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The outlook for U.S. credit in a recessionary economy
Damien McCann
Fixed Income Portfolio Manager
KEY TAKEAWAYS
  • Despite support from the Federal Reserve, downgrades are poised to be more prevalent than in previous cycles
  • The full financial impact of COVID-19 on corporate America will become clearer over the next few quarters
  • For investors who can take a long-term view and be selective, current U.S. high-yield valuations are attractive

With the severity and duration of the economic downturn still unclear, investors may be wondering what this means for U.S. corporate credit, particularly the riskier high-yield sector.


We talked with fixed income portfolio manager, Damien McCann, to get his perspective on the broader credit market and how companies are traversing the pandemic.


What’s your outlook from here?


We’re in a period of incredible uncertainty given the unknown path of the virus. We do know, however, that much of the economy has been significantly disrupted by the pandemic. Revenues and cash flows in many industries are currently under severe pressure. Other industries are faring much better. Second quarter earnings will be ugly but should represent the bottom for most companies. More important than second quarter earnings, however, will be what managements of companies are seeing for third and fourth quarter activity.


My base case is that the U.S. economy is beginning to improve as we speak, and that this recovery will continue through the remainder of the year and 2021. How fast is unknown. I expect an uneven recovery by industry and more volatility, given the unprecedented economic disruption, and the many uncertainties regarding the spread of the virus, containment efforts and progress on therapies and vaccines.


Is this downturn different from the global financial crisis (GFC)?


Each is similar and different. Similarities with the GFC include the significant economic contraction and related sharp rise in unemployment. Both periods include significant stock and bond market volatility, as well as a seizing up of credit markets. Both periods have received significant stimulus and support by governments and central banks.


But the drivers of each downturn are very different. The GFC came from within our economy and markets. The pandemic is an exogenous shock, and the hit to economies is more severe than during the GFC. The monetary and fiscal stimulus came much faster this time around, and in much larger size, because policymakers have learned from the past and want to prevent a severe recession from becoming a financial crisis.


The Fed is actively supporting numerous markets — including U.S. Treasuries, mortgages and credit markets. Some of this is without precedent in the U.S. In my view, these programs indicate a deep commitment by the Fed to ensure credit markets continue to function. This helps explain why credit markets have responded favorably and, after widening dramatically in mid-March to the widest levels on record for a few days, spreads recovered some of that widening later in the month.


What steps are companies taking to manage through this period?


Companies are grappling with a high level of uncertainty about the duration of the downturn. As a result, many companies are taking steps to bolster liquidity. In other words, companies are trying to build up a lot of cash so they can survive this period. Steps companies are taking to build cash include cutting operating expenses and capital outlays, reducing or eliminating dividends and share repurchases, and raising capital.


On this last point, the Fed’s injection of liquidity and its direct participation in corporate bond markets have restored order to markets and made it possible for investment-grade companies and certain high-yield issuers to borrow again.


The combination of the Fed’s support for credit markets, and the severity and uncertainty of the downturn, has led to record levels of investment-grade bond issuance in recent months. Certain companies, such as Disney, have tapped the bond market more than once in recent months. What’s more, companies in the eye of the storm — including certain leisure and travel-related issuers — have been able to access markets.


Companies issues a record amount of bonds in March and April 


Monthly corporate bond issuances for high-yield and investment-grade companies (USD billions)


Source: Bank of America. Data as of April 30, 2020, and shown in USD. The left hand y-axis represents high-yield issuances while the right hand y-axis represents investment-grade issuances. 


What is your expectation for default rates?


I expect defaults and downgrades to be higher than in prior cycles given the severity of the economic contraction. In fact, U.S. corporate downgrades have spiked to their highest level in more than a decade in the first quarter, according to data from Standard & Poor’s.


Companies that are more exposed to economic disruption, as well as those with more leverage and less liquidity, are most vulnerable to defaulting. Despite efforts to cut costs and preserve cash, some companies won’t be able to handle the sudden near full stoppage of economic activity.


I expect downgrades to exceed previous cycles, with the potential for bankruptcies of companies in the U.S. high yield and loan market to exceed 10% over the next year.


Can you provide some colour on “fallen angels” — the large companies such as Ford that have recently entered the high-yield market? How does that impact the high-yield market?


Credit rating agencies have been more aggressive with downgrades in recent years. Given the magnitude of the economic contraction I expect this to continue. There will certainly be many downgrades in the months and quarters ahead.


I also expect more companies to enter the high-yield sector. Some investors fear that a rash of supply in this sector could overwhelm the market, but keep in mind that it has actually shrunk in recent years on fewer issuances and more companies turning to the loan market. In that sense, the high-yield market could use some additional supply. Also, the Fed’s move to scoop up corporate debt should help absorb the shock. In some cases, these downgraded bonds could represent attractive investment opportunities in high-yield portfolios.


In what areas are you finding value?


As I look across the corporate market, exposure to this pandemic and economic contraction varies dramatically by industry and company. For example, at one extreme are certain insurance underwriters that have become more profitable due to fewer claims in this environment. At the opposite extreme are certain leisure companies that have seen revenues fall to zero. But even within this sector, exposure varies significantly based on the business model and balance sheet. Some leisure companies will adapt and survive better than others.


The variation in exposure to the pandemic represents an incredible opportunity for deep, fundamental credit research to add value in portfolios. Our credit analysts are experts on their companies and are in regular contact with managements. They are identifying and investing in issuers with the ability to navigate this period.


Market events like this can and have historically represented a good entry point for long-term investors. Spreads today are broadly comparable to past crisis and recessions, excluding the global financial crisis. I don’t believe in timing the market but do feel that current spreads provide an opportune entry point for a long-term investment strategy.

 

Credit spreads are above other crisis periods, excluding the global financial crisis


Yield differential between higher income sectors and U.S. Treasuries (bps)


Select market declines (based on the S&P 500 Index) over the 20-year period ending 3/31/20. The most recent period is still in correction phase as of 3/31/20.
High yield represents Bloomberg Barclays U.S. Corporate High Yield 2% Issuer Capped Index; investment-grade corporates represents Bloomberg Barclays U.S. Corporate Index; emerging markets debt represents JPMorgan EMBI Global Diversified Index; securitized represents 80% Bloomberg Barclays CMBS ex AAA Index /20% Bloomberg Barclays ABS ex AAA Index.
Source: Bloomberg. Date of crisis reflects highest month-end option-adjusted spread for the crisis period. OAS is a yield-spread calculation used to value securities with embedded options.


What about relative value between investment-grade and high-yield bonds? And what about the BBB-rated area of the market?


While income opportunities are higher in both investment-grade and high-yield corporates, I’ve been finding even more in high yield. In particular, the improved valuations have led to more opportunities within health care, technology companies and consumer staples.


The U.S. BBB market is huge (nearly $3T) and very diverse. The work our analysts have done suggests that a large majority of this particular market is unlikely to fall to high yield during this period. Many BBB companies are high quality and resilient. Some of the BBBs that fall to high yield will be attractive investment opportunities within that space, particularly if the downgrade leads to wider credit spreads.


How is Capital navigating this environment?


From a credit perspective, we are diving deep into understanding which companies will come out of this crisis intact and be able to repay their lenders. Our strong relationship with management teams and focus on fundamental credit research help us in this endeavour, as it’s our belief that that the prospects for recovery will very much be company, industry and geographically specific.


We remain very selective about our investment decisions, which are made on a security-by-security basis. This is especially important in today’s environment as downgrades and defaults become more frequent. Knowing what you’re buying helps mitigate broader credit market risks.


We also can’t stress enough the benefits of a long-term perspective, as a multiyear view may provide investors with the opportunity to capture higher returns.



Damien McCann is a fixed income portfolio manager with 19 years of investment experience. He previously covered energy, leisure and lodging, and rail companies as a fixed income investment analyst at Capital Group. He earned a bachelor’s from California State University, Northridge and is a CFA charterholder.


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