Non-investment grade credit markets have experienced significant volatility in recent weeks due to the spread of COVID-19, its impact on global growth expectations and recent movement towards an oil price war. Credit spreads in U.S. and Global High Yield have widened materially, approaching the 700 basis points level, and leveraged loan U.S. dollar prices have declined into the low-90s. Additionally, hedging costs have declined by over 100 basis points for non-dollar denominated asset owners seeking to invest in U.S. dollar credit. Following recent spread widening and dollar price declines, we think non-investment grade credit is at an attractive long-term entry point for investors.
- The sectors most directly impacted by recent events are industries exposed to Travel and Leisure as well as Energy and Gas Distribution. We think price declines in Travel and Leisure will be transitory, while higher defaults and permanent impairments are likely to increase within oil-focused E&P issuers. We also think price declines in Gas Distribution will prove temporary due to lower direct commodity exposure and the critically important nature of their hard assets.
- Liquid bonds and loans are typically sold first during periods of sharp drawdown in markets, followed by a sorting out of issuers that can survive stressed conditions and those that require restructuring.
- Bottom-up, fundamental analysis of individual credits with a focus on default avoidance will continue to be the primary determinant of long-term performance in high yield and leveraged loans.
- We believe capital markets remain open for high quality businesses experiencing transitory challenges.
- Potential fallen angels and disrupted BBB issuers are providing an additional source of opportunity.
- Further central bank intervention will likely occur in response to market volatility, with the potential for a significant fiscal response depending upon changes in employment and overall economic activity.
U.S. High Yield and Global High Yield Spreads
Source: ICE BofA, Bloomberg. As at March 9, 2020.
U.S. Leveraged Loans Average Price
Source: JP Morgan. As at March 9, 2020.
Limited visibility on the duration and magnitude of COVID-19 makes assessing the impact to GDP growth extremely challenging. This is creating significant dislocations as capital markets do not like uncertainty or low information environments. As information about the extent and spread of the virus becomes more apparent to markets, we expect individual credit selection to increase in importance as investors will be able to better assess the impact on specific industries and credit profiles.
Demand destruction from COVID-19 had already caused a material decline in oil prices over the past month. The sell-off accelerated Friday, March 6, with WTI down 10% to $41.30/bbl after the “OPEC+” (a group of oil-producing nations) abdicated its role in balancing the global market. Over the following weekend, the market received more bad news when it was reported that Saudi Arabia is preparing to flood the market with supply as it looks to gain market share and impose maximum pressure on global competitors, including Russia and U.S. Shale. WTI is now trading down in the low $30s as of Monday, March 9.
We expect crude prices to remain under pressure as the market reacts to demand destruction driven by COVID-19, while at the same time facing the new reality that OPEC+ may no longer play the role of balancing the global market. We expect three primary impacts to non-investment grade issuers from these dynamics:
- Oil-focused E&Ps are likely to experience a higher rate of default and permanent impairment. We expect an increase in overall high yield market default rates of approximately 200 – 300 basis points into the 5 – 6% range due to this dynamic. We do not anticipate an increase relative to our prior expectations for defaults in the Leveraged Loan market due to lower Energy concentration in the loan index.
- Declining oil production in the U.S. will also reduce associated gas production and should help rebalance the natural gas market, and benefit related issuers.
- Gas Distribution bonds and loans have experienced material price declines, but we believe this will be transitory due to lower direct commodity exposure and the long-term strategic nature of their hard assets.
Non-Investment Grade Fixed Income: Top 5 Sectors Most Impacted Feb 20 - Mar 9, 2020
Source: Neuberger Berman. As at March 9, 2020. Benchmark used for Global High Yield is the ICE BofA Global High Yield Constrained Index and benchmark used for Global Loans are the ICE BofA Global High Yield Constrained Index and S&P/LSTA Leveraged Loan Index. Returns reflect the benchmark return.
Large, More Liquid Issuers Get Hit Harder in Initial Stages of Sell-Off
Source: ICE BofA, S&P Global. As at March 9, 2020. Indexes used are BofA High Yield Index 100, BofA US High Yield Constrained Index, S&P/LSTA U.S. Leveraged Loan 100 Index and S&P/LSTA Leverage Loan Index.
Opportunities and Outlook
In our view, high yield spreads approaching 700 basis points and loan prices in the low 90s may provide investors with good prospective return opportunities, even in the face of higher expected defaults that are likely to materialize. Additionally, interest rate cuts and a potential fiscal response could help to limit the duration and severity of economic disruption, as well as improve hedged return profiles in U.S. dollar markets for foreign investors.
We continue to monitor the employment market and how companies deal with current and expected disruptions. With unemployment at 3.5%, will companies lay off employees or will they retain them out of fear of not being able to hire them back later? Will governments intervene to encourage employment, such as through a payroll tax holiday? These are some of the factors that will tilt our outlook negatively or positively depending on the outcomes.
While initial periods of volatility typically see declines in the value of bonds and loans across all companies, we expect that the market will quickly work towards separating out winners and losers. As this dispersion begins, it favors investment managers with scale and research resources to be on the leading edge of sorting through the market to find opportunities. We are already seeing what we believe to be attractive relative value opportunities across ratings categories where we are adding to issuers that we believe will be accretive to future returns.