Today’s CIO Weekly Perspectives comes from guest contributors in the Global Non-Investment Grade Credit Team.
Fixed income markets experienced a unique degree of volatility during the first half of the year.
Starting with a very healthy economic environment, we then saw a record pace of drawdown at the onset of the global COVID-19 pandemic, followed closely by one of the fastest spread-tightening rallies in history.
Monetary and fiscal stimulus played a central role, especially with the first-ever direct purchase of high yield debt by the U.S. Federal Reserve, as did the historically rapid reopening of the capital markets—and the U.S. high yield market in particular.
As asset owners digest the rapid pace of these developments and determine the best path forward for their portfolios, we are often asked what our outlook for defaults looks like across global non-investment grade credit markets, and how this outlook has changed in recent months.
To be clear, at just three months from the market lows of mid-March it is still early in the default experience. However, to summarize our views, our projections for non-investment grade defaults have come down a fair amount.
At the depths of the March selloff, market prices implied a cumulative projected default rate in excess of 30%. Following the Fed intervention in early April, our own initial projections for cumulative defaults through 2020 and 2021 in U.S. high yield and leveraged loans were around 15% and 12%, respectively.
Unprecedented business disruption related to the global health pandemic and extreme commodity volatility, particularly in oil, were key drivers of these views, tempered by nascent strength in capital markets and supportive government policies.
Since April, various constructive developments have occurred that have warranted the lowering of our cumulative default outlooks for 2020 – 21 to approximately 9 – 10% for U.S. high yield and 8 – 9% for leveraged loans.
Importantly, the decline in default projections isn’t exclusive to U.S. markets.
A combination of factors similar to those supporting U.S. markets, especially coordinated monetary policies, have caused us to lower our estimated cumulative 2020 – 21 default rates from 6% to approximately 3% for European high yield and from 11% to approximately 7% for global high yield.
What specifically has helped release the pressure on default rates? A combination of several factors is at play.
A record pace of new issuance during May and June allowed companies to raise additional liquidity and extend the maturity of their debt. Capital markets were open not only to issuers largely unaffected by COVID-19 related disruption but also to many caught in the eye of the storm.
This has given precious additional time for some of the most ravaged business models to heal while avoiding default over the next two years. When a company successfully borrows to create a substantial liquidity buffer, we believe that the investors providing that liquidity are often looking through earnings for the next 12 months based on an assumption that long-term asset values will ultimately recover to the levels of 2019.
Fed announcements also had a meaningful impact.
Certain “fallen angels”—issuers that have been downgraded from investment grade to non-investment grade—now have access to Fed liquidity facilities should they need it. Fed purchases of high yield exchange-traded funds, while small, have added to an already positive technical picture in the market.
Finally, initial data suggest that certain industries, such as housing and autos, have experienced a quicker pace of recovery than expected. It is early days, but these initial positive signs have allowed issuers to access capital and bridge liquidity, hopefully to the other side of this crisis.
That said, not everyone is going to get to the other side unscathed. Companies are taking on more debt, and monetary policy remains primarily focused on higher-quality credits, and for those reasons we think the next phase of global non-investment grade markets will require careful credit selection.
Differentiating between issuers and industries showing signs of rapid recovery versus those with false hope will likely require underwriting rigor and the flexibility to adapt as more data comes in.
Nonetheless, as we set out on this new phase, we think the most important thing to bear in mind is this: global non-investment grade credit markets are in better shape, in terms of their default outlooks, than was originally feared at the onset of this crisis.
In Case You Missed It
- China Purchasing Managers’ Index: +0.3 to 50.9 in June
- Eurozone Consumer Price Index: +0.3% year-over-year in June
- S&P Case Shiller Home Price Index: April home prices increased 0.9% month-over-month and 4.0% year-over-year (NSA); +0.3% month-over-month (SA)
- U.S. Consumer Confidence: +12.2 to 98.1 in June
- ISM Manufacturing Index: +9.5 to 52.6 in June
- U.S. Initial Jobless Claims: +1.43 million in the week ending June 27
- U.S. Employment Report: Nonfarm payrolls increased 4.8 million and the unemployment rate decreased to 11.1% in June
What to Watch For
- Monday, July 6:
- ISM Non-Manufacturing Index
- Thursday, July 9:
- U.S. Initial Jobless Claims
- Friday, July 10:
- U.S. Producer Price Index
Statistics on the Current State of the Market – as of July 3, 2020
|S&P 500 Index||4.1%||1.0%||-2.1%|
|Russell 1000 Index||4.1%||1.0%||-1.8%|
|Russell 1000 Growth Index||4.8%||1.8%||11.8%|
|Russell 1000 Value Index||3.4%||0.3%||-16.0%|
|Russell 2000 Index||3.9%||-0.6%||-13.5%|
|MSCI World Index||3.3%||1.1%||-4.4%|
|MSCI EAFE Index||1.5%||1.4%||-9.8%|
|MSCI Emerging Markets Index||3.7%||4.0%||-6.1%|
|STOXX Europe 600||2.4%||1.6%||-10.7%|
|FTSE 100 Index||0.0%||-0.1%||-17.0%|
|CSI 300 Index||6.9%||6.2%||9.1%|
|Fixed Income & Currency|
|Citigroup 2-Year Treasury Index||0.0%||0.0%||2.9%|
|Citigroup 10-Year Treasury Index||-0.3%||-0.2%||12.3%|
|Bloomberg Barclays Municipal Bond Index||0.0%||0.0%||2.1%|
|Bloomberg Barclays US Aggregate Bond Index||0.1%||0.1%||6.3%|
|Bloomberg Barclays Global Aggregate Index||0.2%||0.2%||3.1%|
|S&P/LSTA U.S. Leveraged Loan 100 Index||0.1%||0.4%||-3.5%|
|ICE BofAML U.S. High Yield Index||0.5%||0.8%||-4.0%|
|ICE BofAML Global High Yield Index||0.5%||0.7%||-3.6%|
|JP Morgan EMBI Global Diversified Index||0.9%||0.8%||-1.9%|
|JP Morgan GBI-EM Global Diversified Index||0.5%||0.6%||-6.3%|
|U.S. Dollar per British Pounds||1.2%||0.9%||-5.9%|
|U.S. Dollar per Euro||0.4%||0.1%||0.2%|
|U.S. Dollar per Japanese Yen||-0.2%||0.3%||1.1%|
|Real & Alternative Assets|
|Alerian MLP Index||-0.1%||-1.8%||-36.9%|
|FTSE EPRA/NAREIT North America Index||5.0%||2.1%||-19.3%|
|FTSE EPRA/NAREIT Global Index||4.0%||2.9%||-18.8%|
|Bloomberg Commodity Index||3.8%||1.0%||-18.6%|
|Gold (NYM $/ozt) Continuous Future||0.5%||-0.6%||17.5%|
|Crude Oil WTI (NYM $/bbl) Continuous Future||5.6%||3.5%||-33.4%|
Source: FactSet, Neuberger Berman.