Increased volatility always presents hidden opportunities. As an inherently risky investment, the high yield market doesn't always receive as much attention, but an increase in cash strapped companies, and recent downgrades, has brought significantly more interest to this market. Given the unprecedented economic stimulus, unknown time horizon for a cure, and inevitable shift in supply chains, not to mention the potential geopolitical power grabs, there are a myriad of unforeseen forces reshaping the high yield market.
Between March 11, when the World Health Organization declared COVID-19 a pandemic, and April 27, companies issued $265 billion in debt. That’s more than double the volume ($108b) for the same period in 2019. As companies need cash to survive the economic shutdown, and some worried about their access to capital in the future, companies are borrowing what they can to bolster their balance sheets. For fixed income investors, there is tremendous opportunity as companies issue new debt, especially as credit spreads have widened.
For issuers, increasing spreads in challenging markets generally means significant increases in the cost of financing, but that hasn’t slowed the pace of new issuances in the market. Yum Brands, for example, came to market on April 1, 2020 with a five-year bond at 7.75%. Only seven months prior, on September 11, 2019, they had issued a 10-year bond at 4.75%, 5 years shorter and 300 bps lower.
Not only is the volume of debt increasing, but the Federal Reserve is pumping money into the economy, shifting the perceived risk. Last month, it reinstated the Commercial Paper Funding Facility (CPFF), first introduced during the 2008 financial crisis, to get credit to businesses to ease liquidity concerns. The Fed said the Treasury will provide $10 billion of credit protection to the central bank’s commercial paper operation.
As the amount of debt has increased, fallen angels, bonds that have been downgraded to high yield from investment-grade as issuers’ credit ratings are lowered, have become an area of concern for portfolio managers. In April 2019, there were 9 fallen angel securities from 5 issuers, according to IMTC data, compared to 378 securities from 14 issuers in April 2020. As volatility and uncertainty increases in the market, fallen angels can cause more issues as investment grade portfolios fall out of compliance and managers are forced to sell.
Kevin Roche, CEO, LHT Consultants, recently spoke to IMTC in detail about the recent volatility and downgrades in the fixed income market. “There has been $103.9bn in downgrades over the past month,” he explained. “This includes big brand names and companies like Ford Motor Co. and Macy’s, which have dropped from BBB to BB.” While this may force sellers who need to remain within investment guidelines, it also provides an opportunity for investors seeking additional yield.
Luckily, the Fed has expanded the scope of its bond-buying program to include a limited amount of recently downgraded high-yield debt. This backstop provides investors with some assurance associated with these names, lowering the relative risk for fallen angels. This has provided investors with a little more confidence amidst the uncertainty around short-term outlooks for the market and confusion as to when, and at what speed, economies will reopen.
As the sector that often makes up the largest percent of the high-yield market, energy’s impact on it is irrefutable. In March, energy lost over 29% in the ICE Global High Yield Index, creating even more volatility for portfolio managers.
Due to fears that the world is running low on storage for an oversupply of oil, the price of the West Texas Intermediate crude oil futures experienced the sharpest decline ever on April 20 by falling to -$40 per barrel. This was the first time in history that an oil futures contract has turned negative. The weeks leading up to this had the energy sector in a frenzy, with bond yields in the Bloomberg Barclays High Yield Energy Total Return Index shooting up more than 300 bps.
While this volatility creates buying opportunities for investors, buyers have many aspects to consider around the risk of oil companies, particularly those based in the Permian Basin of West Texas who struggle to compete with Saudi and Russian supply. After a wave of bankruptcies in 2015-16, investors know the heightened risks in this sector. The stronger companies in the sector tend to not only survive energy price cycles (i.e., when oil dropped to under $10 a barrel in the late 1990s and the energy crisis of 2015), but to come out the other side more dominant.
Investment managers should be discerning around deploying capital in the high yield sector. While trying to capitalize on opportunities presented for higher yields, portfolio managers should consider:
Portfolio allocation: Investment managers have a duty of care to ensure that downgraded bonds align with a client’s investment guidelines and can fit within an investment-grade strategy.
Macro risk profiles: Each issuer has a different level of default risk rooted in the company’s sector and prospects to withstand the impending recession on the horizon.
Credit analysis: Investment managers should carefully analyze debt-issuing entities to measure their ability to meet obligations amidst difficult operating conditions.
Trade fit: Assessing exposure across client accounts enables a manager to identify viable investment ideas and execute them at speed.
The high yield market offers investors a plethora of interesting opportunities as the global economy shifts gears. But investors need good guidance to help them sift through the available bonds and understand each sector’s prospects. As such, it’s crucial that investment managers have a strong handle on the rapidly-evolving market and their client portfolios to help them to make informed decisions quickly to take advantage of the surge of new issuances.
Keen to identify a few falling angels for your portfolio? See how Kevin Roche assesses downgrades on IMTC.
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