Bullish outlook not without risks

The global credit markets have staged a terrific rally since the lows set in March. For investors, the question is: what comes next? To set the stage briefly, this has been a pretty exciting year, not just for equity markets but for bond markets. We’ve seen the Federal Reserve and other central banks either go to zero percent interest rates or maintain zero or even negative interest rates. We’ve seen the reintroduction of quantitative easing programs and central banks that are buying not just government bonds and mortgage securities but now credit securities; and we’re even seeing some of these types of purchase programs extend to emerging markets, in some cases for the first time. 

I've recently sat down with Joe Lynch, Global Head of non-Investment Grade Credit and Dave Brown, Co-Head of Global Investment Grade Fixed Income to speak on this topic and more. 

What are the sectors that you're particularly focused on right now?

I think some that are related to COVID are interesting to us. So healthcare may not be an obvious space, but many of the healthcare providers, whether it be hospitals or facility-based providers, they saw a decline in March and April in activity because people were just afraid to go into a hospital to have some sort of procedure done. But now we’re seeing that volumes are coming back, and are coming back at roughly 90% of pre-COVID levels. So many of the procedures were not canceled. They were just deferred, and those are starting to occur. So we think the market oversold many of these healthcare companies just on fear of significant expenses related to COVID without much in the way of potential reimbursement. And certainly those are not the higher-margin type patients that maybe someone that’s receiving cancer treatment or is having surgery might be. And so healthcare has been a spot that has been attractive to us. 

For the next layer down, we find a lot of the gaming companies interesting, particularly the regional gaming companies. They have a much easier ability to manage cost and cut costs and open up casinos in a smaller way; and that’s much more of a drive-in type consumer. So less about, say, destinations like Las Vegas; but more the regional gaming operators have a lot of flexibility on cost and are actually seeing demand come back. 

Additional sectors that are also interesting would be cable media and telecom. These are industries which generate strong free cash flow that, frankly, as we all know in the work-from-home environment, are all being used more extensively by people; have not been impacted by any sort of business disruptions; and yet, because they have financial leverage, still have a reasonable amount of yield relative to the rest of the investment-grade market. 

The midstream sector within energy is an area that we think certainly has tightened up but is definitely an area that we remain well invested in and we think is relatively attractive. And there are even areas in the airline sector where we’ve been active in secured airline exposure that we think has been giving us some great opportunities. 

And then finally, in this environment of really low yields, search-for-yield environment throughout all markets, we think going overseas and looking at some structured opportunities there, both in corporate hybrids as well as subordinated bank capital, are interesting. They are credits that you get paid to take the complexity risk of structure, subordination in credits that we think are very strong and can really add some extra yield into portfolios, which today, that extra yield is even at more of a premium with low yields across the globe.

We’ve obviously seen weakness in small businesses and real estate, downgrades among large energy companies. And on the default side, you’ve seen a bankruptcy from a car-rental agency. But overall, it’s been pretty muted. Is the default and downgrade in some of those fundamental risks going to remain pretty muted, like we’ve seen so far?

I would expect, certainly on the downgrade side to be muted. We saw pretty quickly the agencies being aggressive with hitting sectors and companies that were being acutely impacted by the virus. So we saw downgrades in retail, in auto, and in energy. Those have played out, and now I think we’re realising that companies get rash and much larger downgrades when business models are no longer effective. Look at banking 10 years ago when the business model that the banking industry constructed for themselves no longer worked. You can look at some of the telecom structures that were put together 20 years ago. That’s when you see large downgrades and default cycles. This shock is of a different nature. Most business models that existed in our markets that were not bubbles in terms of capacity built in industries or anything like that, there was an exogenous shock. And because there has been support from fiscal and monetary areas, in general, companies have been able to manage through this and are reconstructing themselves from a cost and a balance-sheet way that allows them to manage through this. 

Now, if we get a different outcome, and we’re still in a very low or negative-growth type environment in 2021, that will be challenged, and you’ll start to see more downgrades at that point; but in my view, you’re unlikely to get meaningful downgrades for the rest of this year. The vast majority of the defaults really were on stressed businesses that were stressed before the pandemic hit. So think about energy companies or retail companies. Many of them were already trading at stressed levels in January and February when the economy was actually quite strong. And so those companies have defaulted out in the current environment, and we really don’t expect to see much in the way of new defaults or companies that are acutely impacted by the downturn ending up defaulting. Now, that being said, we are issuing quite a bit of new debt to these businesses, and quite a bit of new debt to these companies that are directly impacted in a negative way from COVID.  If we don’t see more of a V-shaped or U-shaped recovery eventually, or into 2021, the issuance that is coming to market today certainly could become the raw material for the next credit cycle and the next wave of defaults that come two or three years down the line. So, despite us being fairly constructive on the market, it’s not without risks. We obviously need to see the recovery be sustained and durable. Otherwise some of these companies that are receiving capital today, it just turns into too much debt or too much leverage in the future.

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