27 May 2021
Path of least resistance
Despite a slight pullback in equity markets, the high yield market has been relatively unscathed. We think investors will rightly continue to buy the dip but that it will pay to be increasingly selective.
The fundamental backdrop has been increasingly supportive for high yield credit markets. Improving rating trends, combined with the fact that default rates have rolled over from what we believe will be the peak of the cycle, serve as the backbone of a strong fundamental picture. Earnings results from the first quarter of this year also proved reassuring, despite Europe particularly suffering from a second wave of the virus. The threats in our mind are twofold. The first is a largescale drawback of support from central banks due to inflation. However, the Federal Reserve has been pointing to transitory drivers, implying that it is unlikely to change its stance on monetary policy just yet. The second is an increasing risk appetite from corporates which could place the credit clock on fast-forward. Most sectors moved quickly from the ‘repair’ to the ‘recovery’ phase. Our concern is that certain credits are moving on to the ‘expansionary’ phase. New issues are predominantly still being used to refinance existing debt, but we are starting to see more issues for mergers and acquisitions and dividends – typically mid- to late-cycle behaviour. We are particularly wary of companies that showed one-off improvements in their earnings during the pandemic. We think investors would be wrong to reward this behaviour and facilitate shareholder-friendly activities.
Fiscal and monetary support have dampened defaults
Risk markets seem to have paused, but high yield has fared a bit better than equities; the S&P 500 dipped about 4% during the second week of May whereas high yield spreads haven’t moved much higher. Since the April lows of 322 basis points (bps) in the US and 293 bps in Europe, spreads are now only 13 bps and 9 bps higher, respectively. At the headline level, high yield spreads are now trading well within historical average levels; at the sector level, cyclicals are almost trading on top of defensive credits, which may look unappealing to dedicated high yield investors. However, the asset class still screens well against competing asset classes and its performance has proved relatively resilient. The current monetary regime remains uncharted and we believe it paves the way for spreads to continue to grind tighter. (Data as of 25 May 2021).
In spite of outflows from retail high yield funds this year of USD 12 billion in the US and EUR 1 billion in Europe, or about 3% and 2% of assets under management (AUM), respectively, we believe the demand picture remains intact. The asset class remains appealing to investors such as unconstrained fixed income funds, which have seen inflows of USD 12 billion this year, roughly 3% of AUM. In terms of supply, the primary calendar has started to slow down, which will come as welcome news to high yield investors following signs of indigestion in recent weeks when a few new deals underperformed. (Data as of 25 May 2021).
What does this mean for fixed income investors?
So far the recovery has been broad based in the high yield market. While we don’t expect default rates to start rising anytime soon, we do think that the next stage of the recovery will bring some form of differentiation. Unless central bank support disappears, it is hard to see high yield spreads widening much. The path of least resistance is spreads grinds tighter with investors buying any dips. As this cycle progresses, we think it will become increasingly important for investors to be more selective – pick the long-term winners in a post-COVID world and avoid the businesses that may never recover or sufficiently grow back into their balance sheets.
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