The ICE BOFA HIGH YIELD INDEX tracks the performance of US dollar denominated below investment grade rated corporate debt publically issued in the US domestic market. the ICE BofA BBB US Corporate Index, a subset of the ICE BofA US Corporate Master Index tracking the performance of US dollar denominated investment grade rated corporate debt publicly issued in the US domestic market. This subset includes all securities with a given investment grade rating BBB.  the ICE BofA US Corporate BB Index, a subset of the ICE BofA US High Yield Master II Index tracking the performance of US dollar denominated below investment grade rated corporate debt publicly issued in the US domestic market. This subset includes all securities with a given investment grade rating BB.EBITDA is A company's earnings before interest, taxes, depreciation, and amortization is an accounting measure calculated using a company's earnings, before interest expenses, taxes, depreciation, and amortization are subtracted, as a proxy for a company's current operating profitability.  A basis Point (BP) is 1/100 of one percent.  Pari-Passu is a Latin term that means 'on equal footing' or 'ranking equally'. It is an important clause for creditors of a company in financial difficulty which might become insolvent. If the company's debts are pari passu, they are all ranked equally, so the company pays each creditor the same amount in insolvency.  LIBOR is the average interbank interest rate at which a selection of banks on the London money market are prepared to lend to one another.  YIeld to Maturity (YTM) is the total return anticipated on a bond (on an annualized basis) if the bond is held until it matures. YIeld to Worst (YTW) is a measure of the lowest possible yield (on an annualized basis) that can be received on a bond that fully operates within the terms of its contract without defaulting. Free cash flow (FCF) is the cash a company produces through its operations, less the cost of expenditures on assets. In other words, Free Cash Flow is the cash left over after a company pays for its operating expenses and capital expenditures. Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates.  DEBTOR-IN-POSSESSION (DIP) FINANCING is is a special kind of financing meant for companies that are in bankruptcy. Only companies that have filed for bankruptcy protection under Chapter 11 are allowed to access DIP financing, which usually happens at the start of a filing. DIP financing is used to facilitate the reorganization of a debtor-in-possession (the status of a company that has filed for bankruptcy) by allowing it to raise capital to fund its operations as its bankruptcy case runs its course.  YIELD TO CALL (YTC) refers to the return a bondholder receives if the bond is held until the call date, which occurs sometime before it reaches maturity. The Dow Jones Industrial Average, Dow Jones, or simply the Dow, is a price-weighted measurement stock market index of 30 prominent companies listed on stock exchanges in the United States.  The Nasdaq Composite is a stock market index that includes almost all stocks listed on the Nasdaq stock exchange.  Along with the Dow Jones Industrial Average and S&P 500, it is one of the three most-followed stock market indices in the United States.  An amend & extend agreement is an agreement between a lender and borrower where the terms of the credit agreement are amended, and the maturity is extended. Loan-To-Value (LTV) is a ratio that measures the amount of a loan outstanding versus the value of an ASSEt. A yield curve is a line that plots the yields, or interest rates, of bonds that have the same credit quality but different maturity dates. A “normal” yield curve is upward sloping as it reflects compensation for accepting the risks associated with longer maturities (i.e. mark-to-market and inflation in the case of Treasury securities). A yield curve in which shorter dated maturities have higher yields is said to be “inverted”. The Treasury Yield Curve is the benchmark upon which all U.S. dollar-denominated fixed income securities are priced. Leverage, in the context of credit analysis, is the amount of debt of an issuer divided by its cash flow, often described as earnings before interest, taxes, depreciation and amortization (i.e. debt/EBITDA). “Spread per turn of leverage” is a measure of the level of compensation, in terms of credit spread, for a unit of risk, defined as one turn of leverage (debt/EBITDA). A put option is the ability of a holder of a security to require a counterparty to purchase a specified security at a specified price within a specified time frame, subject to certain conditions. With reference to corporate bonds, under certain circumstances (e.g. the sale of the issuer), holders of bonds may have the ability to require the issuer (or its successor) to repurchase the company’s bonds at specified price, typically 101% of par. Credit ratings reflect the credit quality of individual debt securities as determined by nationally recognized statistical rating organizations (NRSROs) such as S&P Global Ratings and Moody's Investors Service, Inc. and are subject to change. With respect to S&P, investment grade ratings range from AAA down to BBB; speculative grade ratings range from BB to D.  Loan-to-Value (LTV) is the ratio of the amount of debt of an issuer divided by its total value as determined by the market or a valuation expert. Higher LTV suggests a riskier loan.

ETF DEFINITIONS: THE ICE BOFA 0-3 YEAR U.S. TREASURY INDEX TRACKS THE PERFORMANCE OF U.S. DOLLAR DENOMINATED SOVEREIGN DEBT PUBLICLY ISSUED BY THE US GOVERNMENT IN ITS DOMESTIC MARKET WITH MATURITIES LESS THAN THREE YEARS. GROSS SPREAD IS THE AMOUNT BY WHICH A SPAC IS TRADING AT A DISCOUNT OR PREMIUM TO ITS PRO RATA SHARE OF THE COLLATERAL TRUST VALUE.  FOR EXAMPLE, IF A SPAC IS TRADING AT $9.70 AND SHAREHOLDERS’ PRO RATA SHARE OF THE TRUST ACCOUNT IS $10.00/SHARE, THE SPAC HAS A GROSS SPREAD OF 3% (TRADING AT A 3% DISCOUNT). YIELD TO LIQUIDATION: SIMILAR TO A BOND’S YIELD TO MATURITY, SPACS HAVE A YIELD TO LIQUIDATION/REDEMPTION, WHICH CAN BE CALCULATED USING THE GROSS SPREAD AND TIME TO LIQUIDATION. MATURITY: SIMILAR TO A BOND’S MATURITY DATE, SPACS ALSO HAVE A MATURITY, WHICH IS THE DEFINED TIME PERIOD IN WHICH THEY HAVE TO COMPLETE A BUSINESS COMBINATION.  THIS IS REFERRED TO AS THE LIQUIDATION OR REDEMPTION DATE. PRICE REFERS TO THE PRICE AT WHICH THE ETF IS CURRENTLY TRADING.  Weighted Average Life refers to the weighted average time until a portfolio of SPACs' Liqudation or redemption dates.  The SEC yield is a standard yield calculation developed by the U.S. Securities and Exchange Commission (SEC) that allows for fairer comparisons of bond funds. It is based on the most recent 30-day period covered by the fund's filings with the SEC. The yield figure reflects the dividends and interest earned during the period after the deduction of the fund's expenses. It is also referred to as the "standardized yield."

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