Janus Henderson Investors: Give the Fed credit!

Key takeaway

• Corporate earnings and cash flows are under strain but while defaults look to inevitably increase, they should continue to be largely contained to sub-investment grade issuers.
• Massive and proactive central bank support measures have injected confidence into the markets but this does not preclude sporadic bouts of future volatility and warrants a selective approach.
• The managers believe that more resilient opportunities are likely to be found in higher quality, shorter-dated investment grade issues, and continue to have a preference for financial sector bonds and corporates with defensive attributes.

What’s driving credit markets?

Driven by the continued level of uncertainty of the COVID 19 pandemic, global financial markets have been highly volatile and while recently calmer, remain in a state of flux. Prospects for a vaccine coming to market sooner than expected and lockdowns ending, versus increasing contagion rates, rising deaths and risks of a second wave of infection, seem to be the main drivers of market direction.

Although credit markets have received support from central banks that have introduced new programmes to either buy corporate bonds directly (US Federal Reserve , European Central Bank and the Bank of England) or allow some corporate bonds to be repo eligible collateral (the Reserve Bank of Australia), there has nevertheless been considerable stress and investment grade credit spreads are generally wider today than at the end of February, when the crisis began (see Figure 1).

Figure 1: Credit spreads on investment grade corporate bonds

Source: Bloomberg, ICE BofA US Corporate Index, ICE BofA Euro Corporate Index, government Option Adjusted Spreads (OAS), 12 June 2019 to 12 June 2020. Option Adjusted Spread (OAS) measures the spread between a fixed income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option. The ICE BofA US Corporate Index represents US dollar denominated investment grade corporate debt publicly issued in the US domestic market. The ICE BofA Euro Corporate Index represents euro denominated investment grade corporate debt publicly issued in the European market.

In order to assess whether this repricing presents an opportunity or a risk, it is critical to understand if these changes are mainly driven by technical or fundamental factors. Unsurprisingly in the short term technicals have been the driving factor for credit spread widening. Initially investor demand for cash, given the flight to quality, led to indiscriminate selling of risk assets including credit.

More recently the markets are now giving way to optimism, fuelled by political will and central bank support initiatives. While underlying corporate fundamentals have taken a back seat so far, historical experience suggests that in the medium to long term, fundamentals such as leverage, interest coverage and access to cash will regain their position as the most important variable in driving credit spreads.

Have credit fundamentals changed over the last few months?

Most sectors and businesses are suffering from a reduction in revenue and profitability. But of more importance for credit fundamentals is the accompanying impact on free cash flow. Companies will try to reduce cash burn as much as possible by reducing, or extending out, capital expenditure and reining in variable costs.

As positive cashflow becomes harder to generate and leverage increases, it is important to focus on a company’s liquidity position — a key indicator as to whether it will be able to survive the downturn. How much cash does it have on hand? Does it have access to credit lines or a revolving credit facility? Are corporate bond markets open for new deals?

In answering these questions, it is important to make sure that these credit facilities are committed; if they are not, then it is all too easy for a bank to renege on these ‘commitments’ in times of stress. Companies in stress will often draw down on these lines and despite the negative carry will choose to hold the cash on the balance sheet. That way, management can guarantee that it can access liquidity and buy itself time for demand to recover.

Credit market issuers have become somewhat polarised. Higher quality, investment grade companies have a better chance of weathering the storm given their access to cash, bank credit lines and capital markets (equity and/or credit). For the latter, the US primary debt market has seen a record amount of issuance over the last few months, dominated by strong investment grade companies. Smaller, more indebted and lower rated companies will likely struggle, as they have fewer levers to pull.

Given this last credit cycle was one of the longest on record with almost unlimited access to liquidity, some companies will now struggle to refinance and stay solvent. So not only is there likely to be more credit rating downgrades but also an increase in defaults. However, defaults, consistent with history, could remain concentrated on already lower rated, high yield companies.

What are the rating agencies saying about downgrades?

As the current crisis is an abnormally large negative shock, should a raft of credit rating downgrades be expected? Moody’s recently published a report that analysed movements in ratings since 1920, which considers other economic shocks, including the Great Depression of 1929. The report emphasises that while softer than expected revenue and free cash flow will impact credit quality, rating agencies do attempt to rate through the credit cycle and capture lasting changes in credit quality. For those companies that had an historical rating change (either an upgrade or downgrade) Moody’s examined more than 100 years of data on US companies and noted it only reversed a rating change about 3% of the time within one year and only 20% after five years.¹

¹Source: Moody’s, Sector In-Depth, Ratings move with the credit cycle but do not amplify it, 12 May 2020.

The report also states: “Net downgrades rise in credit downturns, but only by a small amount. This is unsurprising as deteriorating financial and economic conditions are a key indication that aggregate default risks are rising. However, the degree of downgrades is relatively limited, particularly for higher rated issuers that should be more robust in the face of normal cyclical developments. During the past three credit downturns, on average ratings have only declined by around half a notch.”

Nevertheless, we do expect the COVID 19 crisis may result in more BBB bonds transitioning to high yield compared to history given that the BBB segment has hovered around 50% of US investment grade in recent months, from around 35% prior to the Global Financial Crisis². In our experience, bonds that go from investment grade to high yield can fall around 10% in price, so single name issuer selection remains crucial.

²Source: Bloomberg. ICE BofA BBB US Corporate Index as a % of ICE BofA US Corporate Index, 31 May 2020.

What are the rating agencies saying about defaults?

Before talking about defaults, it is worth stressing that most of the data examines just the high yield universe — those bonds rated BB+/Ba1/BB+ (S&P/Moody’s/Fitch) and below — as there are too few investment grade defaults to allow meaningful analysis.
For example, S&P’s average global one year default rate for a BBB- (the lowest investment grade rated) corporate over the last 38 years is just 0.2%, with a high of 1.4% in 1983. The long term annual global high yield default rate is 3.7%.³ The current COVID 19 crisis is expected to drive a rise in high yield default rates.

³Source: S&P 2018 Annual Global Corporate Default and Rating Transition Study, 9 April 2019. Covering 1981-2018 inclusive.

S&P is forecasting the trailing 12 month default rate for US high yield bonds to jump to 10% by the end of December 2020, from 3.1% in December 2019. This assumes a global recession this year. This increase is partly driven by the fact that the percentage of issuers with a B or lower rating stood at an all time high of just over 30% in March 2020.⁴

⁴Source: S&P Global Ratings, Default Transition and Recovery, 20 March 2020.

As with previous crises we expect heightened default risk to remain more or less fully contained within the sub investment grade universe, and specifically sectors such as energy, leisure, gaming and retail.

Is the current crisis the same as the Global Financial Crisis (GFC)?

This COVID 19 driven economic downturn is different to the GFC, as the financial sector is not the source. The severity of the crisis will depend on the individual sector, varying from those heavily impacted (travel, leisure, energy, luxury products), to those less so (food, consumer staples, infrastructure, agriculture, pharmaceuticals, technology).

Whereas in the GFC when pure corporate credits were generally preferred over financial credit, the current crisis sees the reverse as true. Since the GFC, through various new regulations, banks have been forced to substantially increase their loss absorbing capital bases and should be better set to survive. Banks will obviously be impacted by credit losses in their corporate, property and personal loan books but well managed ones are expected to have sufficient capital to take those hits.

One fortunate advantage of having stronger banks this time around is that they are more willing to extend credit to sound corporates, even those in more volatile sectors.

What are the technical factors that are driving the market?

Central banks have been proactive in attempting to support global economies and financial markets. There have been several initiatives that have been supportive to credit markets. These include the European Central Bank (ECB)’s €750bn Pandemic Emergency Purchase Programme (PEPP), which will be conducted through to the end of 2020 and includes all the asset categories eligible under the existing asset purchase programme, and the decision by the US Federal Reserve (Fed) to buy corporate bonds, including selected high yield bonds. In April, the Fed detailed various measures that give it the firepower to inject up to US$2.3 trillion of support to credit markets and the wider economy⁵. Elsewhere, the Bank of England has extended its corporate bond purchase scheme and the Reserve Bank of Australia has allowed some corporate bonds to be repo eligible and is helping to administer the Australian government’s Structured Finance Support Fund that is aiding issuers and the securitised market by buying primary and secondary asset backed and mortgage backed securities.
Given this extraordinary support from central banks and show of additional firepower if needed, technical factors are currently overwhelming pure credit fundamentals. Credit investors have gained comfort that there is a potential ‘buyer of last resort’ and credit spreads have since narrowed from their peak crisis wides.

⁵Source: US Federal Reserve, “Federal Reserve takes additional actions to provide up to $2.3 trillion in loans to support the economy” press release, 9 April 2020, Deutsche Bank, COVID-19: Policy responses by G20 economies, 21 May 2020.

What are the main takeaways and where do we see opportunities?

The global financial outlook is still uncertain. As such, we remain attentive to the possibility of volatility and with it, credit spread widening. The pace of credit rating downgrades will likely increase and defaults rise, but this should continue to be largely contained to sub investment grade issuers.

All said, the coordinated efforts by global central banks to inject confidence and stability back into the system by supporting credit should not be undervalued. Almost universally, central banks telegraph that they will continue to do whatever it takes. The wider spread on corporate bonds also may offer investors the opportunity to benefit from potentially higher returns. As such, at this juncture, we are comfortable adding some credit risk; not universally but in a highly targeted fashion, while remaining alert to the ongoing uncertainty and sporadic bouts of future volatility.

Within our remit, we firmly believe that more resilient opportunities in credit are most likely to be found in higher quality, shorter dated, investment grade issues, and continue to have a preference for financial sector bonds and corporate sectors with defensive attributes. We also expect to take advantage of opportunities in the more liquid jurisdictions such as the US, which continues to have a higher degree of support from the Fed, versus other central banks.