SINK OR SWIM
going up?
the industry mulls whether the fed will help or hurt high yield
risky heights
is the implied five-year high yield default rate of 35-40% accurate?
high hopes
FocusING on sustainability can help investors TO build more resilient bond portfolios
With Treasury yields so low, it’s no wonder money continues to flood into the high yield space. And yet, so much has changed. The Federal Reserve’s unprecedented entry into credit markets combined with uncertainty over the economic recovery from the pandemic is creating both turmoil and opportunity. While central bank intervention has been vital in terms of supporting the market, it leads to a number of new questions: What will be the longer-term effect on price discovery? What will be the effect of the fallen angels? Will we see a swarm of zombie companies? Do fundamentals still matter? And if they do, when might a correction come? On the flip side, amid the volatility that seems certain to arrive somewhere along the line in the next six to 12 months, there is also likely to be considerable potential for gains, especially as consumer spending starts to pick up in a post-lockdown world. In this supplement, we try to assess these difficult but vital questions across the breadth of the credit market: Which sectors will be the winners and losers, and how investors are dealing with dispersion at individual security levels.
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The Fed has entered the high yield space, but questions are being asked about whether this will help or hurt the market
Issuance in the US high yield bond market is tracking at its busiest pace for any June on record, with $23.88bn priced through June 12, according to a recent research note from LCD. The figure follows a strong May, which ended with a record-setting total for that month, and the third-highest issuance ever for April. Year-to-date volume was $176.8bn at the close on June 12, up 56% year-on-year, according to LCD. Improved borrowing conditions and tightened spreads are drawing in new issuers. Investor cash flows are also on the rise – US high yield bonds posted an inflow of $5.1bn during the week ending June 10, according to data from Lipper. The surge added to 11 consecutive weeks of positive flows into high yield funds.
Investors would be forgiven for looking at those numbers and wondering why the Federal Reserve announced in June that it would expand its high yield bond buying program to include individual securities alongside its purchases of shares in high yield ETFs. To understand, investors need to look closely at what happened during the onslaught of the fastest bear market in history in March. Beyond the dislocations that are typical crisis fodder, in the immediate aftermath, the Fed noted that what the pandemic was doing to credit markets – and indeed corporate balance sheets – was essentially an act of God. The Fed isn’t about to bail out every company under pressure, but it is clear that Fed chair Jerome Powell wants to make sure investors know that there are still some guardrails as markets navigate a botched pandemic response and a burgeoning recession.
BAILEY McCann
A MARKET DIVIDED
Response to the Fed’s involvement in the high yield market has been swift and loud. Feelings register on a continuum from a basic agreement with Powell’s assessment to doomsday prophecy warning that this is the end of price discovery as we know it. The reality is risky to be sure but will hardly do more to bring about the end of active management than an active manager’s own recent poor performance. ‘If you look at what the Fed has done, it announced programs with $50bn of capacity and of that it has used about $5.25bn. That’s not a lot,’ said Jeff Friedman, co-portfolio manager of GMO’s Credit Opportunity strategy. The strategy looks for opportunities in the credit and special situation equity markets. ‘Initially, people thought that this was going to distort the market, but in reality, they’ve spent just under $1.5bn per week on ETFs and, otherwise, they’ve just waited. That could change, of course. But the Fed’s moves so far have been more about psychology than anything else.’ Matthew Bartolini, head of SPDR Americas research at State Street Global Advisors agreed. ‘Really what we have seen the Fed do is put a ceiling on how far down things can go in the high yield market,’ he said. ‘It was a controlled entry that is going to be supportive to risk assets overall.’ Since the Fed’s announcement, spreads have tightened and some issues have returned to pre-pandemic levels. Bartolini added that despite the intervention, winners and losers are still emerging and there are opportunities for managers and investors that stay disciplined. However, not everyone is convinced. For those that are skeptical of the Fed’s entry into high yield, the big issue is moral hazard. ‘The more price-insensitive buyers that enter the market, the more pricing gets distorted,’ said Carl Kaufman, portfolio manager of Osterweis Strategic Income fund. He said investors have to think through whether what they’re seeing in terms of pricing reflects the fundamentals of a given balance sheet or whether it reflects Fed intervention propping up an otherwise vulnerable balance sheet. ‘The question is when does it correct?’ said Kaufman. ‘Even if the Fed holds the bonds to maturity, the risks are price distortion and a misallocation of capital. Does the US want to risk becoming like Japan where the government is the biggest equity holder?’
CASH RULES
As the market tries to sort through a perplexing set of macro factors – including the pandemic, recession, Fed intervention and a complete lack of policy response – trying to assess balance sheet risk is harder than ever. For sectors where the fall has been hard and deep, such as oil, cruises or hospitality companies, steering clear is easy. But elsewhere, the picture is a bit muddy. Tech and healthcare companies are still cash positive and performing well. For companies in sectors like industrials or for some consumer names, it’s too early to tell if reopening will equate to immediate revenue. When it comes to assessing quality, cash is everything. ‘We’re looking really closely at cashflow. Where was it coming from before the pandemic, what happened with lockdown, and so on,’ said Michael Kirkpatrick, managing director and senior portfolio manager on the leveraged finance team at Seix Investment Advisors. ‘There are still companies that don’t need money right away. Quality issuers are still quality issuers in a lot of sectors.’ Investors may also want to consider companies that aren’t necessarily brand names but fulfill critical functions. Companies such as IronMountain, which maintain physical and digital records for businesses, tend to have higher-quality issues in part because the work they do remains necessary throughout lockdowns. Companies that provide other critical infrastructure needs, such as NCR, which makes ATMs, tend to issue higher-quality bonds and are less likely to be adversely impacted during this time. ‘These are the kinds of companies that exist in the background and their work doesn’t stop even if the economy stops,’ said Osterweis’s Kaufman. High yield managers are also buying multiple tranches of quality companies in part because the initial selloff provided a unique opportunity. ‘In some names where we feel like the quality is there, we bought multiple tranches at the downturn in order to build a meaningful position,’ said Kaufman. ‘That doesn’t always happen for us but we bought some longer dated paper. There were new issues and we bought those too. It was a unique opportunity set and we’ve been able to participate in the snapback.’ Overall, most quality issuers have made it through the first wave of the downturn relatively unscathed. However, the next six to 12 months will likely provide another test as the contour of the recession becomes clearer.
BACK TO EARTH
Perhaps it was the length of the economic recovery coming out of the financial crisis or the prevalence of cheap readily available capital, but so far, this crisis appears to have fewer zombie companies and stronger fallen angels. Managers tell Citywire that the new crop of fallen angels have stronger balance sheets and better risk/return profiles than they have had in prior crises. ‘I think we’re going to see a continued ratings migration downward through investment grade and the rest of high yield,’ said Lon Erickson, portfolio manager on the fixed income team at Thornburg Investment Management. ‘Metrics like cash flow are going to be challenged if you’re a business that has been closed or operating at limited capacity for the past three months. But with the Fed involved, there will still be some support. So, the question becomes: Do you want to fight the Fed?’ For Erickson, assessing fallen angles means looking at where a given company was pre-pandemic and weighing that against speculation on how the recovery looks. ‘We don’t think it’s a V-shape as some have said,’ he said. ‘It could be a U or it could be a Nike Swoosh, each one of those ideas is going to have a different risk model.’ Almost universally, managers Citywire spoke to for this piece suspect that, despite the unprecedented circumstances faced by markets, fallen angels are likely to outperform into the recovery as they have in past cycles. Support from the Fed helps, but broadly, companies tend to be less levered than they have been in the past and balance sheets tend to be stronger. While there will still be an uptick in defaults and maybe even a few zombie companies, companies entered the downturn in a better position than they have been heading into other recessions. As a result, managers say, they expect a very positive return on risk. ‘As with anything, you have to pick your spots,’ Seix’s Kirkpatrick said. ‘You want companies that are going to have levers to pull if the crisis deepens, be that the ability to sell assets, the ability to get financing from somewhere, or the ability to do an equity deal if needed.’ If companies use those options prudently they should be able to recover and if they don’t, they should still be able to rebound. ‘It’s a heads-I-win, tails-I-win scenario,’ he said.
UNTIL THERE’S A VACCINE
Ultimately, no matter how much liquidity the Fed pumps into the market we’re still in a pandemic until there’s a vaccine. Despite reopening, the pandemic will still influence corporate and consumer decisions. Those decisions will happen against a backdrop of a recession, heightened geopolitical tensions, and, later this year, a presidential election. As the number of coronavirus cases climbs, there may also be renewed pressure to return to lockdown measures, as China has done. ‘It’s hard to see a scenario over the next six to 12 months that doesn’t come with a lot of volatility,’ State Street’s Bartolini said. Sticking to higher-quality high yield bonds could help mitigate some of that volatility but there’s really no way of knowing. High yield bond ETFs, which is where the Fed began its entry into the corporate bond market, have largely leveled off following some initial dislocations as a result of the sudden drawdown. That’s changing how investors are using them. ‘If you’re an asset manager and need to improve your liquidity profile, you could hold a portion of your portfolio in a high yield bond ETF and get that done,’ Bartolini said. Investors have also moved to shorter-duration paper to avoid taking on added risk. Going shorter in high yield means that investors expect that a company will be able to refinance or they’ll get discount bonds. Osterweis’s Kaufman expects that the preference for shorter duration will remain for a while. ‘What’s been interesting to me to watch is that when we go through these air pockets, it used to take months or years to recover and now it takes weeks. So, markets are beginning to adjust to that reality,’ he said. Overall, even with shortened durations, the outlook for credit remains broadly positive. Consumer spending has returned after a steep drop off in March and April while people came to grips with lockdown measures. Spreads throughout the credit market have tightened, returning to pre-pandemic levels in some sectors. Underwriting remains relatively tight, which means that despite financing being cheap, companies will still have to put together deals that will pass muster. Taken together, all of these factors are constructive for investors. ‘We’re still finding a ton of opportunities,’ said GMO’s Friedman. ‘Some of what we’ve experienced in lockdown is going to be permanent – it’s hard to see retail fully recovering from here, for example. But elsewhere, there are significant total return opportunities. The Fed isn’t going to bail every company out and there will be a dispersion of return across sectors. But there will be winners and losers. For managers that are disciplined about their choices, volatility and uncertainty can create opportunities.’
Mid-market high yield: an overlooked SEGMENT OF THE HIGH YIELD MARKET
JACK CIMAROSA Portfolio Manager, MSIFT High Yield Portfolio (MSYIX) Morgan Stanley Investment Management
You focus on the mid-market segment of high yield, what’s the rationale for that? It’s an overlooked and under-researched area. The high yield market contains a lot of passive money, via index products and ETFs, and these products tend to cluster in the largest credits, which make up about a third of the market in terms of the number of issuers. For a number of technical reasons, mid-market credits tend to trade at wider spreads than what we consider to be comparable credits that are larger. So, the result is typically higher yields and potentially better returns, while default and credit risk are in line with the rest of the high yield market. What is the specific opportunity for mid-market credits at this point? The Federal Reserve’s unprecedented intervention in high yield has caused a real bifurcation in the market, to the point where I would argue that our mid-market space is as cheap as it has ever been. That’s on both an absolute basis, and relative to the rest of the high yield market. If you look at the high yield market as a whole, it has now retraced almost all of the Covid-19 spread widening. Year-to-date returns, as measured by the Bloomberg Barclays U.S. Corporate High Yield Index, are down just 2-3%, and spreads are now inside of 600 basis points (bps) after blowing out as wide as 1100bps in March. Large ETF-eligible names and Fallen Angels have rallied back and recovered in record time. But the mid-market space has lagged, and while this is typical since these smaller credits don’t immediately benefit from fund flows into ETFs, this technical has been exacerbated by the Fed stepping into our market. To quantify that, we typically expect a 100bps to 150bps premium for going into the middle market versus staying in larger, more on the run high yield credits. At the moment, the premium is closer to 350bps or 400bps. So while many parts of high yield have rallied significantly, we believe there is still a lot value in this space and we think it may benefit from a compression trade as investors look for remaining value. How do you see the picture for defaults? Defaults will likely increase but because of the Fed program and increased liquidity in the market, we expect a smoother move up than we had previously anticipated, and in our view, active management will be critical to help avoid problem sectors.
How a niche segment of high yield could be a sleeper hit for the future
The team defines middle market as companies with $150 million to $1 billion of total bonds outstanding. Risk Considerations. No assurance a Portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities in the Portfolio will decline and that the value of Portfolio shares may be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects of events. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments, changes in interest rates, the creditworthiness of the issuer and general market liquidity. High yield securities (“junk bonds”) are lower rated securities that may have a higher degree of credit and market risk. See prospectus for details. The views and opinions are those of the author as of the date of preparation and are subject to change at any time due to market or economic conditions and may not necessarily come to pass. This general communication, which is not impartial, is for informational and educational purposes only, not a recommendation. Information does not address financial objectives, situation or specific needs of individual investors. The Bloomberg Barclays U.S. Corporate High Yield Index measures the market of USD-denominated, non-investment grade, fixed-rate, taxable corporate bonds (excludes emerging market debt). Securities are classified as high yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below. The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. One basis point = 0.01%.
Investors should consider the Portfolio’s investment objectives, risks, charges and expenses. The prospectus, which contains this and other information and should be read carefully before investing, is available at morganstanley.com/im.
© 2020 Morgan Stanley. Morgan Stanley Distribution, Inc. 3137345 Exp. 6/30/2021
Risky heights
High yield spreads imply a five-year cumulative default rate of 35-40%, but is risk really that high?
Credit spreads have been volatile in 2020. Having started the year at their tightest level in more than 10 years, they blew out to almost 1,100 as Covid-19 fears triggered a sharp selloff in risk assets. The option-adjusted spread (OAS) of the ICE BofA US High Yield index reached this year’s tightest level of 338 bps over comparable treasuries on January 20, according to data from Ares Management Corporation. Soon after, a double whammy of the spread of Covid-19 outside China and weakening Opec support for oil prices led to a wave of selling and high yield spreads reached recent wides of 1,087 bps on March 23.
That was significantly below all-time wides of 2,132 bps reached during the depths of the great financial crisis in 2008, though wider than more recent mini-cycle wides in the high 800s seen in 2011 and 2016. ‘While well inside the historic numbers experienced in 2008, this marks only the third time in history the market has seen spreads surpassing 1,000 bps and prices below $80,’ said Steven Fraley, vice president at Innovest in Denver, Colorado. The Federal Reserve came to the rescue with primary and secondary market corporate credit facilities allowing for the purchase of investment-grade corporate bonds. That created support for credit broadly, and high yield rallied, led by higher-rated bonds. On April 9, the Fed increased these facilities and expanded them to include fallen angels that had been downgraded from investment grade since March 23, as well as high yield ETFs. Its first-ever purchase of high yield bonds prompted a more risk-on stance in the market. ‘This came at a time when companies needing operating cash could not find buyers as investors flocked to Treasurys, creating a temporary freeze in the credit markets,’ Fraley said. ‘Since the announcement, the credit picture has brightened and spreads have narrowed significantly.’ Fiscal and monetary stimulus, improving data on the spread of Covid-19 and massive inflows to the asset class have seen spreads grind tighter – to around 600 by mid-June. They nevertheless remain elevated. ‘At around 600 bps, they are well above the five-year average of 440 bps,’ said Hunter Hayes, vice president of Intrepid Capital in Jacksonville, Florida.
JENNIFER HILL
IMPLIED DEFAULT RATE
The issuer-weighted default rate, which measures the percentage of individual issuers that have defaulted, is less than 4%. ‘This level is sure to rise in the near term, but it remains at historically low levels,’ said Karl Mayr, head of credit trading at 280 CapMarkets in New York City. At nearly 100 bps above the long-term average, spreads imply a five-year cumulative default rate of around 35-40% – a ‘frightening figure’, Mayr said. ‘However, one must realize that this figure depends on assumptions including recovery rates and most importantly that wide spread levels persist for a period of five years. Market distortions and extreme spread levels have historically only lasted for relatively shorter periods of time.’ During the financial crisis, for example, spreads normalized over a period of just over a year with the average OAS on the high yield index tightening from 2,132 bps to 586 bps between December 2008 and January 2010. Using spreads to forecast an implied default rate is challenging for other reasons, according to Eric Hess, managing director of Newfleet Asset Management in Hartford, Connecticut. ‘First, credit spreads provide compensation for things beyond just credit losses such as liquidity premiums,’ he said. ‘Second, the liquidity premium demanded by market participants is correlated with default risk – rising default expectations generally leads to outflows from the asset class, so liquidity is more expensive. ‘Third, the implied default rate requires a recovery assumption which may differ among market participants, and, finally, some expected defaults are likely already trading at recovery levels so will not add to future credit losses despite a rising default rate.’ For Matt Lloyd, chief investment strategist at Advisors Asset Management in Monument, Colorado, recovery rates might surprise on the upside as private equity and private debt investors battle over myriad companies that hit tough times. ‘Corporate issuance could top $2tn for the year, which also will curtail the higher estimates of the default rates,’ he said. ‘With a low-interest-rate environment both domestically and internationally, the large levels of cash that have been on the side-lines for many years provide an even greater backstop should the recovery not be in the V-shaped or square root symbol as we see.’ High yield defaults, including both bonds and loans, reached 4.1% in April compared to 3.5% in March, according to S&P Global Ratings. It has pencilled in a figure of 12.5% for the year to March 2021. Aegon Asset Management anticipates a default rate of 6-8% during 2020, assuming there is not a significant second wave of Covid-19 infections. That is in the same ballpark as Ares’ estimate of 8% for the coming year. While many market participants see a scenario where high yield default rates are historically high over the next year, and remain so for another year or possibly two, making longer-term predictions is fraught with difficulties. ‘We do not estimate this rate beyond 12 months as there are too many uncertainties relating to the virus, markets, upcoming presidential election and central bank responses, among others, to make predictions useful,’ said Kapil Singh, a partner at Ares in Los Angeles, California.
ESPECIALLY SUSCEPTIBLE
The nature of the recent selloff and economic turmoil is very different to the crisis of 2008. That crisis was borne out of fundamental issues in the financial sector – today’s is rooted in the coronavirus pandemic and its impact on the global economy. While monetary and fiscal stimulus can help restore liquidity to credit markets and offer companies the ability to survive for longer, it cannot ultimately resolve solvency issues and impending bankruptcy risk. ‘Fed intervention cannot make a bad credit a good credit – there are a lot of bad credits out there right now,’ said Hayes at Intrepid, pointing to many companies sitting on record levels of debt headed into this crisis and issuing more debt to survive the lockdown. ‘Even if we return to a normalized economy soon, which is not a given by any means, corporate balance sheets will be significantly weaker,’ he said. ‘Leverage greatly reduces a company’s margin for error, so any sort of exogenous shock combined with even weaker balance sheets could be the gust of wind that blows over the house of cards.’ While the technology and healthcare sectors are less at risk of defaults, energy companies and those dependent on consumer discretionary spending, such as travel and leisure, are especially susceptible. ‘Risk is especially high in the energy sector where companies issue massive amounts of debt to fund their capital expenditures,’ said Ken Van Leeuwen, managing director of Van Leeuwen & Company in Princeton, New Jersey. From the January to the end of April, the energy sector accounted for half of all defaults, according to 280 CapMarkets. Oil and gas companies worldwide have also accounted for a slug of new issuance, raising $171bn of debt in loans and bond markets in the three months to the end of May – around the same amount of issuance in the whole of 2019, according to Advisors Asset Management, which cited Bloomberg. Hess at Newfleet expects many more names in the energy sector to default before we see any clear resolution to the pandemic and related economic shutdowns. ‘Energy will be an important sector to watch, so a focus on oil prices is important to many E&P [exploration and production] companies,’ said Jim Schaeffer, head of leveraged finance at Aegon in Chicago, Illinois. ‘If oil can remain above the $40 level, many high yield energy companies will have much lower default risk.’
FUNDAMENTAL RESHAPING
More sector-specific bankruptcies coupled with more downgrades – fallen angels are expected to amount to $475m by the end of 2020, according to S&P Global Ratings – leads Fraley at Innovest to expect an increase in the total size and a ‘fundamental reshaping’ of the high yield market. For him, it is important to understand the distribution of sector risk and credit quality when assessing default risk, and to tread carefully. ‘With Treasury yields at or near historic lows, it is understandable that investors looking for increased yields and return potential in the fixed income markets might be attracted to current high yield spreads,’ he said. ‘We would advise to proceed with caution and turn to an active manager with deep credit research expertise, flexibility in their investment approach and strong risk management oversight.’ The most important measure for Aegon is liquidity. ‘The second-most important measure is whether companies need to address near-term maturities, which is why an open capital market willing to extend credit is critical,’ Schaeffer said. For Intrepid, default risk is company specific. ‘We go to great lengths to scrutinize individual issuers’ balance sheets, sources of liquidity and the reliability of their cash flows in this sort of uncertain environment,’ said Hayes. ‘If you do your homework, there are plenty of fantastic credits trading at attractive yields in this market.’
KEN VAN LEEUWEN
‘We favor most high yield sectors except energy and travel/leisure. With low oil prices, defaults within the energy sector may very well push defaults into high double digits. We see value in other areas of the high yield market, such as communication, financials, industrials and certain technology companies that are generating strong cash flows. We also focus on credit quality of the companies. There is better relative value in BB- and B-rated bonds with relatively low default risk compared to their lower rated counterparts.’
MY FAVORITE PART OF THE HIGH YIELD MARKET
Mananging director and founder
VAN LEEUWEN & COMPANY
HUNTER HAYES
Vice president and portfolio manager
INTREPID CAPITAL
‘We look for issuers with financial flexibility and operational resiliency. A good example is a counter-cyclical business like a pawn shop. In good times, these businesses generate stable free cashflow and some of them have great balance sheets with high cash levels and low leverage. But in recessionary environments, these businesses really shine as more individuals pawn items for quick cash. This translates into better margins for the operator and more free cash flow generation. Other pockets of the market that are compelling include utilities, consumer staples and vice products like tobacco, cannabis and alcohol.’
KAPIL SINGH
Partner and portfolio manager
ARES MANAGEMENT CORPORATION
‘In February, as the Covid-19 issue became more serious, we had above-average levels of cash across our high yield portfolios to prepare for dislocations and opportunities. We then increased higher-rated and more defensive segments of high yield as relative value improved dramatically through March. Our industry positioning has increasingly favored more insulated and subscription-based sectors, including cable/media, utilities, technology and telecoms. Since the Fed’s April announcement of further support, we paused our shift to higher-quality segments and net added single-B risk. We have also re-added energy and autos to address large fallen angels.’
KARL MAYR
Head of credit trading
280 CAPMARKETS
‘Spreads have rallied significantly from the wides, leaving the market relatively fairly priced and defaults are just beginning to rise. Defaults are difficult to model due to the many uncertainties surrounding Covid-19 as well as the impact of the unprecedented monetary and fiscal stimulus around the globe. With so many uncertainties and the recent rally in spreads I would tend to favor higher-quality and shorter-duration exposure. I would focus exposure on stable sectors such as consumer staples, basic industrials and telecoms in the BB-rated universe, and avoid energy, retail, travel and leisure.’
DREW DOSCHER
Head of distressed debt sales and trading at StoneX
STONEX
‘Time will tell if the default risk is appropriately priced. Covid-19 and the fiscal and monetary responses to it are still in the early stages. The obvious plays are healthcare, technology and consumer staples. We can see the clear bifurcation between those spaces versus where the distressed opportunities will be found – in retail, energy, restaurants and consumer services. However, the biggest opportunity now that the fallen investment-grade trade has paid huge dividends to those distressed clients savvy enough to have lived through the cycle in early 2000s is leveraged loans – a $1.8tn market and growing.’
A Full Cycle Approach to High Yield
JERRY CUDZIL Portfolio Manager & Head of Credit Trading
STEVE PURDY Portfolio Manager & Head of Credit Research
As a full cycle credit manager, is this the time to be playing offense or defense in the High Yield marketplace? While spreads have remediated since late March, we continue to find compelling value opportunities in the high yield market. Given TCW’s full cycle investment philosophy, we are constantly adjusting our portfolio’s risk profile to match the opportunity set in the market. In recent years, we observed multiple late cycle warning signals and thus conservatively positioned our portfolios by shortening spread duration, reducing exposure to cyclicals and shunning CCC issuers. Amidst spread widening in March 2020, we moved our portfolios to a neutral posture across the high yield risk spectrum. Yields are now healthy enough to compensate for underlying credit risks, but we do not anticipate this will be a “V” shaped recovery. We believe our neutral posture enables us to earn an attractive yield while protecting downside and preserving the ability to capitalize on future volatility. What areas do you find attractive or unattractive in the High Yield space today and why? We remain underweight the lowest-rated cohort of the high yield market. These businesses entered the recession with either high leverage or cyclically sensitive business drivers, or both. Based on our proprietary credit research analysis, we believe that many of these businesses will not be able to withstand the combination of a one-time, quarantine-induced revenue shock and a drawn-out economic recovery. We expect leverage levels to remain persistently elevated for these businesses, ultimately leading to increased defaults. Defaults, of course, impair principal for bondholders. How does liquidity factor into your portfolio construction process? In the late stages of a credit cycle, we construct our portfolios to prepare for the coming deleveraging. We engage in “high-grading” portfolios by shifting to overweight in both short duration and high quality bonds. This rotation positions us with bond holdings we will be able to sell if and when risk appetite reverses. In March 2020, just such an event occurred. While liquidity in the market collapsed, we sold our high quality bonds to investors urgently seeking to de-risk their portfolios. We then redeployed those proceeds into lower quality and longer dated bonds at deeply discounted prices. By being a “liquidity provider” in times of volatility, we believe we can generate compelling risk-adjusted returns over the course of a cycle. How is this credit cycle different than preceding ones? The global pandemic creates an utterly unique investing landscape that we believe will translate into increased performance dispersion at the issuer and sector-level. “Unprecedented” is the word repeated by management teams as they withdraw their earnings outlooks amidst the dual impacts of social distancing and recession. With the trajectory of recovery simply unknowable, the importance of individual credit selection has never been higher. Our detailed, asset value focused research approach allows us to intensively analyze the impact on cash flows for each and every issuer amid this historic dislocation. Has government intervention in the credit markets provided enough of a backstop, or are the risks too pronounced? While the Fed has proven to be powerfully capable of providing liquidity to the capital markets, it lacks the ability to impact underlying business fundamentals. Broadly speaking, we believe economic uncertainty has triggered cautiousness in businesses and consumers that cannot be offset by monetary policy alone. And this limitation is particularly apparent in sectors directly affected by the pandemic. For example, the Fed can provide funding for the airline industry, but it cannot convince consumers it is safe to fly. As the recession persists, revenue weakness will inevitably drive elevated gross debt balances, irrespective of liquidity hoards. Whether the Fed has provided enough liquidity to “bridge the gap” to a recovery remains to be seen, but we aim to protect portfolios in the case that the revenue revival falls short. Why is it critical to take an active management approach to High Yield late in the credit cycle? We believe it is imperative for high yield portfolios to minimize principal loss at the end of the cycle to achieve attractive long-term returns. As mentioned, our high yield philosophy is anchored by cycle awareness and intensive bottoms-up credit selection. Entering 2020, this discipline guided our conservative positioning which limited drawdown and enabled enthusiastic risk taking in specific, comprehensively researched securities at discounted prices. These lower purchase prices minimize downside risk and enable the capture of attractive prospective returns for our portfolios.
This material is for general information purposes only and does not constitute an offer to sell, or a solicitation of an offer to buy, any security. TCW, its officers, directors, employees or clients may have positions in securities or investments mentioned in this publication, which positions may change at any time, without notice. While the information and statistical data contained herein are based on sources believed to be reliable, we do not represent that it is accurate and should not be relied on as such or be the basis for an investment decision. The information contained herein may include preliminary information and/or “forward-looking statements.” Due to numerous factors, actual events may differ substantially from those presented. TCW assumes no duty to update any forward-looking statements or opinions in this document. Any opinions expressed herein are current only as of the time made and are subject to change without notice. Past performance is no guarantee of future results. © 2020 TCW
With this year’s severe economic contraction, unprecedented fiscal and monetary intervention, and high levels of market volatility, TCW Portfolio Managers Jerry Cudzil and Steve Purdy discuss the state of the high yield market, where the key risks and opportunities lie, and how TCW approaches high yield portfolio construction
High hopes for high yield
After taking a hit during the March selloff, greater accessibility and accommodative policies could see high yield grow to new heights
The past six months have been anything but boring for investors in high yield. As Covid-19 cases started to rise in March and countries across the globe went into lockdown, markets experienced dramatic falls – and high yield was no exception. Over the five weeks to March 20, 2020, the fastest selloff on record took place in the US high yield market. The average spread on the ICE Bank of America Merrill Lynch US High Yield index increased from 500 to 1,000 bps over Treasury bonds in the space of 21 days. By March 23, the average spread on the index had reached 1,082 bps. It took 11 months for the same degree of spread widening to take place during the financial crisis, according to asset manager Eaton Vance. Fortunately, events took a positive turn in late March and early April after Federal Reserve chair Jerome Powell said the central bank would use its powers ‘forcefully, proactively and aggressively’ to help the economy to recover from the Covid-19 pandemic. Measures included slashing interest rates to nearly zero and expanding the Secondary Market Corporate Credit Facility. Under this program, the central bank can buy up to $750bn worth of corporate credit, including single-name investment-grade bonds and so-called ‘fallen angels’ – credits downgraded from the lowest investment-grade status to high yield. The Fed can also buy shares in investment grade and high yield ETFs. Meanwhile, the central bank can lend money directly to investment-grade companies via the Primary Market Corporate Credit Facility. Spreads started to narrow following the news, as investors were tempted back into the market. ‘Retail and institutional investors alike sought to take advantage of the historically rare entry point into the asset class, coupled with accommodative policy,’ explained Steve Concannon, co-director of high yield bonds at Eaton Vance.
Tim Cooper
TIME TO INVEST
So where did the most attractive opportunities emerge following the March selloff? Barings’ head of US high yield David Mihalick and Martin Horne, head of global high yield, observed that a number of high-quality companies were trading down significantly in April – even though they looked sound from a fundamental perspective and unlikely to experience a massive disruption to earnings. ‘Food manufacturers, cable providers and packaging companies, for example, seem to be operating more or less as usual – and in some cases may even be benefitting from stronger sales during this period. We believe these businesses are also likely to experience the quickest recoveries once this event is behind us – something the market does not appear to be pricing in,’ Horne and Mihalick said in April. They also highlighted potential investment opportunities among businesses that were on a solid footing prior to March but now face short-term challenges as a result of the pandemic. ‘While these businesses may require liquidity to move through this short-term pain, they were on solid footing coming into this event and will likely emerge in decent shape afterward. Cinema businesses, travel companies and sports franchises, like Formula 1 Racing, are examples,’ Horne and Mihalick said. While it can be difficult to look through market noise and negativity, the portfolio managers pointed out that crises typically present investors with investment opportunities – and the volatility created by the coronavirus pandemic is no different. However, careful navigation and selectivity within high yield is crucial. ‘Markets are impossible to time. But if the past is any indication, a steadfast focus on fundamentals and bottom-up, credit-by-credit analysis can help identify issuers with the potential to thrive beyond today’s events – and this crisis, ultimately, may prove to be a significant opportunity for value creation,’ Horne and Mihalick said. Financial advice firm Edward Jones raised its allocation to high yield to an overweight position within its asset allocation framework following the first quarter selloff and the widening of spreads. ‘To us, that was a reflection of the huge amount of uncertainty that existed in the economic outlook, and thus the huge amount of stress that was being put on the credit system, particularly the corporate credit system. We thought that valuations in the high yield space had gotten to a level where investors were being compensated for a much higher level of risk,’ said Craig Fehr, investment strategies principal at Edward Jones. The team at Edward Jones spotted opportunities within sectors that had experienced a modest rebound in April but continued to offer value, such as financials and industrials. ‘We more broadly looked at sectors that have underperformed even after this rally has taken shape. The benefit that we have in taking a much longer-term view is that you can find these opportunities when the market is panicking in the short-term. ‘If you look at sectors, like financials and industrials, they have certainly rebounded but are still substantially lower than many other areas that have done better, like technology and the consumer sectors,’ Fehr said. However, the team is steering clear of commodity and energy names, which they suspect will remain under pressure due to lower oil prices.
A SELECTIVE APPROACH
Steven Concannon and Jeffrey Mueller, co-directors of high yield bonds at Eaton Vance, take a different view. They are seeing selective opportunities in the energy sector across the global high yield universe. However, they acknowledge this isn’t a trade for the faint-hearted. ‘Defaults will increase in this sector, in our opinion, but returns from bonds in this sector that do not default will also, in our view, be significant,’ the portfolio managers said in a commentary. They have also identified investment opportunities among the fallen angels, which have been downgraded from investment grade. ‘We think sensibly investing in companies that have the ability to bounce back to investment grade will be a great way to generate returns from here,’ the managers said. Finally, they urge investors not to overlook opportunities in the primary market. ‘A lot of challenged companies have had to come to the market looking for short-term financing to ensure they can get through this pandemic, and this has offered some really good opportunities for high yield investors to lend to companies that we think are good quality businesses over the long term,’ Concannon and Mueller said. Sonali Pier, manager of the Pimco Diversified Income fund, describes the high yield investment opportunities created by the first quarter selloff as ‘short-lived’. This is because significant inflows followed the Fed’s announcement that it would buy corporate credit, causing spreads to narrow. By April 29, the average spread on the ICE Bank of America Merrill Lynch US High Yield index had fallen to around 800 bps over Treasury bonds. ‘The Fed’s announcements helped markets to properly function, reducing liquidity risk. However, solvency risk remains in the vulnerable parts of high yield,’ she added. By June 16, the spread on the ICE Bank of America Merrill Lynch US High Yield index had fallen to 580 bps. Although, there has been volatility along the way, with spreads rising to 640 bps during the previous week after another selloff took hold. ‘Broadly, we would call current levels roughly fair – once accounting for the increase in the default rate, though we realize markets have a tendency to overshoot. We are looking to work with issuers where we can create adequate downside protection via covenants and participate in the upside,’ Pier said. The portfolio manager remains cautious in her outlook for high yield over the next six to 12 months. ‘The caution is due to a high level of uncertainty on the path and duration of Covid, the upcoming election, and the potential for trade conflicts. ‘We have seen robust inflows into high yield, as the global search for income continues in a low yield environment. However, we have also seen an increase in supply from the fallen angels and there’s a risk of impairment in some high yield credits,’ Pier said.
RISK-REWARD TRADE-OFF
Edward Jones’s Fehr is braced for a wave of defaults and delinquencies during the second half of the year. Against this backdrop, he said it will become even more important for investors to understand whether they are being rewarded appropriately for the risks they are taking. This is where the expertise and extra level of analysis provided by active managers can provide an edge. He expected further bouts of volatility will be created by what he described as a ‘two-step dance’ between the incoming retrospective economic data and markets, which are forward-looking in nature. ‘I think that dance will get clunky at certain times and that will show in volatility, but I think the high yield space is another area where you are making investments in the longer-run outlook for economic recovery, and we still think that is the most likely outcome,’ he said. Fehr believes there is still a strong case for long-term investors to have an appropriate allocation to US high yield bonds, but they must be prepared for market turbulence along the way. This is likely to be caused by short-term setbacks as economies attempt to reopen. ‘As we look out broader term, our view is that economic recovery both in the US and around the world is going to be durable and sustainable, but it is not going to be smooth. As the economic recovery continues, that should broadly help credit and should benefit the returns in high yield bonds,’ he said.
Uncovering Opportunity in a Rebounding U.S. High Yield Market
RIZ HUSSAIN Lord Abbett Investment Strategist
A whipsaw in valuations has left many investors wondering if there is still merit to an allocation to U.S. high yield credit. High-yield credit spreads in late March reflected too dire an outcome around potential defaults and losses in years to come, and there was excess liquidity premium to be harvested by investors with a strategic mindset. We do not believe the defaults to come over the coming years will cumulatively rank as the worst high yield credit cycle over recent history, but that’s no longer implied by credit spreads either. High yield spreads have largely rebounded to levels consistent with those observed earlier this year when major equity indexes were around current levels. The ratio of high yield to investment grade credit spreads is just marginally above its 10-year median, helping to put the spread rally into a cross-asset context. Over the past two months, investors’ uncertainty and still-defensive posture has manifested itself in a preference for the higher quality buckets of BBs and Bs while CCCs await broader sponsorship even with their recent rally. We believe the alignment of credit and equity investors’ interests that we see now still allows for “equity-like” upside in credit with the relative downside protection of being a creditor. However, we think it’s worth looking for more potential price appreciation within BBs. Fallen angels remain an alpha opportunity The discussion around opportunity at the border of investment grade and high quality high yield is particularly timely today given over $175 billion of fallen angel volume year-to-date1. We’ve held that fallen angels provide fertile ground to provide alpha to high yield strategies as many fallen angels work to regain their investment grade status in years to come. In our view active management remains a necessity in this opportunity set as not all fallen angels are created alike. Much like the aftermath of the 2015–16 energy rout, many once investment grade energy credits specifically in the exploration and production (E&P) subsector have led the way higher again since late March as oil prices rebound and the highest quality credits remain well positioned to recover over coming years. Meanwhile fallen angels that may face secular headwinds for longer, including Macy’s, Royal Caribbean Cruises, and Delta Airlines, have had to resort to raising “rescue” financing in the secured bond market, offering specific collateral to entice providers of credit. [References to individual companies are for descriptive purposes only and do not reflect opinions on their investment merits.] CCCs: a small part of high yield but more widely dispersed than before The proportion of the high yield market comprised of CCCs is near a historic low. Why does that matter? Most simply, when we consider one of the biggest performance drags on the asset class, it comes from the price declines down the path to eventual defaults or restructurings. In the chart below, we track the cumulative default experience of the BB, B and CCC ratings groups of the 2000 and 2007 high yield market cohorts as they represented the worst five-year cumulative default experience over the past 20 years. As the chart suggests, the highest intensity of default experience comes from CCCs, with comparatively fewer defaults coming from BBs and Bs. And it’s notable that with over 50% of the high yield market now in BBs, this is the highest rated high yield market ever. Meanwhile the CCC weighting is appreciably lower than it was at the beginning of the Great Financial Crisis of 2008-2009. We believe any allocation to CCCs has to be less about gaining exposure to lower quality credit generically, but more so a deeper dive and sector focus to differentiate among the potential survivors and casualties in this default cycle. In fact, today’s CCC valuations are more widely dispersed than when compared to other prior periods of high defaults (the early 2000 cycle and the 2008-09 financial crisis). In particular, the existence of today’s comparatively “fat left tail” at wider spreads/lower prices suggests investors have been more discerning in the rating category and that potential default may already “be in the price” for many stressed issuers. This tiered pricing may subsequently present less downside risk to returns due to price declines that have already taken place in our view. CCCs could continue to rally if the current investor rotation into “value” factors persists, but we remain more focused on idiosyncratic credit risk drivers. The author wishes to thank Katie Cheung for her contributions to this report.
With the broad financial market recovery since late March, U.S. high yield is no longer as dislocated, but the rationale for a strategic allocation to the asset class remains intact in our view
¹ As of 25 June 2020 Lord Abbett is not affiliated with Citywire. The views and opinions expressed are those of the author, are as of 25 June 2020 and subject to change based on subsequent developments and may not reflect the views of Lord Abbett as a whole. It should not be assumed that investments in the companies, securities, sectors and/or markets described were or will be profitable. The information provided is not intended to be relied upon as a forecast or research regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment or serve as a recommendation or offer to buy or sell securities. Fallen angels are bonds that have been downgraded from investment grade to speculative grade status. Bond credit ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities, and typically have higher yields than investment grade securities due to the increased risks associated with lower-rated securities. Lord Abbett is the owner of the service mark for its knight design logo. sequam volessi tatur, si sequae id quias venisto voloribus.
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