The secret to sourcing yield without duration risk
At the risk of stating the obvious, 2020 was a year marked by the challenges of COVID-19. In the first part of the year, we saw large drawdowns in risk market, as well as the uncertainty created by both the health and economic impacts of COVID-19. The last part of the year saw the exuberance from the vaccine, the impact of fiscal and monetary policy, and a better result than feared for corporate earnings, which led to a very strong risk rally.
A positive macro outlook
As we look into 2021, a few things are at the top of our mind which will drive performance. You'll likely have uneven performance in global economies given new restrictions put in place, as well as a slow vaccine rollout. Likewise, you'll have differing levels of fiscal support, which will cause a deceleration of growth in certain markets. That being said, financial conditions remain quite easy, which will cushion some of this blow. You'll likely start seeing some signs of inflation, most notably in the US, which may cause real yields to rise a little bit, but at the same time, we don't expect any central bank action as a result. What this will likely do is cause a demand for yield based products, which high yield is a beneficiary of, given the positive outlook of credit fundamentals as well as the negative correlation that high yield has to inflation and rates.
Overall, our bias is for stronger growth into the first half of 2021. The fiscal support will continue, and central banks will be on watch in case there are additional tail risks within the market.
High Yield to shine
When we look to 2021 and even 2022, we're seeing that there will likely be a sharper level of growth given the large drawdowns as a result of COVID-19. What this will do is cause corporate earnings to really expand this year and next, which is why you've seen this improvement in sentiment in the last six months.
This is the sort of economic environment that benefits high yield credit, as the high yield market entered this downturn in pretty good shape.
For one, the level of new issue volume was a record last year, but most of that was done for refinancing in general corporate purposes. Companies have de-risked their balance sheets by reducing their interest costs and pushing out maturities, as well as building a cash cushion in case of an unanticipated drop in earnings if there is a further downturn. This is in contrast to 2007, where almost a third of the market was used for M&A and leveraged buyout purposes, means much more aggressive levels of financing.
Secondly, net credit leverage metrics as illustrated in the chart below only remains slightly above the period in 2019 as a result of the improved economic environment. We expect this to get better.
When we slice and dice the overall market, we see that over half the market is really a winner as a result of the downturn. So whether it be the companies that are involved in health care, cable TV, beverage and tobacco, food and drug retailers, telecommunications - these are all winners from COVID-19. And that’s where we've been finding good opportunities and returns.
What we've tried doing in the below chart is a bottom-up analysis on where we think defaults are going to end up.
What we see here is a sharp decline in the level of defaults in the market for 2021. In 2020 there were names that were very exposed to the downturn and COVID-19, and the ones that were not able to raise capital fast enough obviously defaulted. Now, as capital markets open back up, those firms that didn't default were able to improve their balance sheets by selling equity and debt. So even though we're under a new level of lockdown that may extend out for several more months, we don't anticipate that will cause any additional defaults. And so defaults within the market will likely be at, or below, long-term historic average ranges. When you look at this chart, looking back almost 20 years in periods of declining default rates, generally credit spreads improve from there leading to strong total returns for the asset class.
Finding yield without duration risk
Now that the US election is behind us, we can look to see what sectors will be impacted as a result of Biden’s victory. Given that COVID-19 is still raging within the US, we'll likely see a fiscal stimulus that will be expansionary for economic growth in the US.
When we think of our overall themes within fixed income for 2021 and talk to our various clients globally, one of the themes that are emerging is ‘Where can investors get yield without taking a lot of duration risk?’
What we have here are the major asset classes within fixed income. As you can see, high yield is one of those asset classes that have a very high level of yield, even in today's environment with low levels of interest rate duration. Because of this desire for investors to focus on yield without duration, we think that high yield is a major beneficiary of that.
When we look overall at the market for 2021, we're very constructive. We think that:
- Economic growth should be fairly strong, especially in the first half of the year. If there are any unexpected hiccups in the market, we think central banks will be there to help.
- Economic growth will lead to improving corporate fundamentals, which should improve credit profiles and lead to declining credit spreads. Overall this should lead to a good high total return for the market.
- Impacts of things like the US election are well behind us at this point which again, should lead to more stability within markets.
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