Portfolio Manager Seth Meyer discusses how a return to normal in 2021 should be supportive for credit markets, but declining spreads increase the importance of careful industry and security selection.
- We believe the final quarter of 2020 laid the foundations for lower volatility in the year ahead through the serial announcements of efficacious vaccines, the beginnings of a change in American politics and signs of an improving economy.
- We remain particularly positive on below investment grade corporate credit, because we believe the risk/reward ratio is more attractive when companies are in the process of deleveraging, and note that the average credit quality of the high yield corporate bond market has improved over the last decade.
- Nevertheless, corporate bond spreads have rallied a lot since the lows in early 2020. As spreads tighten, the correlation between industries and sectors tends to decline and the dispersion of future performance tends to rise. As such, more careful industry and security selection can lead to more attractive risk-adjusted returns.
The coming year is likely to see a return to normal. However, given the extent of the economic, political, social and health-related turmoil we saw in 2020, normal is of course relative. The good news is, volatility tends to be mean reverting by its nature (which means things cannot get even worse forever). Whether it was the serial announcements of efficacious COVID-19 vaccines, the beginnings of change in American politics or an improving economy, we believe the final quarter of 2020 laid the foundation for lower volatility in the year ahead.
We expect the distribution of a COVID-19 vaccine through the first half of the year will fuel continued economic recovery. A recovering global economy also should help the US economy. The 2020 economic crisis was unique in being a synchronised global recession and we expect 2021 could see a similarly synchronised recovery. What was a vicious spiral could become a virtuous circle as recovery in one region supports others. This, on its face, is a positive for corporate and securitised bond markets, but it is equally important to recognise where companies are in their broader credit cycle.
Thanks to the US Federal Reserve’s (Fed) aggressive interventions, companies had access to capital through the worst periods of 2020, allowing them to borrow, buy time and avoid insolvency. Indeed, we believe corporate bond defaults peaked in early 2020 and expect they will decline further in the year ahead. This view is supported by the decline in distressed bonds (defined as having a price below 70 to 80 cents on the dollar) as defaults typically rise and fall with distress. Now, with both bloated balance sheets and a more positive outlook, companies (broadly speaking) have already begun a process of repairing their credit profiles, and we expect this will continue through 2021 and likely well into 2022.
We remain particularly positive on below investment grade corporate credit because we believe the risk/reward ratio is more attractive when companies are in the process of deleveraging. Of course, markets are forward-looking and the aggregate spread of the US high yield market1 has been approaching its long-term historical average, raising justifiable questions about how much recovery is priced in. However, we think it is important to compare apples to apples, and the high yield market has evolved. Today, the portion of the US High Yield Index that is rated CCC (the weakest credit quality) is around 13%. In 2008, it reached as high as 30%2. This evolution over the last decade towards higher aggregate credit quality suggests lower aggregate spreads are appropriate. Furthermore, looking back over the history of high yield spreads, current levels are more likely to appear in times of rising default rates, not declining default rates.
Nevertheless, corporate bond spreads have rallied a lot since the lows of the first quarter, and thus more selectivity is appropriate. Passively adding to the high yield asset class may not be as rewarding as it can be when index spreads are at their widest. As spreads tighten, the correlation between industries and sectors tends to decline and the dispersion of future performance tends to rise. As such, careful industry and security selection can lead to more attractive risk-adjusted returns.
It is important to note that just because volatility tends to be mean reverting does not mean it can go down forever. Many of the same variables that drove performance in 2020 could re-emerge as sources of risk in 2021. While neither a serious hiccup in the distribution of COVID-19 vaccines nor the Democrats taking control of the US Senate appear likely today, both scenarios are possible and both could spook markets.
Conversely, the economy could recover faster than expected, raising the spectre of inflation. Again, we do not think this is likely given the amount of excess capacity in the US economy, but given the low absolute level of yields across the government, corporate and securitised markets, rising interest rates could have an outsized impact on total returns. And, as 2020 showed us, surprises can happen. The bottom line is that diversity remains prudent – however likely we think a return to normal will be in the year ahead.
1Measured by the Bloomberg Barclays U.S. High Yield Index.
2Source: Bloomberg, as of 22 November 2020.
Correlation: How far the price movements of two variables (eg, bond or fund returns) match each other in their direction. If variables have a correlation of +1, then they move in the same direction. If they have a correlation of -1, they move in opposite directions. A figure near zero suggests a weak or non-existent relationship between the two variables.
Credit Spread: The difference in yield between securities with similar maturity but different credit quality. Widening spreads generally indicate deteriorating creditworthiness of corporate borrowers, and narrowing indicate improving.
Default: When a bond issuer fails to meet their repayment obligations to bondholders. The default rate measures the percentage of defaulting bonds within the defined market over a set period.
High-yield or sub-investment grade bonds involve a greater risk of default and price volatility and can experience sudden and sharp price swings.
Securitised bonds or securitised debt markets: Securitised debts are bonds backed by one or multiple pools of collateral, such as mortgage loans backing residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS), or non-mortgage debt backing asset-backed securities (ABS).
Volatility: The rate and extent at which the price of a portfolio, security or index, moves up and down. If the price swings up and down with large movements, it has high volatility.
Yield: The level of income on a security, typically expressed as a percentage rate.