COVID-19 has shaken up high yield and changed up the investment ecosystem
The asset class is always prepared for a crisis, but the uneven impact of the virus means fundamental credit analysis is more important than ever.
- Relatively few high yield issuers should need to refinance debt in 2020 and 2021 thanks to the sector’s flexibility.
- Hedging costs for euro investors have fallen.
- The hard stop in parts of the economy will lead to defaults, likely in two waves.
- The arrival of former investment grade issuers into the high yield universe will have a material effect on the market.
- Spreads remain elevated, but have narrowed. Intervention by central banks has been decisive and has provided a useful backstop.
- The global high yield market is seeing uneven demand across the rating spectrum.
As the COVID-19 pandemic cast its shadow over our economies, the high yield debt market has seen considerable changes of its own – not least the glut of downgrades bringing formerly investment grade (IG) issuers into the sector. However, this presents signs of resilience and opportunities for investors.
Two fundamental aspects of the high yield (HY) market have given issuers a chance to weather the storm. First, HY companies tend to ‘term-out’ debt – habitually moving shorter-term arrangements to longer-term. Second, firms typically have a degree of flexibility from revolving credit facilities (RCFs) which allow them to access cash, up to a predetermined limit, at any time. In short, there is no widespread and sudden refinancing requirement on the horizon. In a sector used to stressful conditions, the wiggle room is already incorporated.
That said, damage is inevitable. The hard stop in parts of the economy has seen activity slump – in some cases to near-zero and for month after month. It has been dramatic for retailers, restaurants, airlines and many more. In high yield, the energy sector, and particularly US oil, has taken some of the hardest hits.
Bridging the gap
Spreads have narrowed from their peak, but remain well above pre-crisis levels, which we think offers good value for UK insurers and pension schemes. As of 22 July, spreads in Europe were 483 basis points (bps), compared to 533bps in the US and 559bps globally1. This is tighter than the peak in March (by 383bps, 554bps and 535bps respectively) but still about 200bps wider than the start of the year. US issues still dominate – accounting for more than half of the global high yield market. For UK and European investors looking to access the US market, it is worth noting that hedging costs (see Figure 1) have tumbled. After historical highs in late 2018, effective zero rates from the Federal Reserve mean currency hedging costs are now at lows not seen since 2015.
The spreads we have seen are almost equivalent to the tech crash in 2002. The only period with dramatically wider spreads was the global financial crisis where they briefly hit 2,000bps in US HY (see Figure 2). We believe that the swift action and the sheer scale of monetary and fiscal policy announced to combat the coronavirus around the world – and the willingness to do more in future – has helped to avoid this outcome.
Defaults will rise in the global HY space. This doesn’t rob the HY sector of its appeal, but it does mean that care is needed when taking advantage of these market conditions.
The demand picture in HY has been a curious beast, with liquidity holding up well at the more distressed end of the market, and among issuers who were well shielded from the virus impact or which even have a positive crisis story to tell (such as in healthcare). In the latter group, some companies are trading not far below where they traded before, but some investors see value here as the default risk remains low.
In the middle group, however, where visibility about prospects is relatively low, liquidity has been weaker and prices suffered early in the crisis. That means the potential for both risk and value is perhaps highest here, in our view. And it is here, too, that good credit analysis will be able to add the most value, although it may take time to position portfolios.
Within these groups, across sectors and within sectors the effects of the pandemic have been uneven. Balance sheet liquidity has always been a key part of our credit research tools, but it is particularly relevant now to determine which individual companies may have trouble bridging to the other side of this crisis in both a base case and a more stressed case where lockdowns persist or return.
This issuer-by-issuer approach applies equally to the influx of so-called fallen angels from the IG segment into HY – the dollar volume of fallen angels hit a record $91.5bn in March. This ongoing effect of the crisis is having a material impact on the size and structure of the HY market and will bring buying opportunities as the market adapts. Fundamental analysis and valuation remains the starting point for any individual trade.
In an unprecedented crisis, barely a decade from the last one, markets have rightly been rattled. But as volatility softens, attention should turn to the value on offer.
1Source: Inter Continental Exchange 22 July 2020
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