March is not even halfway through, but has already presided over the largest fall in the price of European high-yield bonds since October 2008. The BofA European Currency High Yield Index is already in the minus 8% this month, but the unprecedented fall in prices also offers opportunities. Within Europe, I would now rather invest in Italy than the UK or Germany.
So says Andrew Wilmont, manager of The Pictet EUR High Yield fund, in conversation with Investment Officer. He sees parallels with 2008, because just like then, panic seems to have struck. ‹It’s hard to find liquidity now, and there isn’t always a counterparty to take it up if you want to sell. There are still bids, but the situation changes every day›.
At first, companies from Italy and the travel industry were hit particularly hard. But more liquid bonds also went down fast, because they are easier to sell. In the end, therefore, we saw little differentiation in the market,› says Wilmont.
In addition, some junk bonds have already fallen so far in value that they represent no more than the value of the assets of the company in question. As a result, they can’t drop much more. Usually the recovery rate of a bond at a default is around 40%. Therefore, a crash often starts with a risk sell-off in which such bonds are sold, but is followed fairly quickly by a liquidity sale in which the better-quality bonds also take a hit›.
Wilmont went underweight credit risk relative to the benchmark on 27 February, when the markets had just completed the first phase of the sell-off. ‹We do this by means of credit default swaps. In the last week of February, market sentiment, based on valuations and momentum, suddenly dropped sharply. That was the signal for us to reduce our risk›.
‹Market is bottoming’
Yet Wilmont thinks the market is now bottoming. ‹I expect that the fiscal measures taken by governments will now slowly come through,› he says. ‹Friday’s announcement by the German government that they will provide unlimited support to affected companies, for example, immediately caused high-yield spreads to fall by 50 basis points.›
The risk premiums on high-yield bonds are now around 600 basis points. ‹In a full recession, credits still have to go further, up to a spread of 1200 basis points. But this is not a normal recession, because it’s due to a virus. When the first panic is over, people will start looking again where they can put their money in this low-interest rate environment. A yield of 5.5% like now looks a lot more attractive than the 2% we had a month ago.›
Wilmont may expect a stabilisation, but this does not mean he is ready to increase the risk in the portfolio again. ‹The beta bonds, which have gone down mainly for liquidity reasons, will go up first in this scenario. For more cyclical bonds, a recovery always takes longer. So now I prefer to buy non-cyclical companies, preferably in areas where the virus is already at its peak, such as Italy. After all, you can assume that it reaches all countries. Some clients still want to know how much exposure I have in Italy, but that’s not really a relevant question anymore at this stage›.
Falling angels
Meanwhile, the majority of newly issued investment-grade bonds have a BBB-rating, the lowest possible investment-grade rating. A month ago, when the corona crisis had only just started, the OECD already sounded the alarm about this. In the meantime, the danger this poses to markets only seems to have increased. After all, most airlines, cruise liners and travel agencies have a BBB-rating. The same applies to a number of car manufacturers and other cyclical companies, which could be affected by the declining economy.
‹If a lot of the same kind of companies enter the high-yield market shortly after each other, that segment can indeed get quite a knock›, Wilmont knows. ‹Prices could go down a lot. As an investor I might choose bonds of one or two companies from a sector that are in the best condition, but I really don’t buy them all›.
Yet there will not be an epidemic of falling angels from one day to the next, even if the corona crisis gets even worse than we can now imagine. ‹Credit rating agencies only get money to issue a rating when a company issues a bond, because that’s the only thing it gets paid for. As long as there are no plans to do so, the rating usually remains unchanged›.
For example, the Norwegian airline Norwegian Air Shuttle, which has been on the brink of bankruptcy for months and had to lay off half of its staff last week, still has an investment-grade rating. ‹We will see falling angels, but it could take one or two quarters until we see that happen.›