The credit market sell-off has been indiscriminate so far, but we believe that as we enter “phase two” the winners and losers of the crisis are set to emerge.
Credit markets have endured a painful few weeks of what we’d call “phase one” of the Covid-19 crisis response: indiscriminate, panicked selling and the market effectively frozen. Liquidity has been very low, making it difficult to buy and sell bonds, and for a few days no new bonds were issued.
Few companies were spared as investors rushed to exit the market without differentiation or regard for whether some companies could, in fact, get through the crisis in good shape or, in some cases, even benefit.
For example, hotels, airlines and restaurants are exposed, with revenues and cash flows likely to fall close to zero, but others, such as food retailers and telecoms, could do quite well. That these latter sectors have endured similarly painful sell-offs as others seems unjustified.
The extent of the sell-off can be seen in the moves in credit spreads (the difference between the yield on a corporate bond and the yield on a government bond of the same maturity), which have rarely if ever widened so fast. This means investors are now being paid much more than they were to take on the risk of lending to companies.
The last time we saw credit spreads this wide was during the European government crisis in 2011, although we are still a way off the levels of the 2008-09 financial crisis.
Faster policy support this time around
Governments and central banks have responded quickly and proactively though, suggesting that lessons have been learned from the past, particularly 2008. The measures they’ve introduced make it clear that they have a much better understanding of how to support the financial system, particularly in Europe. As a result, we think the risk that the financial system collapses should be quite low.
We should therefore start to see the credit market shift gears, from indiscriminate selling to better consideration and differentiation between those sectors and companies which could be more resilient or even benefit from the current crisis, and those that will not.
This marks the start of what we think will be “phase two”, where buying and selling is more selective, and winners are more clearly separated from the losers. Phase two brings with it meaningful opportunity, especially for investors able to distinguish between the two.
Phase two opportunities: Europe
In Europe we think we are coming to the end of the widening of credit spreads. In the violin charts below we can see spreads on BBB-rated investment grade European bonds (blue violin on the left hand chart) range from 50 to around 400bps. The range has extended a bit, but nowhere near as much as in 2011.
Additionally, a decent proportion of the market is now trading at above 200bps, certainly more so than over in the past five years or so. So there’s a good opportunity to buy very healthy yields in European investment grade credit at much reduced prices (yields move inversely to prices) compared to history.
Similarly, in European high yield, a significant proportion of BB- and B-rated bonds had risen to 1000bps and still trade at very elevated levels. In BB, we can see that from 2017 onwards the market has mostly traded at around 250 bps, but had shifted to much closer to 750 bps.
Phase two opportunities: US
Valuations are also very attractive in the US. In investment grade, yields rose to around 4% (which implies a recession) and over 11% in high yield. The investment grade market has functioned well despite the shock of the last three weeks or so; the new issuance market didn’t really even close and there is record demand from Asian investors and insurance companies.
There will almost certainly be further volatility, downgrades and defaults. All of these will occur and some sectors will be harder hit than others, for example the energy and consumer discretionary sectors. But overall, downgrades and defaults will be idiosyncratic rather than systemic.
The Federal Reserve buying corporate bonds is a game changer in our view, not only in terms of improving the liquidity picture for investment grade, but also in that it creates much greater incentive for companies to maintain their investment grade rating.
US high yield looks compelling too. Not only is there significant upside given current prices, but the difference in the credit spreads within the market has normalised. At the beginning of the year only a small proportion of issuers traded at more than 100bps above the index. The market was essentially comprised of very cheap stressed energy, with all other sectors very expensive. Now, there seems to be a much broader opportunity set and real opportunity for both security and sector selection going forward.
Attractive return prospects
We are at a new starting point across credit markets with healthy return prospects ahead. Historically, when we’ve had these types of starting points in spreads, excess returns in the investment grade market have averaged between 15% to 25% over the following years, and between 15% to 45% in high yield. So there is real opportunity to generate return starting at these market levels.
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