Buy & Maintain Credit Update No3: Bumpy credit markets offer value for long-term cashflow portfolios
- Monetary policies remain supportive and have pushed spreads tighter since the peak of the crisis
- There is a heightened risk of high yield defaults and record high potential for ‘fallen angels’
- Liquidity remains challenging. The primary market remains the best route for allocations and a spike in long-dated issuance may be useful for pension schemes and insurers.
- Valuations remain attractive from a historical viewpoint, but the BBB premium looks modest
- Investors focused on cashflow have several options to adapt to the crisis conditions
- Overall in CDI portfolios there is an opportunity to capture an attractive spread level over the long term, but selectivity is key
The COVID-19 crisis is focusing minds on the fallout in corporate credit markets. Monetary and fiscal policies remain highly supportive across regions, pushing spreads tighter since the peak of the crisis in March, but valuations remain attractive even when factoring in the likely bumps along the road.
Those bumps will include defaults. Ratings agency Moody’s has lightened its gloomy outlook in recent days, but remains very cautious. In US high yield it currently expects a default rate of 13.3% in its base case scenario (7.8% in European high yield). That compares to the current rate of 5.4% in the US and 2.0% in Europe.1
We are more upbeat, but still expect the US rate at 7.9% in our own base case (1.7% in Europe). When we factor in higher estimated default rates in the more pessimistic scenarios – as much as 22.6% in Moody’s worst-case – it serves to highlight the fragility fostered by the coronavirus and the global lockdown that has sought to fend it off.
In investment grade (IG) this raises the prospect of a rush of ‘fallen angels’ – credits that move into high yield territory. This can make some IG investors forced sellers, as well as offering a glut of new assets to high yield portfolios. So far, we have seen 25 fallen angels in the US over just two months, worth about $150bn. For context, that’s the kind of level we might normally expect over a three-year period. The number of ratings on S&P’s Creditwatch negative is also at a record high – and a useful signal of downgrades to come.2
Making the most of record new issuance
Bond liquidity, meanwhile, has seen some improvement but remains tricky. Some BBB names attract very little interest (zero for some BBB- issuers) and our preferred avenue remains to reinvest via the primary market which has been very active since the end of March.
This has allowed us to benefit from the new issue premium, which is currently generous, while remaining highly selective as supply surged to record levels. Companies are issuing bonds due to cash burn in the lockdown conditions and to build a buffer that might see them out the other side. It had been an opportunity open largely to the most highly rated firms, but since the end of April, more BBB issuers have come to the market, accounting for as much as 70% of new supply. Maturity, meanwhile, has moved up the curve with average issuance at about 13 years over recent weeks – useful for those of us building long-term cashflow portfolios for insurers and pension schemes. Most have performed very well, with spreads tightening aggressively after issuance.
In total, over the year to date, companies have issued close to $900bn of IG credit. We expect that to grow to $1.5trn over the full year. That would be 25% higher than the previous peak in 2017.
The entry point is still open
So how has this new issuance been absorbed? First, of course, we have the central bank buying that has underpinned demand. Second we have the IG volume leaving the market with the fallen angels. Third: valuation. Spreads now remain twice as wide as normal, even with the improvement since the peak, and the price is right to bring in new investment.
This pace of primary deals won’t last – the startling wave of issuance we have seen will soften as companies become more comfortable with their cash levels. But we do expect to see the market perform well over the rest of the year. Valuations still offer a good entry point for selective investors and we expect the yield curve to steepen from its relatively flat levels as more long-dated deals reach the market. It is worth noting that the BBB premium looks modest, particularly in GBP and EUR, and there is no real need for IG investors to go down the rating spectrum to secure a good spread.
So how are we helping clients to adapt to this changing environment? We find most are aware that this period of volatility could offer an attractive opportunity – that cashflow has rarely been cheaper to acquire. We are in discussions with many pension schemes about how to adapt. In this environment there is clearly a heightened need to consider in detail the individual characteristics of each client, from their cashflow demands to how they are funding those to their hedging requirements.
In general terms, though, clients wanting to access these opportunities fall into three broad groups. First, there are those schemes or insurers with cash available to access credit markets, or who can make their liability driven (LDI) portfolios work harder to the same end. This is a fairly straightforward decision. Second, there are those already invested in IG markets but who could benefit from adjusting their portfolios to capture the advantageous spreads and better meet their cashflow needs. This too can be done relatively simply – liquidity remains pretty benign, and we believe we have a track record for keeping trading costs low when capturing this spread.
The third group have a more challenging call to make to take advantage of the unique credit environment. Clients may benefit from selling riskier assets – equities or structured finance assets perhaps – in order to capture spread. This opens up the possibility of crystallising a loss – never an easy decision.
In the background of all this, we must remember that the outlook remains hazy, and default risk – as we’ve seen – is clearly a factor. Timing will be important, particularly for that third group of investors. We have various tools to help manage marketing timing (e.g. via trigger monitoring) to release cash for credit investments when they can capture the right level of spread. Clients may use leverage opportunistically to build their credit portfolio at these levels, which could be funded by sales of riskier assets further down the line.
Investment involves risk. The value of investments, and the income from them, can go down as well as up and an investor may get back less than the amount invested.
- Source: AXA IM, Moody’s, S&P as at 18/05/2020
- Source: AXA IM, Moody’s, S&P as at 18/05/2020