BOND BULLETIN
07/03/2020
GFICC Investors
Evolving high yield dynamics
Credit markets have been subject to far more rating downgrades than upgrades this year. How does this dynamic affect the high yield market and what does it entail for future return prospects?
Fundamentals
At a time where revenues have plummeted across most sectors, central bank support and state-backed funding are the main props to fundamental credit quality. The principal concern of most businesses has been liquidity preservation, but the price of survival will mainly be an increase in net indebtedness. This rise in indebtedness has been recognised by the credit rating agencies, with a sharp increase in credit downgrades in the high yield market being met with almost no offsetting upgrades. However, overall credit quality has been supported by record fallen angels (downgrades from investment grade to high yield), which have amounted to over $240 billion. The high yield market also entered this downturn with a higher average credit quality than in the period leading up to the 2008 financial crisis (currently B+ for US high yield and BB- for European high yield). Similarly, the market is bolstered by the fact that it lends more on a senior secured basis than it used to (close to 20% for US high yield and 35% for Europe). Overall, we expect default rates to rise over the course of the year to about 8% in the US market and about 6% in Europe. While these rates are lower than previous spikes, they could remain elevated for some time.
Upgrade/downgrade ratio (cumulative 12-month rolling)
Source: J.P. Morgan Asset Management & Moody’s. Data from 2008 to 30 June 2020. EHY (European high yield): The calculation universe is based on the ICE BofA Global High Yield Index (HW00) filtered for developed markets, ex-financial sector and EUR denominated. USHY (US high yield): The calculation universe is based on the ICE BofA Global High Yield Index (HW00) filtered for developed markets, ex-financial sector and USD denominated.
Quantitative valuations
The easy money has been made already, with high yield posting its best quarterly returns since the second quarter of 2009: the US market was up 9.54% and Europe 11.22% higher in the three months to 30 June. With spreads tightening by 442 basis points (bps) in the US and by 372bps in Europe since their peak on 23 March, it’s unlikely that returns will continue to be this high given spreads have less room to tighten. However, with a yield to worst of 6.86% in the US market and 4.75% in Europe, it is possible that elevated levels of carry could still backstop returns. The ratings migration has also bolstered performance, with this year’s fallen angels outperforming previous vintages and the BB market. Lower-rated bonds have generally underperformed as downgrades and defaults have been priced into the market, but US and European single Bs have bounced back 19% and 22% respectively from their lows. The question is whether they can continue to post such returns given the looming macro backdrop. (All data as at 30 June 2020)
Technicals
June has been the busiest month of supply on record, as US and European high yield issuance recovered from the drought earlier this year. Some of the sectors worst affected by Covid have been among the biggest issuers, with capital markets increasingly willing to fund lower-rated issuers that offer attractive coupons. At the same time, demand continues to be strong enough to digest rising supply, not only from mutual funds, but also institutional buyers and central banks themselves, with the Federal Reserve and the European Central Bank both expanding their asset purchase programmes to include high yield ETFs and fallen angels.
What does this mean for fixed income investors?
While we expect high yield default rates to pick up, the market’s strong footing going into the crisis, combined with substantial responses from governments and central banks, should keep defaults lower than they otherwise would have been. Fallen angels, which tend to have more levers to pull on in order to get back to investment grade status, should also continue to help offset some of the negative returns from high yield issuers that are downgraded. The sheer size of these fallen angels may even improve the overall credit quality of the high yield market. Therefore, while returns may not continue to bounce back as strongly as they have, the relatively high levels of carry should still ensure that high yield offers attractive risk/reward characteristics in the current environment.
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
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