29/10/2020
Moving to the next phase
While the course of the Covid-19 pandemic continues to cause great uncertainty, could volatility in European high yield spreads present an opportunity for fixed income investors?
Fundamentals
With positive surprises across most sectors, European high yield third-quarter earnings so far appear to confirm the trend of recent months: companies are holding up better than had been expected back in the first quarter. Loose monetary and fiscal conditions have helped corporate issuers to amass cash piles through both banks and capital markets. As a result, 2020 is likely to end with realised defaults of no more than 3%, which is remarkable when considering this year’s economic shock. There is still significant fundamental risk posed by the incremental debt that has been raised to fund additional liquidity requirements, and by the uncertain path to a sustained earnings recovery as infection rates rise again. A repeat prescription of further mobility restrictions to lower reinfection rates accompanied by an extension of fiscal measures to support demand would help pave the way for spreads to tighten, but under such a scenario some sectors are unlikely to be spared. While third-quarter results and ratings momentum, in aggregate, suggest that the cycle has reached its low point, weak credits across many sectors, including retail, travel, and leisure, could have further to fall.
Quantitative valuations
Since the March wides, European high yield spreads have retraced by 426 basis points (bps), which represents a 72% recovery. Since the start of the second quarter, spreads have been trading in a range of around 440bps to 500bps. The top of the range has tended to be met with renewed buying, given the global grab for yield that has been supporting markets for many months now. This practice should continue while technicals remain supportive. To move through the lower end of the range would likely require a fundamental improvement to the trajectory of the pandemic. A vaccine approval, for example, could alleviate the pressure on high yielding credits in stressed industries, such as consumer discretionary and airlines. Looking at spreads today, we think that the most compelling argument for high yield valuations can be made against European investment grade spreads, given the BB part of the European high yield market trades at a ratio of 2.7 and a spread discount of 222bps, with 1.5 years lower duration.
The spread discount of BBs vs. BBBs is above average
Source: Bloomberg; data as of 28 October 2020.
Technicals
More than EUR 150 million has flowed out of European high yield over the last three months, as appetite among investors to add risk has waned amid uncertainty over the US election outcome. However, the ongoing earnings season, half-term holidays and the seasonal reduction in new issuance as we head into the last two months of the year mean that supply dynamics should remain supportive. It still also seems likely that the overriding technical backdrop of policy support, coupled with the search for yield (given that negative yielding debt globally is now at all-time highs at almost USD 15 trillion), should prove supportive for spreads.
What does this mean for fixed income investors?
With high yield technicals holding steady as we prepare to enter the next phase of the credit cycle, fundamentals and valuations are the main focus. From a fundamentals perspective, it is important to distinguish between those sectors that remain resilient to a Covid world, and those that may be unattractive now but stand to gain significantly from a vaccine breakthrough. For now, caution is warranted in the latter category given that we still have no clear vaccine timeline. In terms of valuations, meanwhile, we need to examine valuations in the context of a range that looks fairly well established. While the continued macro uncertainty sets a plausible lower bound for near-term spread tightening, the necessity of a strong fiscal and monetary response to bridge economies to the end of the pandemic is likely to put a ceiling on any spread widening. Against this backdrop, fixed income investors may want to take advantage of European high yield volatility while it lasts.
About the Bond Bulletin
Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.
Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.
Fundamental factors include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
Quantitative valuations is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors)
Technical factors are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum