The economy and markets have come a long way since the darkest days of the pandemic, with major U.S. equity indices largely regaining lost ground and the spreads on many fixed income securities narrowing to close to pre-crisis lows. Economies are generally regaining strength, albeit slowly and in fits and starts depending on local outbreaks and sensitivity to COVID-related weakness, while full recovery appears dependent on the approval and distribution of vaccines. Politics is complicating the picture, with significant policy differences between the major parties and real questions as to who will control the presidency and Senate in January.
In our view, recent performance in fixed income has resulted from a convergence of improved fundamentals, the low interest rate environment and central bank support. Actions by the Federal Reserve and others helped avoid worst-case scenarios by maintaining liquidity and financial stability in a time of crisis. In the initial phase of the lockdown-related market collapse, the Fed immediately moved short-term rates back to zero and reinstituted a range of quantitative easing programs to keep markets functioning and maintain access to liquidity and credit, with purchases of Treasuries and investment-grade credits, but also of quality high yield and municipals, among other sectors. More recently, the Fed has reworked its approach on inflation policy, suggesting that it will no longer initiate proactive rate increases, but await evidence of price increases before taking action. The net result is the likelihood that interest rates, and by extension, bond yields, will remain at low levels for an extended period.
Central Bank Support Has Contributed to Fixed Income Resilience
Major Central Bank Balance Sheets
Source: Bloomberg. As of August 31, 2020.
This creates some key challenges for investors. First, although Treasuries maintain their traditional role of providing ballast in portfolios, the asset class offer little in terms of yield or return potential. Moreover, reduced yields generally make it harder to find rewarding fixed income exposure generally, which has accelerated the global search for income and further compressed yields. For individual portfolios, municipal bonds continue to provide an appealing source of potential tax-advantaged income. However, to further diversify and capitalize on available return outlooks, we believe that corporate bonds also offer valuable exposure, focusing particularly on investment grade bonds and quality elements of the high yield universe. Notably, many companies have benefited from the supportive rate environment to refinance and extend maturity dates on their bonds, enhancing their financial flexibility and ability to weather current weakness.
A Lack of Yield
Market Value of Negative-Yielding Bonds in Bloomberg Barclays Global Aggregate Bond Index
Source: Bloomberg. As of August 31, 2020.
Refinancing Has Enhanced Issuer Flexibility
U.S. Dollar Investment Grade Bond Issuance
Source: Goldman Sachs. As of September 3, 2020.
Still, this has not altered the fundamental realities faced by many industries, as evidenced by retail bankruptcies, restaurant closures, airline losses and the like, while we think it’s important to recognize the truly variable nature of the current operating environment. Although our Asset Allocation Committee continues to anticipate a U-shaped (gradual) overall economic recovery, this average obscures the “K-shaped” trajectory of many sectors, industries and even individual businesses, depending on their sensitivity to COVID-19, but also on factors such as online operations, the ability to function remotely, the adaptability of their business models and much more.
For fixed income managers, we believe a key task is to identify these differences, to consider the stability of given credits and assess potential risks, including companies’ ability to survive should the pandemic regain strength or force renewed lockdowns of various parts of the country or economy. Moreover, it’s crucial for managers to assess to what degree such fundamentals are reflected in securities pricing in order to weigh overall risk and reward potential.
Sector Dynamics Through COVID-19
Given generally low rates, we believe that differentiation among individual credits provides a key source of return potential for bond investors in the current environment. While focused on quality, we believe that in light of the ongoing recovery and central bank support, it can make sense for investors to hold both investment grade and high yield issuers with an understanding of the dynamics that may currently be affecting their businesses.
At the sector level, we generally favor the less “COVID-exposed” areas such as financials, telecommunications and media that may actually benefit from changes in the current economy. We remain cautious about many areas that are either cyclically sensitive or particularly affected by COVID-related disruptions. However, given the variation in conditions and the gradual progress on economic strength, we see pockets of opportunity in more challenged segments as well. Below, we provide some high-level views of sectors in both categories to highlight the role that research can play in building effective credit exposure.
More Insulated Sectors
Financials: Well Prepared. U.S. issuers entered the recent downturn in a position of strength tied to prudent reforms enacted in the years following the financial crisis. Regulations have constrained trading profitability, but also lowered business risk and earnings volatility, while balance sheets are sound, with higher capital and liquidity levels. As such, the financial system was well prepared to withstand recent weakening in credit conditions. In our view, capital and liquidity should be more than supportive for the big banks over time. In the near term, higher trading levels and debt issuance tied to the crisis should support earnings, although allowances for credit losses have deteriorated, while slower economic growth and lower rates could pressure revenue growth.
U.S. Bank Capital Remains Near Historical Highs
Tangible Common Equity/Tangible Assets
Source: Barclays Research, Bloomberg, company reports, FDIC. Data through 2Q 2020.
Telecom, Cable and Media: Stable Picture. While consumer viewing habits continue to evolve, we are constructive on higher-quality, market-leading operators due to their stable cash flows and generally defensive credit profiles. Risks to bondholders from M&A have fallen due to regulatory pressures, while companies with elevated leverage are using free cash flow and asset sales to reduce debt. With a domestic base and minimal trade exposure, we believe the sector should be able to sustain earnings even through a renewed slowdown. Overall, demand for telecom/broadband services should remain solid, given that they have evolved to become “non-discretionary” for many consumers. Companies in this sector are showing commitment to maintaining high ratings, with high cash levels, cost controls and extension of debt maturities.
Technology: Mixed Signals. This sector includes large, well-capitalized companies with significant cash positions, although increased M&A and “shareholder-enhancing” activities in recent years add an element of risk. Technology exposure to COVID-19 is mixed, with hardware and semiconductors more affected than software and payments. IT spending is expected to weaken as enterprises push off investments, with a considerable impact on hardware. Shareholder return potential remains a key part of company capital allocation plans, but buybacks have slowed to preserve liquidity, a trend that favors bondholders. We expect leverage to rise as earnings growth slows and new issuance emerges, but this shouldn’t be enough to hurt current ratings.
Global Autos: Demand Shock. Auto retailers are feeling the pressure of fewer dealership visits, but more online purchases could help manufacturers and suppliers, while their balance sheets are more stable and cost structures more flexible than in the financial crisis. A potential uptick in individual car ownership and an incremental shift away from ride-sharing could prove supportive. Still, recovery in auto demand to previous highs could take three to five years, and the pace and shape of the recovery could largely be a function of future government support. We believe consolidation is likely to continue, with scale and global scope more important than ever. In our view, better-capitalized manufacturers with a focus on electric vehicle development should outperform over the near and longer term.
Retail: E-Commerce and Essentials. The impact of the COVID-19 pandemic on retailers has varied depending on the strength of their e-commerce capabilities and whether their stores sell “essential” products and thus could stay open during lockdowns. Prior to the required closures, many brick-and-mortar retailers were grappling with the challenge of accelerating e-commerce adoption. Those with more debt and limited liquidity have had difficulty weathering the current storm, leading to many bankruptcies. Those with stronger e-commerce capabilities and the ability to stay open have often seen resilient sales, even if offset by a weaker margin mix and higher operating costs. They stand to benefit should e-commerce continue to accelerate.
Leisure: Pent-Up Demand. After cratering early in the pandemic, travel and leisure figures are improving, suggesting pent-up demand. “Drive-to” destinations, including regional theme parks and casinos, have been outperforming “fly-to” destinations like Las Vegas and Orlando mainly due to continued consumer hesitancy to travel by air. Rental car companies are working to restructure; and with touchless transactions, they could regain market share lost to ride-hailing services. Across the sector, we believe businesses are largely complying with customer expectations for a higher standard of cleanliness, but many will not fully recover until a vaccine is widely distributed.
Health Care: Varied Landscape. Providers and medical device companies were initially hurt by a decline in routine doctors’ visits and elective surgeries, but conditions have improved. For insurers, fewer procedures have been a positive as their revenues are based on contracted premiums, not volume. Pharmaceutical companies have generally seen resilient demand. Looking ahead, larger and better-capitalized hospitals are likely to manage through the current disruption with the help of government relief and the return of volumes. But the shock of the virus has magnified our guarded view of the not-for-profit sector, while political risk is a concern generally. Overall, we believe the health care system is now better able to manage the ongoing pandemic, with patient access to the system driven largely by regional dynamics.
Airlines: Slow Ride Out. Passenger volume declines and credit stresses resulted in a sharp drop in flights, and we expect the recovery to be slow. Manufacturers and their suppliers remain pressured as deferrals and cancellations affect cash flows; government assistance has been a short-term support, but another large-scale package seems unlikely. We think major airlines can avoid bankruptcy, assuming air travel ramps up at a moderate pace and the workforce can be right-sized to match demand. Overall, we believe leisure travel should drive an initial increase in demand, followed by corporate travel.
Energy: Select Opportunity. Lockdowns and changes in customer behavior have affected energy companies to varying degrees. Reduced reinvestment should support an eventual rebalancing of supply and demand, but a recovery may take time due to increased inventory and changing consumer behavior. We are focused on low-cost oil producers that are able to navigate a prolonged downturn. We also see potential in natural gas-focused producers, as low oil prices support an improvement in longer-term fundamentals, while some midstream issuers with less market exposure may provide a value opportunity. Diversified refiners have raised liquidity, improving their credit quality.
Taking a step back, the picture for quality corporate credit appears relatively benign given the gradual trend of economic recovery, degree of monetary support, and the power of the debt restructuring by many issuers. At the same time, it’s important to understand current risks. First and foremost is the path of the virus, which has proven more durable than many anticipated, with the return of colder weather and the flu season creating new hazards.. Renewed, significant lockdowns, while not the most likely scenario, could also potentially upend management plans.
Another issue is the U.S. election. We will leave the prognostication to others, but the significant differences in views as to taxes, regulatory climate and other issues could lead to different paths for the economy and the various industries that could benefit or suffer from government policy. That said, larger, quality companies are often not only financially flexible, but have the ability to adapt with the regulatory environment. Even as the U.S. has reduced regulation in some areas, many individual companies have chosen to maintain compliance with sometimes more stringent international standards, in part due to shifting investor and consumer expectations.
A third risk affecting the financial markets generally is the potential for renewed inflation. While the Fed has long hoped for higher inflation, it has rarely been successful in achieving its 2% target, and has shifted its policy to allow prices to “run hotter” in the future. However, extraordinary monetary easing, coupled with more government spending, could contribute to pricing pressures eventually. With the Fed likely on hold until at least 2023, there will be ample time to reposition portfolios should inflationary conditions change.
Managing Through Current Challenges
In managing these and other risks, including ongoing trade and geopolitical tensions, we believe that a focus on credit fundamentals, and how they may change in different economic scenarios, is crucial to fixed income investing in the current climate. Building diverse exposure to corporates, municipals and potentially other fixed income sectors, and drawing on private credit where feasible, can all play a part in developing portfolios that maximize yield and return potential while limiting exposure to market volatility and default risk. Given the recovery since March, coupled with ongoing central bank support and low rates, the easy path to returns has likely narrowed. However, in our view, the market tendency to ignore or misprice individual issuer prospects should allow active managers to find opportunities and enhance potential for portfolio income.