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In this quarterly edition of our credit review, we take you through the Macro, Fundamental, Valuation, Sentiment and Technical forces that have been driving the investment grade and high yield markets, together with our thoughts on where to be positioned in the fixed income markets for the quarters ahead.
The quarter kickstarted with a rebound in US manufacturing sentiment with the ISM manufacturing PMI rebounding to the neutral level of 50. The labour market was strong with additional job gains in non-farm payroll data and wage growth was still solid at 4.0%. All of this has since been turned on its head and those macro data points are now backward looking and meaningless following the outbreak of Covid-19.
The macroeconomic landscape paints a bleak outlook for credit, which is reaching the end of a protracted cycle where borrowers have enjoyed a relatively low number of annual defaults to their debt obligations. Global central banks were long warned that they could run out of ammunition to keep this credit cycle going any longer but along with direct fiscal support, continue to pull out all the stops to defend the credit markets. Until we have better visibility on the longevity of quarantine measures, the real impact of Covid-19 on economic growth and the severity of decline to H1-20 corporate earnings, the markets will continue to be steered by sentiment and technical factors.
We reiterate from our previous quarterly investment outlook that credit metrics have been on a gradual weakening trend. We are going into this crisis with median net leverage of 2.6x on BBB-rated bonds as of Q3-19, up almost one whole multiple of EBITDA compared to 1.8x five years ago. With the devastating impact Covid-19 will have to economic growth and $3.4tn of BBB-rated debt in the US (more than half of the entire US IG index), investors are once again fearing potential fallen angel risk in the market.
Looking at recent history, the percentage of US investment grade bonds being downgraded to high yield remained comfortably under 1% of the index through 2017-19. We expect fallen angels through the next 12 months to rise to 3-4% dependent on the length of the recession.
Rating agencies could be more lenient when assessing the credit impact of debt-financed acquisitions when the outlook for revenue growth and cash generation for companies was positive. Now that the economic backdrop has flipped around and we’re expecting see year over year declines to corporate earnings, we expect agencies to show less tolerance to the issuers. Kraft Heinz and Occidental Petroleum are two examples of BBB issuers that had maintained their IG ratings following transformational acquisitions in prior years but were eventually downgraded this year. In the case of Occidental, following the fall in energy prices caused by the Saudi/Russia oil price war, it was clear the company would be challenged in growing into its new capital structure created by the acquisition of Anadarko. Occidental announced an 80% cut to its dividend and 30% reduction in capital spending to conserve cash flow but that was too little too late in the eyes of the rating agencies. Kraft Heinz on the other hand, refused to cut its dividend nor provide a strategic update on how it will bring its leverage back down to a pre-Heinz acquisition level. The agencies wasted no time to junk Kraft Heinz.
While we expect IG corporates to reduce capex, cut back on operational expenses and draw down on revolvers to defend their balance sheets and improve their liquidity, the Kraft Heinz case highlights uncertainty over the willingness of companies to cut back on shareholder rewards. To provide context, an estimated 70% of free cash flow generated by US IG companies is directed to shareholders with this being even higher than average in the utilities, transportation and capital good sectors. With equity markets having taken a bruising, it remains uncertain how many boards of shareholders will be willing to cancel dividends or pause share repurchase programmes. In our technical section below, we comment on the Fed’s support to US domiciled IG companies. We like healthcare, telecom and the utilities sectors and seek to avoid automotive, consumer discretionary, mining and energy. We note that out of the BBB- rated issuers, the most at risk of downgrade is Mexican stated owned oil producer Pemex, which has $58bn of outstanding debt in the BAML/ICE US IG index.
We reduced our US high yield position in Q4-19 given stretched valuations and concerns that the escalating US China trade war could dampen global economic growth and sting the more cyclical industries, namely oil and gas. We then followed this by closing out of our EUR high yield position in the first quarter as initial quarantine measures in Italy and the lack of a co-ordinated medical response from the EU created the new reality of deep downside risk to our position.
Using EBITDA as a proxy for free cash flow, the interest coverage ratio gives us one indication of a company’s ability to keep up with interest payments. We can see that this factor has been on a downward trend (more pronounced for the lower rated single-B and CCC and below rated credits) and the paradigm shift in earnings and free cash flow expectations post Covid-19, will push a greater number of high yield issuers into default over the next twelve months.
A broad-based approach to investing in high yield is challenged by the bifurcation of the market into sectors directly impacted by Covid-19, lower oil prices and sectors with no direct impact as the fundamentals are still at risk from the global recession. In the former group, among the hardest hit are hotels, gaming, discretionary travel and the non-food & beverage retailers. Las Vegas has been here before in the great recession of 2008 and following terrorist incidents but this time round, government enforced casino shutdowns and recession-induced decline in consumer demand will weigh heavily on visitation numbers. The benefits of global diversification for casino operators has greatly diminished with no material pickup in Macau, where casinos have already re-opened for a month as medical monitoring and quarantine measures have been taken very seriously. Gaming revenues have hit zero for some US operators, hotel occupancy has plummeted, business conferences have been cancelled, entertainment events are being rescheduled and we don’t expect a sharp rebound as fears of contagion in crowded public spaces and a second wave will overhang the sector. Equally, we believe that there will be second and third effect of hitting the brakes on discretionary travel as a segment of leisure travellers who are more risk adverse, will not travel at any price in the crucial summer period if and when travel restrictions are fully lifted. Government bailout funding is inevitable for the airlines to keep the industry flying in the face of materially lower air traffic demand, average ticket price declines due to overcapacity, committed capex for aircraft deliveries and costly hedges on high fuel prices. We see little respite to operating expenses and cash flow from staff redundancies and cash ticket refunds to customers.
The other elephant in the room is the energy sector, which will be the largest determinant of total defaults in the index in 2020. The US high yield index has a weighting of 14% in energy sector bonds by face value of total debt. After factoring in the duration and the higher proportion of distressed issuers in the sector, in duration times spread (DTS) terms, the adjusted risk contribution of the sector is closer to 30% of the entire index, thus explaining the energy sector’s significant influence on the index.
Exploration and production companies have been hit twice by both falling demand from China and also new supply coming online after OPEC+ failed to reach an agreement on production. High yield producers have been quick to respond through the lowering of activity levels and halting growth plans but once the protection of commodity hedges comes off, in the months ahead we will be sure to see more actions with asset sales, for any players that can find a buyer, and liability management exercises, for producers that can convince bondholders for relief. Distressed E&P companies Chesapeake and Denbury Resources are two of those with sizeable upcoming bonds to repay that are likely to go down that route and exhaust all its options through covenant waivers, up-tiering debt exchanges and pledging more security to creditors to fend off filing for bankruptcy and maintaining a sustainable capital structure the firm can still grow into once out of this period of pain.
Rating agency Moody’s provided its base case for US high yield default to rise to 6.8% over the next twelve months if the recovery is V-shaped (this compares to expectations of sub-3% at the beginning of the year). The agency has gone further to say that if the crisis deepens with severity and longevity more comparable to the great recession of 2008, defaults could rise to 16.1% and up to 20.8% under an “extremely severe” recession. March 2020 has seen three defaults in the US high yield index. All three were energy credits (Foresight Energy, Hornbeck Offshore and Pioneer Energy) and we expect defaults to continue to be heavily weighted towards energy, but also non-food & beverage consumer sectors.
To end this section on a lighter note, with every recession and downturn we’ve seen in the past, survivors will emerge and often take market share organically or through consolidation to become more competitive and build stronger credit profiles This highlights the need for issuer selection over a broad-based approach to investing in this market environment.
Following the capitulation in credit markets and with credit spreads having reached the widest levels for a decade, this calls for taking a different approach to valuations than we have in previous quarters. Rather than assessing how a rating bucket, sector or part of the maturity curve trades versus where it has traded historically, we have applied a relative value to approach, allowing us to capture dislocated opportunities that have potential to spring back faster and further in a market rebound.
For investment grade, the widening gap between A and BBB rated credits highlights investor concerns over fallen angel risk; the risk that an investment grade rated bond is downgraded to BB+ or below and in turn, leading fund managers to force sell junk rated bonds they no longer have a mandate to hold. We find the 160bps differential between A and BBB credits as attractive, when comparing to the one-year average of 52bps, and can justify adding quality, defensive and diversified credits in this rating segment to our portfolios.
We generally see better value in moving down the credit rating spectrum than further out the maturity curve, as the spread pickup on the rating curve is much steeper than the maturity curve. However, when corporate earnings are a constant moving estimate and there is a high degree of uncertainty to just how far the underlying credit risk of constituent bonds will shift to the right, it is difficult to determine the fair value of the credit spread in the lower rated segments. We also don’t believe current spread levels have priced in second and third order effects of the lockdowns, which could lead to a further technical recession in early 2021.
To contextualize performance through this crisis, we must compare it to the downturn in the global financial crisis. If we compare the US investment grade market today to 2008, it has now grown to $6.7 trillion from $2.5 trillion while the composite quality of the index has also deteriorated (total BBB-rated bonds has grown to 50% from 35%). The interest rate regime inhabited by credit markets was also profoundly different. In the months going into this downturn the federal funds target range was between 1.50-1.75% vs 5.00-5.25% in 2008. Coupons on bonds are at a lower starting point this time, providing less protection to price downside and greater sensitivity to interest rate changes. The table below shows how performance in US and UK government bonds and falling yields have helped to soften the blow to total returns, compared to 2008.
Dislocations clearly are aplenty in this market as investors are still gauging the magnitude of damage to corporate credit metrics. We believe we need to at least get through Q1 2020 earnings season before high yield markets stabilise and for risk in the market to have fully transferred to the fund managers and investor types that understand the risk. Covid-19 will hit returns in certain sectors harder than others and as a result, create increased dispersion of investment performance. For a snapshot of the high yield sectors that trade the widest, air transportation currently trades over 4 standard deviations wide to the broader index, followed by gaming (3.3 SD), leisure (2.3 SD) then energy (1.4 SD). We believe sector allocation, issuer analysis, duration management and security selection are crucial tools for any credit investors to generate positive risk-adjusted returns in these choppy markets.
Sentiment and Technical
Throughout March, the sentiment and technical factors that we assess including liquidity, flow, new supply of bonds and central bank support were pushed to the extremes.
We have seen a growing number of investors and funds over the years preferring to hold instruments that are large, standardized and liquid. The disadvantages of this bias became clear in March as fund managers that were hit by client redemptions sought to unwind this crowded trade in an attempt to sell what they can. This led to redemptions in the most liquid parts of the market, which were BB-rated bonds by issuers with large capital structures in the high yield segment, shorter dated bonds in the investment grade universe and credit ETFs in general.
We were not surprised that the smaller part of the fixed income market towards the CCC end of the credit spectrum had been frozen with investors unable to find price clearing levels. However, we were alarmed when these sharp drawdowns led to the widest bid-offer spreads we have seen in the front end of the investment grade market and flattened the investment grade curve into an inverted curve.
This severe market dysfunction prompted the Federal Reserve to step in and restore confidence to markets by providing a backstop in the form of two mandates. It created the Primary Market Corporate Credit Facility (PMCCF) to purchase new issue bonds with maturity up to four years and extend loans to corporations and the Secondary Market Corporate Credit Facility (SMCCF) to buy bonds maturing within five years in the open market. The criteria for eligible bonds are that the companies are headquartered in the US with material operations in the US, with at least two investment grade ratings from the rating agencies. Consequently, this excludes all hard currency emerging market issuers and ‘yankee issuers’ from the UK and Europe. Banks and other companies in sectors that are expected to receive direct financial assistance from the government, will not be eligible either.
On Good Friday, the Fed expanded the criteria of the PMCCF and SMCCF to include fallen angels that held two investment grade ratings from the agencies as of 22 March 2020, but were still at least BB-rated. This provided further support for recent fallen angels including Ford Motor Co. The facilities will also have a sleeve for buying high yield ETFs. We would not be surprised if the Fed were to expand the criteria of its corporate bond purchasing facility again in the near future especially if credit conditions deteriorate. As the Fed continues to pull out all the stops to support the US economy and stall the end to the credit cycle, with this backstop in mind, we find comfort in selectively increasing our exposure to short dated investment grade bonds that are eligible for purchase by the Fed. We think that there is potential to capture superior risk-adjusted returns in the belly of the credit spectrum, the crossover BBB/BB space as BBB-credits are explicitly supported by the Fed and BB-rated credits are now partially relieved of the supply pressure from potential fallen angels.
We have seen similar pledges in support of corporate bond markets announced by the ECB and also to a lesser extent the Bank of England. The ECB initially turned up with a delayed response to support the markets through a limited €750bn Pandemic Emergency Purchase Program (PEPP) but later decided to ditch issuer limits on its existing Corporate Sector Purchase Program (CSPP), essentially in a copycat move to the Fed that also echoed sentiment of previous ECB chief Mario Draghi’s “whatever it takes” approach. Following two weeks with issuers shut out, EUR IG primary markets reopened on 23 March and deals have generally been well supported although issuers have had to pay new issue concessions around 50bps to get deals through.
Despite the recent market volatility and having seen refinancing markets shut for an entire week in March amidst market volatility, US investment grade issuance came in at a record $262 billion for the month. The previous record was set in May 2016 at $178 billion of new issuance. This brought the total gross issuance for the quarter to $481 billion which was up 44% year on year. Much of this was driven by lower interest rates, after the Federal Reserve cut the Federal Funds Target range to 0-0.25%, allowing blue chip companies with the strongest credit ratings to continue to access financing via the debt capital markets. Issuance in the first quarter was skewed towards single-A rated issuers (54%) and even more so in March, with single-A bonds representing 64% of total US IG issuance.
In sharp contrast, in the US high yield space, new issuance markets were shut for nearly the entire month of March as the rapidly declining market pushed borrowing costs higher and deterred junk-rated corporates from reaching out to lenders. Interestingly, it was B1/B+ rated YUM Brands, owner of the KFC, Pizza Hut and Taco Bell franchises, that thawed the ice and successfully sold $600m of new unsecured bonds to investors on 1 April. With this positive litmus test showing signs of life in the market, we expect other sub-investment grade rated corporates to join in tapping the markets in a move to shore up liquidity and clean up their maturity schedules.
Past performance is not a reliable indicator of future returns. Forecasts are not a reliable indicator of future returns. If the information is not listed in your base currency, then the result may increase or decrease due to currency fluctuations.
If not otherwise indicated, all graphs are sourced from Dolfin research, April 2020.
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