Wirecard fell from investment grade to insolvency in just six days. Investors across Europe will now be asking themselves tough questions about what went wrong and how this one slipped through the net.
At LGIM, all of our active fixed income funds steered clear of Wirecard, so instead we’re considering ‘what went right?’ – not to congratulate ourselves, but to make sure that we look out for similar red flags across our investment universe.
Analysing a company for the first time takes a long time, so we’re constantly looking for ways to filter the vast amounts of information at our disposal to help us identify the most relevant material more quickly.
In the case of Wirecard, our first port of call was our Active ESG tool – a proprietary system which pulls in oceans of environmental, social, and governance (ESG) data and filters it into positive and negative signals for our analysts to evaluate. When we ran Wirecard through our tool, it raised red flags immediately.
The Financial Times (FT) had already highlighted numerous allegations of accounting irregularities against Wirecard well before it issued its first bond in September 2019. Clearly this was to be the main focus for our meeting with management, and we drew on expertise from across LGIM. Our fixed income ESG analyst and an expert from our Investment Stewardship team worked alongside our telecoms, media, and technology analyst to assess the deal.
During our meeting with Wirecard executives, it soon became clear that the responses offered by the company’s management were even more concerning than the allegations themselves. We were told that the FT journalists were in cahoots with short sellers to manipulate Wirecard’s share price. Frankly, it didn’t ring true. The explanations around the accusations, particularly on why so much money was routed through offshore locations, also made very little sense to us.
Caught off balance
It’s a basic question from an investor to any bond issuer: why do you want to borrow money from us? In Wirecard’s case, the company planned to use the proceeds of its bond issue to repay some bank loans, having been advised by its banks that bond-market conditions were receptive.
This isn’t universally a negative signal, but if the banks – which have access to company information that we do not – seemingly want this exposure off their balance sheet, it’s something to investigate.
Neither a borrower BBB
Another consideration was that Wirecard was rated by only one agency. Any issuer with only one rating is a signal for concern; when that solo rating is a low BBB, we have to assume that the other two agencies thought it was junk.
The vast majority of investment-grade bond issuers tell us that they are committed to their ratings, but it’s important that we question that commitment and rely on our own judgement as to whether it will still be there when things go wrong. It’s particularly hard to take a commitment to investment grade seriously when a company has only one rating, and when it has had that rating for less than a week.
It is standard bond-market practice for any low BBB company to include coupon steps in its bonds in order to offer protection to investors – if the rating is cut to junk, the coupon increases (usually by 125 basis points). An issuer sacrifices some financial flexibility by including this clause, but if it intends to remain investment grade then it costs them literally nothing. There were no coupon steps in the Wirecard bond.
Yield under pressure
None of these concerns in isolation were enough to completely rule out an investment in Wirecard. Whatever the risks, there’s a price for everything, and it’s very rare that we think that price is zero.
However, given the scale of our concerns, we believed that Wirecard needed to offer yields materially higher than its peers in order to compensate adequately for the risk. It did not, instead pricing at an incredibly low 0.5% coupon. It was an easy decision.
When the FT revealed further allegations against Wirecard a month later, the price dropped by around 15 points, taking the yield to almost 4%. We took another look at this stage, but ultimately decided that it was still not worth the risk.
While we benefit from the analysis, quantitative screening and efficiency our Active ESG tool provides, instances like this rely as much on a qualitative, experienced reading of a situation. Fraud is almost impossible to spot in advance, but with hindsight there are always signs that something wasn’t right. As the trend towards ESG continues to accelerate, we believe our Active Engagement approach will help steer portfolios away from potential ESG-related downgrades, junkings, and in this case default.
As active investment-grade fund managers, avoiding defaults is critical if we are to preserve our clients’ capital. That’s true at any point in the credit cycle, but it’s now more important than ever as the economy turns and companies face the worst operating conditions they have experienced in years.