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22.04.2020 59

Revisiting the global high yield outlook in the wake of the COVID-19 pandemic

Published April 22, 2020

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The essential


  • Global HY markets sold off aggressively between February and March in response to the COVID-19 outbreak, the oil price war and the liquidity freeze in some markets. An analysis of past peak-and-trough episodes in the US HY market shows that on most occasions investors have enjoyed positive market returns just one year after the peak. Three years past such a peak, market returns have proven positive in all six occurrences since 2000.
  • The current sell-off may not be the most severe in terms of drawdown but its rapidness was unprecedented as it took place over just one month. The recovery phase has historically been slower than the sell-off, as a wave of defaults is triggered after the market has bottomed out. This might be the case in 2020 as well, but conditions are different from those of 2008, when the crisis originated from the financial sector. Today, it originates from the pandemic and its impact on the global economy. Corporate fundamentals deteriorated after the GFC, with generally higher leverage and slowing sales growth. However, the debt servicing cost is lower today than it was in 2008 and policy stimulus is being delivered quickly, with significant easing not only on the monetary policy side, but also on the fiscal side. For the first time ever, the Fed has launched a purchasing programme for recently downgraded HY bonds. These measures should help cushion the HY default spiral. With US GDP contracting by 2% this year (our base scenario) and given the current distress levels, we foresee the US HY default rate jumping to 11.5% by February 2021 from 4.5% in February 2020, then rapidly declining as the economy recovers. Therefore, the US HY market appears to have already discounted most of the bad news and any further deterioration is unlikely.
  • Investment convictions: on US HY, selectivity will be of paramount relevance, with a focus on industries and companies that are relatively insulated from the effects of the virus. Active long-term investors could identify mispriced securities and reposition their portfolios to achieve ample liquidity and take advantage of possible price dislocations. Given the current market stress, the downgrade wave should prove an important dynamic. However, fallen angels have had very strong return profiles historically and the Fed’s decision to buy them could limit the pressures on this segment. The market volatility is probably not over yet and markets will stabilise only when indications emerge that the virus can be brought under control through an effective vaccine and the mortality rate reduced through drugs that lessen its effects.
  • On EU HY, we favour BB names in defensive sectors due to the current low visibility on the economic outlook. The EU HY primary market was closed in March, but this situation is likely to prove transitory and we expect solid BB names in the defensive sectors to return with fresh issuance. In cyclical sectors, investors should wait for more clarity on how long the lockdown measures will last. The rating distribution of EU HY issuers compared with their US peers shows a higher share of BB-rated names. Hence, the EU HY market is of better average quality and could offer diversification opportunities.
  • On EM HY, we believe that this asset class is oversold. EM HY offers high diversification, both from a regional and sectoral perspective, and has low duration, which should help the rebound once the market recovers. Volatility could remain high and investors should look for a combination of value and quality styles, with a preference for defensive sectors. We believe that there is value in sectors such as TMT, real estate, healthcare and – selectively – financials and utilities. From a regional perspective, we see value in China and Latin America. There are risks and opportunities in these markets. The risks are that the economic weakness is prolonged by an extension of the lockdowns across the global economy. However, opportunities could be found through robust credit analysis to find resilient credits with depressed valuations.
  • From a global HY perspective, current market conditions are complex, with an unprecedented crisis accompanied by an unprecedented policy response. Much of the current gloom is already priced in, but diversification is paramount. Exposure to the global HY market allows investors to benefit from different growth drivers, corporate fundamentals and recovery timings from the pandemic. While we cannot call the bottom of the market and acknowledge that volatility is likely to remain high, we believe that the market will normalise and strengthen once the pandemic’s peak has passed. Current dislocations may be seen as opportunities for investors who are able to bear some volatility and who have an appropriate investment horizon.

 

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