The US election has dominated market news over the past fortnight. But in our view, the outlook for global high yield remains the same. In this blog, we look at three of the reasons why we believe the rebound in high-yield prices isn’t yet over: monetary policy and fiscal stimulus, default rates, and credit quality.
Monetary policy and fiscal stimulus
The policy reaction to any material economic dislocation is always the same: low rates and stimulus. The extraordinary monetary policy actions following the market turbulence at the end of March continue to keep a lid on interest costs, while fiscal stimulus measures have helped revenues. In addition to supporting credit markets across the spectrum by bringing spreads back down from their peaks, these actions helped restore investor confidence.
Some have argued that the rebound in high-yield bond prices is over but, in our view, that would be inconsistent with past experience. The chart below shows the changes in spread levels in US BB-rated bonds during the 24 months following the most recent market crises.
The dotted line for March 2020 goes to 22 September 2020, six months after the COVID-19 peak. Following recent moves, the BB spreads were in the 52nd percentile as at 12 November 2020. So looking at these previous episodes overall, not only has the high-yield market rebounded quite quickly after significant selloffs, but those rebounds have continued for periods of a couple of years. We therefore think that the recovery in high-yield markets has only just begun.
After any spike in defaults there is normally a huge tail-off in bankruptcies and survivorship bias takes over indices, especially as the ranks of high-yield bonds are swollen by ‘fallen angels’. In combination with low rates and stimulus, if you take an investment universe where the weakest companies have already been weeded out, then a collapse in default rates no longer looks surprising.
One of the interesting features of recent market movements has been that the rapid downgrade activity by the rating agencies has been accompanied by a relatively muted impact of downgrades to fallen-angel status. This is largely due to the unprecedented level of direct government support, which has reduced the absolute opportunity in fallen angels by cutting off the downside in price, although it has potentially created appealing risk-adjusted return potential in relative terms.
Many companies will now be focused on improving their credit profile and maintaining their credit rating. Yields are also likely to be at historically low levels which, from a fundamental perspective, should lead to an improvement in credit quality as interest costs sink.
The market has now refinanced so much that few companies need any extra liquidity, and new issuance from here is more likely to be designed to lower coupons and extend what is an already benign maturity schedule. With government bond yields having collapsed, even fallen angels can refinance at coupons lower than they are currently paying.
Beyond the US election and looking forward into mid-2021, by which time further stimulus is likely to be on the way, we believe the quality of the high-yield bond universe will have increased and that defaults will be at low levels, with the bulk of these companies aiming to improve both their credit profile and their credit rating.
Meanwhile, historically low yields should lead to a material improvement in credit quality as interest costs fall. This depression of yields everywhere, combined with potentially increasing concerns over dividends and rents, is in our view likely to create a vast and increasingly desperate search for income, alongside a desire to avoid defaults.
In the environment of declining defaults that we anticipate, we believe this combination of factors could push spreads to record lows and create a strong demand for high-yield bonds.