Over the course of 2019, PIMCO became increasingly cautious on risk assets and corporate credit in particular, since we felt that we were in the later stages of the business cycle, during which credit typically underperforms. Having allowed our credit exposure to decline to cycle-lows as of the end of 2019, the market correction brought on by the COVID-19 pandemic is a turning point that gives us cause to reassess our views, refresh our valuation metrics and revisit the case for credit.
For Australian investors, we believe that there are now opportunities to invest in domestic credit at attractive valuations. The case for Australian credit is enhanced by a strong government health response, robust fiscal support and disciplined action by Australian companies who have protected their balance sheets via extensive equity raisings, dividend suspensions and deferrals, and reviewing capital spending. This marks a genuine improvement in credit fundamentals and is not simply a result of central bank support.
Valuations for investment grade credit have significantly improved
Although investment grade (IG) spreads have contracted since the height of the March volatility, they are still significantly wider than they were before the March correction.
Figure 1 shows the percentile rankings of average spreads of European and U.S. IG and high yield (HY) credit benchmarks (measured against average levels going back to August 2000). Prior to the March correction, spreads were tight relative to their historical range: spreads were below the 20th percentile for U.S. IG, U.S. HY and European HY, whilst European IG was around the 40th percentile. As of May 2020, credit spreads had widened to around the 75th-80th percentile, having blown out to the 90th percentile during the peak stress period in March and early April.
IG spreads now price in a 15% cumulative probability of default over the next five years, whereas the peak (worst) five-year realized cumulative default rate for IG since 1980 has been 2.4%. Likewise for HY, the cumulative probability of default implied over the next five years is 40%-45%, whereas the worst realized cumulative five-year default rate has been between 31% and 39%. Therefore, whilst a prolonged recovery from the COVID-19 pandemic may result in a rise in corporate defaults, spreads are already compensating investors for a relatively high level of defaults.
The supply/demand dynamics have improved in favour of IG credit
Central banks in Europe, the UK and U.S. have expanded quantitative easing (QE) measures to include IG credit. The increase in demand from central bank purchases and the front loading of issuance in response to the COVID-19 pandemic means that we expect net supply to turn neutral in Europe and modestly negative in the U.S. for the rest of the year. With cash rates now near or below zero in most developed markets, the search for yield and ongoing need for income is also providing a powerful technical tailwind to IG credit.
Australian credit fundamentals are improving
Australian credit benefits from a strong health response, robust fiscal support, and prudent corporate balance sheet management. The swift actions taken to lock down the country, supported by significant fiscal spending and increased testing capabilities has thus far resulted in a relatively successful containment of the COVID-19 virus. Whilst we still expect a bumpy recovery, it does appear that tail risks (i.e. the chance of worst-case scenarios) have reduced.
The size of Australia’s fiscal support package at around 10% of GDP is large in a global context (as seen in Figure 2), and there is some evidence of consumer and business sentiment and activity starting to improve from a shallower trough than was first feared.
Furthermore, Australian corporate bond issuers have acted swiftly to support their balance sheets and maintain liquidity and credit quality. Measures have included:
- Delaying large capital projects (e.g. Woodside and Santos),
- Deferring the decision to pay a dividend until the impact of COVID-19 has become clearer (e.g. Lendlease, Downer EDI, Qantas and Mirvac),
- Suspending the dividend entirely (e.g. Sydney Airport, Scentre Group and James Hardie), and
- Raising new equity (e.g. Vicinity Centres and Incitec Pivot).
Several issuers have carried out a combination of these strategies. According to Bloomberg, in April alone, more than 60 companies offered AUD11 billion in equity placements, which was considerably larger than any prior month on record even through the 2008-09 financial crisis.
These actions have largely protected the companies’ credit profile at the expense of equity returns. Each company has also continued to pay their interest coupons throughout the period, highlighting one of the benefits of investing in bonds over equity.
Case studies: How two cyclical Australian companies managed the challenging conditions
Woodside Petroleum: In March, Woodside faced sharply lower liquefied natural gas (LNG) pricing under its oil price-linked sales contracts as the oil price materially declined due to demand uncertainty related to COVID-19, coupled with a supply shock caused by major oil suppliers increasing production. This resulted in the company’s BBB+ credit rating being placed on negative watch.
Woodside had been strengthening its balance sheet in recent years in preparation for funding several large new gas projects located off Western Australia. This meant the company was well placed to react to the downturn, with low gearing (ratio of debt to equity) of around 14% and available liquidity of AUD7.9 billion. Woodside reduced its 2020 investment spending by 60% and deferred the target investment decision dates for several of its major projects.
Incitec Pivot: The company started 2020 with its balance sheet in the opposite position to Woodside and its credit rating already on negative outlook. This was due to a number of one-off environmental and production issues that occurred in 2019 and resulted in Incitec Pivot carrying higher-than-typical leverage. In a positive outcome for bondholders, Incitec Pivot announced an equity raising of up to AUD675 million, consisting of a fully-underwritten institutional placement of AUD600 million and a non-underwritten Share Purchase Plan, as well as the suspension of the interim dividend.
Incitec Pivot’s management described the equity raising as “pre-emptive”, with the intention of strengthening the balance sheet in light of the potential impact that COVID-19 may have on customer demand and commodity pricing, also stating that it was in line with the company’s commitment to “maintaining a strong investment grade credit rating”. The combination of the equity raising and dividend suspension was sufficient for both S&P and Moody’s to remove the negative outlook on the company’s BBB rating.
Australian structured credit remains a valuable source of income and spread diversification
Whilst Australian corporate credit has not been included in the local monetary policy QE toolkit, the market for residential mortgage-backed securities (RMBS) has had strong support from the Australian Office of Financial Management’s (AOFM) Structured Finance Support Fund (SFSF). The SFSF has actively supported the warehousing segment (purchase of loans that will serve as collateral in a securitization) and both primary and secondary markets. The SFSF has invested a total of AUD1.92 billion, split across AUD254 million in primary purchases, AUD666 million in secondary purchases and AUD1 billion in warehouse facilities (see Figure 3). Purchases in the secondary market have strongly favoured non-bank lenders, including prime and non-prime RMBS.
Rising unemployment will be a headwind for the RMBS market as prepayments slow and non-performing loans rise. However, strong fiscal support along with specific hardship provisions and underlying support from the AOFM should see the top shorter-dated AAA rated tranches of Australian RMBS remain a valuable source of income and spread diversification.
Investing in Australian credit is more attractive than it has been for some time
In our view, Australian credit offers a strong improvement in fundamentals and more attractive valuations than we have seen for some time. Although IG spreads have contracted since the height of the March volatility, they are still significantly wider than they were before the March correction. While we always believe it is important to be active and selective when investing in credit, we also think that there are opportunities to be found in the Australian IG and structured credit markets.
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