Capital Ideas^™

 

In this Q&A, Capital Group fixed income portfolio manager David Daigle discusses what is currently driving US high yield markets. He also discusses some important topical issues in high yield, including the impact of fallen angels¹ on the high yield market, the current state of liquidity within high yield bonds and some key valuation themes across the differing credit rating bands.

 

How does the current crisis stack up in your mind compared to what you have seen in the past?

I have been in the high yield bond market now for 26 years and have seen most of the ups and downs that the modern high yield market has experienced. There are a few aspects of this downturn that I think are consistent with prior cycles, such as in 2002 or 2008, and then a couple that are inconsistent. 

With each of these cycles, the corporate credit market was characterised by high starting leverage and high starting valuations that made it susceptible to a macroeconomic shock.  What is different this time is the nature, scope and velocity of that shock.

The nature of this shock has been a health-related crisis that caused severe financial and economic stress. In 2008, there was a macroeconomic shock caused by the unwinding of excessive leverage in the global banking system; major banks were forced to liquidate the substantial credit risk that had accumulated on their balance sheets. That liquidation episode caused the banks to sell at least a trillion dollars of assets from their balance sheets and drove credit spreads materially wider.

What is interesting about what we've been through the last couple of months is that there has been no evidence of stress in the banking system from this shock. In fact, the US banking system entered this crisis in the best shape that it has been in for decades. Even with smaller regional banks that may be exposed to stresses in real estate or small business loans, we have not seen any evidence of bank failures or liquidity problems. That is distinctly and importantly different from what we saw in 2008 and to some extent in 2002.

The velocity and scope of this shock has been much greater than what we saw in 2008 and in 2002. In certain ways, the volatility of this downturn exceeded what we saw in 2008. The VIX index hit an all-time high in March 2020, and we saw six days in which the 30-year US Treasury moved by more than 25 basis points. By comparison, in 2008 we had only three such days. We entered an equity bear market, with stocks down more than 20%, in less than a month, which was the fastest bear market on record.

The volatility was a reaction to the developing pandemic news, but some of it was driven by certain macroeconomic investment strategies such as risk parity. In high yield, we saw extreme flows in the high yield exchange traded funds (ETFs), some of which were driven by these strategies.

Risk factors you should consider before investing:

• This material is not intended to provide investment advice or be considered a personal recommendation.
• The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
• Past results are not a guide to future results.
• If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease.
• Depending on the strategy, risks may be associated with investing in fixed income, emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems.