GRANDSTAND of Justin Jewell, senior manager at BlueBay’s Global Leveraged Finance Group. Comment sponsored by BlueBay Asset Management.
Credit investors, especially those operating in the swampy corners of the high yield and leveraged loan markets (also known as high yield bonds), tend to be notably concerned. The great performance of the high yield market in 2020 (where we saw that the global universe offered 6.5%(1) and US and European equivalents 6.2%(2) and 2.9%(3) respectively) may have dispelled concerns for a short period of timeBut the natural tendency to worry has resurfaced.
During the first weeks of 2021, when the vaccination plan had not yet been implemented and infection rates seemed to be out of control in many parts of the world, it seemed counterintuitive to maintain a positive position in credit markets with a credit rating below investment grade. After unusually low default rates in 2020, will we see a return to higher rates this year? It seems not …
The defaults seen last year were mostly in companies already hurt in the retail and energy sectors that, after years of tension, ended up falling. There was no general wave of disasters in the high yield bond market. Given the intervention of decision makers in fiscal and monetary policies to avoid a liquidity crisis, many defaults were avoided. We we expect this year’s levels to be around the five-year average or 3% -3.5% for bonds with a credit rating below investment grade.
Given the expectations of stability, the main concern is profitability. The financial crackdown, following extensive quantitative easing by central banks, has meant that US $ 18 trillion of debt offers a negative return, substantially reducing the chances of achieving returns above 4%.
Percentage of the fixed income market that is listed in different profitability brackets
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The more cautious investor will naturally go for the investment grade sector, but the reality is that the opportunity to obtain profitability is very limited (42% of the European investment grade market started 2021 with a negative return).
This low-yield environment and expectations of higher rates is forcing investors to adapt. We are seeing a strong willingness to lend to companies with a high yield credit rating that could be going through a temporary critical situation, but that offer relatively attractive returns, as long as those companies are expected to survive.
Historically, high yield credit has performed well in the recovery phase of the business cycle; shorter duration and higher profitability suggest that this asset class is well positioned within the fixed income universe to provide potentially attractive returns as the economy recovers from the shock suffered in 2020.
Overall, the global high-yield bond universe offers a return of 4.3%, with the European market offering 2.9% and the United States 4.3%(4). Also, what is more significant, high yield bonds are less sensitive to interest rates than investment grade credit, with an average interest rate duration of the global universe of approximately 3.9 years, compared to the duration of the universe(5) overall investment grade of 7.1. Reflation concerns hold true for fixed income investors, but we do not view reflation as a significant threat to high yield credit.
In a way, the market is extrapolating this recovery and beginning to sense when support policies will be reduced. Europe lags behind the United States in terms of the vaccination plan and therefore accommodative policies are more likely to be maintained longer. Inflation remains well below target and fiscal support has been guaranteed in principle for the duration of the pandemic in most European countries. Therefore, we do not expect any change in asset purchases in Europe in 2021, although this does not prevent a further steepening of the curves or the likely relaxation of policies in the United States during the second half of 2021 have any impact.
If returns increase aggressively, it could be detrimental to many of your risky assets, including equities. Regarding fixed income, we expect more pressure to be felt in those parts of the market that offer lower profitabilitysuch as US Treasuries, where the carry would not be sufficient to cover the capital losses associated with higher bond yields.
In summary, medical advances and the reopening of economies will play an important role in defining which asset subclasses within fixed income will perform better this year. Fortunately, to this day, the high yield bond market is rated better than at any point in this cycle Thanks to the worst-hit names already falling in 2020 as many Fallen Angels, who previously had an investment grade rating, were hurt by the bump.
We expect a further economic recovery in 2021 to support returns, with default levels remaining low and investor need for income high.
Asset allocators face a tough challenge in 2021 and, from our point of view, those assets that offer higher returns and with a shorter duration appear to offer key solutions for portfolios. However, as always, there will be names to benefit and others to lose in the post-COVID world, and good stock selection will be key.
Sources:
1 ICE BAML Global High Yield Constrained Index (Hedged to USD) a 31 de diciembre de 2020.
2 ICE BAML US High Yield Index as of December 31, 2020.
3 ICE BAML European Currency High Yield Constrained Index (Hedged to EUR) a 31 de diciembre de 2020.
4 Universo Global High Yield: ICE BAML Global High Yield Constrained Index; Universo High Yield EEUU: ICE BAML US Yield Index; mercado Europeo: ICE BAML European Currency High Yield Constrained Index. Data as a 26 de febrero de 2021.
5 Interest rate duration statistics for the ICE BAML Global High Yield Constrained Index (‘Universe High Yield Global) and Bloomberg Barclays Global Aggregate Corporate Index (‘ Universe Global Corporate Investment Grade) as of February 26, 2021.
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