High yield: Opportunities on the rise as the fallen angels descend
- There is no maturity wall waiting for high-yield (HY) issuers. Relatively few should need to refinance debt in 2020 and 2021 thanks to the sector’s flexibility
- The hard stop in some parts of the economy will do significant damage. We are stress testing base case and worst-case scenarios
- The global HY market has split into three clear segments, with demand only sustained at both extremes. Companies stuck in the middle are struggling to attract investors
- Spreads are elevated, but not catastrophic. The intervention by central banks has been welcome and decisive
- The arrival of former investment-grade issuers into the HY universe will have a material effect on the market. We will be very selective buyers and will rely on deep research to find value in names across the rating spectrum
High yield is used to moments of stress
The coronavirus outbreak and its spread around the world has driven volatility across asset classes and markets. It remains a difficult task to predict the nature and speed of our exit from this crisis, but there are useful markers for how certain assets are positioned. In high-yield (HY) debt, the pain has been sharp and the impact considerable – not least from the glut of downgrades bringing investment grade issuers into the sector. However, there are also signs of resilience.
Underpinning this idea is a simple observation. As we came into this extraordinary period, there were two fundamental aspects of the HY market that gave issuers a chance to weather the storm. First, HY companies tend to term-out debt – consistently moving shorter term facilities to longer-term. Second, firms typically have a degree of flexibility in the form of revolving credit facilities (RCFs) which allow them to access cash, up to a predetermined limit, at any time.
In other words, there is no maturity wall. In a sector used to stressful conditions, the wiggle room is baked in – we expect that relatively few companies should need to refinance debt in 2020 and 2021.
That said, the conditions we are witnessing now are of another order of magnitude entirely. Damage is inevitable. The hard stop in parts of the economy has been extreme and we have all seen how shops and restaurants, airlines and sporting events have seen activity slump – in some cases to near-zero. In HY, the energy sector has been heavily impacted, particularly US oil. Even with no debt to refinance, might some of these companies have cash needs in excess of their RCFs?
Bridging the gap
Balance sheet liquidity has always been a key part of our credit analysis, but it is particularly relevant now to determine which 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 longer. Unsurprisingly we have been reviewing holdings for short-term liquidity needs in both scenarios.
For the moment, stress levels are elevated, but not catastrophic. As of 28 April, spreads in Europe were 660 basis points (bps), in the US 801bps and globally 813bps1 . This is around 200bps tighter than the peak in March and perhaps 500 wider than the start of the year.
These spreads are equivalent to the peak of the technology crash in 2002. The only period with wider spreads was the financial crash of 2009 where they hit 2,000bps briefly (see Fig 1).
Our base case is that the swift action and the sheer scale of monetary and fiscal policy announced so far – and the clear willingness to do more in future – will help to avoid this outcome. This case is potentially supported by the clearly better capitalisation and functioning of the banking system as a whole, compared with 2008/2009. The speed has been strikingly different compared to the Lehman crisis, when months passed before concerted action. We have seen rapid intervention using a well-designed playbook.
A house divided
Regardless of the effectiveness of central bank and government measures, however, defaults will rise in the global HY space. We think this may well occur in two phases. The first wave would arrive over the next few months, and most likely affect those companies that were on the brink anyway, or which have been hammered by the COVID-19 impact. An additional set of defaults would then be very possible as we move through 2021, when the effect of any stimulus wanes, and when the true impact of the outbreak on various sectors is much clearer.
Right now, the HY market appears to be made up three sections. First you have the issuers that look most shaky, which might be due to excessive leverage, the virus impact, or a combination of both. Bonds in this group are trading heavily down, but liquidity at this end of the market is holding up – there has been a good deal of capital on the side-lines waiting for some decent distressed opportunities
At the other end of the scale you have those companies which are relatively well shielded from the virus impact and which started this period with conservative balance sheets. They might even have a positive crisis story to tell (such as in healthcare). This group is a relatively large part of the HY market in Europe. Some of these companies are trading not a long way below where they traded before, but there may well be reasonable value here as the default risk remains low. Demand remains robust and the market remains liquid.
Then we have the middle group – companies where visibility about their prospects is relatively low. Liquidity in this area is 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 due to the lower liquidity.
Ratings agencies have downgraded issuers with surprising speed and vigour. That has created a wave of ‘fallen angels’ as some large issuers lose their investment grade rating. The chart below shows the March spike in the monthly dollar volume of fallen angels – at $91.5bn it is a level we have not witnessed in 20 years.
This effect will improve the average credit quality of the HY universe while downgrades of existing HY issuers will act to weaken it. One thing that is clear is that there will be more supply in HY. This will have a material impact on the size and structure of the market and will bring buying opportunities as the market adapts.
We believe there should be no blind rush to snap up fallen angels, especially in weaker sectors. Value is possible because investment grade (IG) investors may be forced sellers and the companies concerned are likely to be larger and more resilient. However, fundamental analysis and valuation remain the starting point for any individual trade. Equally, those issues dropping down the HY ratings scale do not necessarily offer good reasons to sell.
The new supply might have given the high-yield market a bad dose of ‘indigestion’, hence the cheers that greeted news the Federal Reserve intends to keep names that were IG rated (BBB- or higher) at 22 March eligible for its purchase programme, providing their new rating is at BB- or above. We believe this is very useful breathing room for businesses and good news for high yield investors.
We would expect pressure to build on the European Central Bank to follow suit. Currently it has a policy of holding any names downgraded from IG, but it may yet relax the rating thresholds in its own corporate sector purchase programmes. That would be a significant move, as we think the IG names in Europe that will fall to into the high-yield universe have the potential to reach €75bn or more.
In an unprecedented crisis, barely a decade from the last one, markets have rightly been rattled. But even as the volatility continues, attention will slowly turn to the value opportunities. We can see good reason to increase duration and risk positioning, where appropriate, over the coming weeks and months while controlling risk for more stressed situations that may arise. History suggests that entry into the HY market at these sorts of spreads has a good probability of a very strong return over a one-year view, although this is not guaranteed.
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