Finding opportunities in the COVID recovery
With spreads now back to their pre-COVID levels many investors are wondering whether there are still opportunities within the investment grade (IG) markets.
Vaccine has paved the way towards a fundamental improvement
Following a challenging 2020, the fundamental backdrop for global investment grade markets has begun to show signs of improvement this year. The University of Oxford estimates that as of February 21, 2021 over 2.5% of the global population have now received at least one dose of the COVID-19 vaccine. Countries like the UK and the U.S. are significantly further ahead with 26% and 19% of the population partially vaccinated. The rollout of a vaccine offers a light at the end of the tunnel, especially for companies whose business models have been disrupted due to the pandemic and subsequent economic lockdowns.
Progress on the vaccine rollout and the possibility of a return to normalcy has also been supported by ongoing patience on the part of credit rating agencies. In 2020, the USD and EUR IG markets witnessed 3% and 2% fallen angels, respectively, in line with prior downturns in the credit cycle and yet significantly lower than initial fears. While the patience of rating agencies is unlikely to last indefinitely, it does provide COVID-impacted companies with precious breathing room to repair their balance sheets while retaining their IG credit rating.
Still attractive opportunities within investment grade markets
Significant fundamental support has triggered a sharp tightening in headline spreads. Within the U.S. IG markets, it took just 200 trading days (from March 23, 2020 to January 17, 2021) for spreads to recover to their pre-COVID levels; the fastest recovery ever witnessed in the IG markets. While spreads have retraced significantly since their wides in March 2020, the headline figures disguise significant divergences beneath the surface.
The below chart compares an equally weighted basket of defensive sectors, such as utilities and supermarkets, that have been relatively unscathed due to the pandemic versus an equally weighted basket of more COVID-impacted industries such as airlines, autos and restaurants. While the supportive fundamental backdrop has certainly helped those issuers that have been hardest hit by the pandemic, there remains a significant valuation gap for active investors to explore.
US IG Credit: Defensive vs COVID-impacted sectors
Technicals continue to support demand
The technical backdrop for IG markets remains supportive. With over USD 15 trillion in negative yielding debt, the positive yielding IG market continues to look relatively attractive. This is especially true for investors located in Europe and Japan where regional central banks have adopted negative interest rate policy. For a Japan-based investor, once adjusting for hedging costs, as at March 4, 2021, the U.S. IG market offers a yield of 1.68%, significantly more compared to the 0.14% offered by the domestic government bond market. These technical factors, combined with ongoing central bank purchases, should continue to support inflows into IG credit markets for the foreseeable future.
Improving corporate health and a strong technical backdrop should continue to fuel spread compression within the IG markets. While headline spreads have narrowed significantly since their wides in March, we believe that there remains opportunities in higher beta parts of the IG market, particularly within bank capital and European Industrial Hybrids. In addition, the vaccine rollout should provide a pathway towards business normality for COVID-impacted issuers and support their underlying fundamentals.