For financial professionals in Finland

The turn: high yield on the road to deleveraging

Tom Ross, CFA

Tom Ross, CFA

Portfolio Manager


25 May 2021

Tom Ross, within the Global Corporate Credit Team, looks at whether the trajectory of credit fundamentals supports the strength in high yield bond markets.


  Key takeaways

  • High yield bond prices have recovered sharply in the past year, partly in anticipation of improving corporate prospects.
  • Data reporting schedules mean credit metrics will lag actual recovery, but evidence is already mounting of fundamental improvement.
  • Selectivity remains paramount and we view sectors along three distinct categories in terms of their capacity to recover.

 

We are now more than a year on from the sharp falls in asset prices at the start of the COVID-19 crisis. It is fair to say that the recovery in asset markets has been rapid. Central bank support and government stimulus packages have succeeded in tempering the economic damage that would ordinarily have resulted from the closure of whole swathes of the economy.

High yield corporate bond markets have responded positively. Credit spreads (the additional yield that a corporate bond pays over a government bond of equivalent maturity) widened aggressively during the early part of the crisis in 2020, yet by mid-May 2021 global high yield credit spreads had tightened back to almost pre-crisis levels.1 But what about all the extra debt companies have taken on to tide over the loss of revenue during lockdowns? Are markets saying that debt levels do not matter?

Indebtedness may have peaked

A cursory glance at the chart below shows the rapid rise in corporate indebtedness (leverage) in Europe. The gross leverage ratio (Total debt/EBITDA) measures the total debt that a company has relative to its earnings before interest, tax, depreciation and amortisation are deducted. This provides a multiple of debt to earnings. Net leverage (Net debt/EBITDA) is the same ratio, but with the total debt reduced by the amount of cash (or equivalents) that the company holds on its balance sheet. A higher multiple reflects more indebtedness and vice versa. The chart may initially look bleak but there is a lot we can infer from it.

European high yield leverage ratio

European high yield leverage ratio

Source: Morgan Stanley Research, Bloomberg, company data, quarterly datapoints, December 2003 to December 2020. Gross leverage ratio = total debt/earnings before interest, tax, depreciation and amortisation (EBITDA). Net leverage = net debt (total debt minus cash and cash equivalents)/ EBITDA. Earnings are on a trailing 12-month basis.

First, note the big gap between gross leverage and net leverage. This tells you that, in aggregate, companies within the high yield market have been hoarding precautionary cash. In fact, according to JP Morgan, European high yield issuer cash balances grew to a record level of approximately €190 billion at the end of 2020.2 This is likely a reaction to the stop-start nature of lockdowns, as well as some companies opportunistically raising cash while borrowing rates appear cheap. With vaccine programmes advancing and economies re-opening, we can probably expect some pay down of this debt or the cash to be put to more productive uses.

Second, the net leverage figure fell in both the third and fourth quarter of 2020. This was at a time when many European economies and other parts of the world were operating social distancing restrictions, so the economy was not operating at full capacity. Companies were getting better at reconfiguring supply chains and operating more efficiently, but Morgan Stanley reported that earnings at high yield issuers still dipped 2% quarter-on-quarter in the final quarter of 2020.3 Companies, however, cut their capital expenditures, freeing up cash. Reduced dividend payouts to shareholders were another way to retain cash in the business.

Third, there is a lag of three to six months for aggregate leverage figures to become available. This is because we have to wait until companies have officially reported their earnings and the state of their balance sheets. The final datapoint on the chart, therefore, gives a snapshot of where companies were a few months ago rather than where they are today. Both anecdotally from conversations we are having with issuers and from the stream of data coming through, we know that the economic picture has been improving. While the first quarter of 2021 involved ongoing restrictions, the rollout of vaccine programmes has allowed a gradual re-opening. We have seen from high frequency data (such as retail sales and public transport usage) within countries that are advanced with their vaccine rollouts that confidence is rapidly returning and activity levels are picking up. For example, gross domestic product growth data in the UK showed a strong rebound in March as schools returned, online sales grew and construction picked up.4

Three distinct categories

What is more, debt has not been amassed homogenously. This is worth bearing in mind when looking at aggregate debt levels. Companies within different sectors will have had very different experiences. First, there are those companies totally unaffected or even benefiting from COVID (such as content streaming companies and logistics). Here, earnings have remained robust and debt (if it has grown) has typically been to fund growth rather than to pay for revenue shortfalls. Second, there are those companies in cyclical sectors, such as autos, resources, chemicals and consumer goods, that have been able to bounce back as manufacturing has recovered and consumers have begun to spend more freely on goods. A third category are those areas of services that are still hampered by social distancing restrictions, such as sectors associated with international travel; here there is less clarity on when leverage levels may begin to decline.

Ultimately, we care more about where leverage will be in six to eighteen months’ time as opposed to right now. Of course, this assumes companies have sufficiently resistant balance sheets or access to liquidity to see them through to better times. Most do, which is reflected in a global high yield default rate that is well below peak levels of the last major crisis.5

Clearly, there are threats to corporate credit valuations, from vaccine resistant variants leading to fresh economic dislocation through to worries about inflation, but the experience of the third quarter of 2020 showed that earnings can recover rapidly when economies are allowed to reopen. The loss of revenues and rise in leverage was abrupt, but so too could be the recovery.

1Source: Bloomberg, ICE BofA Global High Yield Bond Index, government option adjusted spread, 17 May 2021.
2Source: JPMorgan, adjusted for issuers that were yet to report, 13 April 2021.
3Source: Morgan Stanley, median figure, 7 May 2021.
4Source: ONS, GDP monthly estimate, UK; March 2021, 12 May 2021.
5Source: Moody’s. The trailing 12-month default rate for global speculative bonds peaked at around 6.8% in December 2020, compared with 13.4% in 2009 following the Global Financial Crisis, 10 May 2021.

Balance sheet: A financial statement that summarises a company's assets, liabilities and shareholders' equity at a particular point in time.
Cyclical sectors: sectors that are highly sensitive to changes in the strength of the economy, such as miners or companies that sell discretionary items, such as autos.
Default: The failure of a debtor (such as a bond issuer) to pay interest or to return an original amount loaned when due. The default rate is a measure of defaults over a set period as a proportion of debt originally issued.
High yield bond: A corporate bond that has a lower credit rating than an investment grade bond. Sometimes known as a sub-investment grade bond. These bonds carry a higher risk of the issuer defaulting on their payments, so they are typically issued with a higher coupon (interest payment) to compensate for the additional risk.
Fundamentals: the basic information that contributes towards the valuation of a security, including financial information, growth prospects and qualitative factors such as management experience.
Yield: The level of income on a security, typically expressed as a percentage rate. For a bond this is calculated as the annual coupon payment divided by the current bond price.

These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. Any securities, funds, sectors and indices mentioned within this article do not constitute or form part of any offer or solicitation to buy or sell them.

 

Past performance does not predict future returns. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.

 

The information in this article does not qualify as an investment recommendation.

 

Marketing Communication.

 

Glossary

 

 

 

Important information

Please read the following important information regarding funds related to this article.

The Janus Henderson Horizon Fund (the “Fund”) is a Luxembourg SICAV incorporated on 30 May 1985, managed by Henderson Management S.A. Henderson Management SA may decide to terminate the marketing arrangements of this Collective Investment Scheme in accordance with the appropriate regulation. This is a marketing communication. Please refer to the prospectus of the UCITS and to the KIID before making any final investment decisions.
    Specific risks
  • An issuer of a bond (or money market instrument) may become unable or unwilling to pay interest or repay capital to the Fund. If this happens or the market perceives this may happen, the value of the bond will fall.
  • When interest rates rise (or fall), the prices of different securities will be affected differently. In particular, bond values generally fall when interest rates rise. This risk is generally greater the longer the maturity of a bond investment.
  • The Fund invests in high yield (non-investment grade) bonds and while these generally offer higher rates of interest than investment grade bonds, they are more speculative and more sensitive to adverse changes in market conditions.
  • Callable debt securities, such as some asset-backed or mortgage-backed securities (ABS/MBS), give issuers the right to repay capital before the maturity date or to extend the maturity. Issuers may exercise these rights when favourable to them and as a result the value of the fund may be impacted.
  • If a Fund has a high exposure to a particular country or geographical region it carries a higher level of risk than a Fund which is more broadly diversified.
  • The Fund may use derivatives with the aim of reducing risk or managing the portfolio more efficiently. However this introduces other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
  • If the Fund holds assets in currencies other than the base currency of the Fund or you invest in a share/unit class of a different currency to the Fund (unless 'hedged'), the value of your investment may be impacted by changes in exchange rates.
  • When the Fund, or a hedged share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency, the hedging strategy itself may create a positive or negative impact to the value of the Fund due to differences in short-term interest rates between the currencies.
  • Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
  • Some or all of the ongoing charges may be taken from capital, which may erode capital or reduce potential for capital growth.
  • The Fund may invest in contingent convertible bonds (CoCos), which can fall sharply in value if the financial strength of an issuer weakens and a predetermined trigger event causes the bonds to be converted into shares of the issuer or to be partly or wholly written off.
  • The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
  • In addition to income, this share class may distribute realised and unrealised capital gains and original capital invested. Fees, charges and expenses are also deducted from capital. Both factors may result in capital erosion and reduced potential for capital growth. Investors should also note that distributions of this nature may be treated (and taxable) as income depending on local tax legislation.
The Janus Henderson Horizon Fund (the “Fund”) is a Luxembourg SICAV incorporated on 30 May 1985, managed by Henderson Management S.A. Henderson Management SA may decide to terminate the marketing arrangements of this Collective Investment Scheme in accordance with the appropriate regulation. This is a marketing communication. Please refer to the prospectus of the UCITS and to the KIID before making any final investment decisions.
    Specific risks
  • An issuer of a bond (or money market instrument) may become unable or unwilling to pay interest or repay capital to the Fund. If this happens or the market perceives this may happen, the value of the bond will fall.
  • When interest rates rise (or fall), the prices of different securities will be affected differently. In particular, bond values generally fall when interest rates rise. This risk is generally greater the longer the maturity of a bond investment.
  • The Fund invests in high yield (non-investment grade) bonds and while these generally offer higher rates of interest than investment grade bonds, they are more speculative and more sensitive to adverse changes in market conditions.
  • Callable debt securities, such as some asset-backed or mortgage-backed securities (ABS/MBS), give issuers the right to repay capital before the maturity date or to extend the maturity. Issuers may exercise these rights when favourable to them and as a result the value of the fund may be impacted.
  • The Fund may use derivatives towards the aim of achieving its investment objective. This can result in 'leverage', which can magnify an investment outcome and gains or losses to the Fund may be greater than the cost of the derivative. Derivatives also introduce other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
  • If the Fund holds assets in currencies other than the base currency of the Fund or you invest in a share/unit class of a different currency to the Fund (unless 'hedged'), the value of your investment may be impacted by changes in exchange rates.
  • When the Fund, or a hedged share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency, the hedging strategy itself may create a positive or negative impact to the value of the Fund due to differences in short-term interest rates between the currencies.
  • Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
  • The Fund may incur a higher level of transaction costs as a result of investing in less actively traded or less developed markets compared to a fund that invests in more active/developed markets. These transaction costs are in addition to the Fund's Ongoing Charges.
  • Some or all of the ongoing charges may be taken from capital, which may erode capital or reduce potential for capital growth.
  • The Fund may invest in contingent convertible bonds (CoCos), which can fall sharply in value if the financial strength of an issuer weakens and a predetermined trigger event causes the bonds to be converted into shares of the issuer or to be partly or wholly written off.
  • The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
  • In addition to income, this share class may distribute realised and unrealised capital gains and original capital invested. Fees, charges and expenses are also deducted from capital. Both factors may result in capital erosion and reduced potential for capital growth. Investors should also note that distributions of this nature may be treated (and taxable) as income depending on local tax legislation.