Global Head of Portfolio Construction and Strategy Adam Hetts talks to Seth Meyer and Tom Ross, portfolio managers on the high-yield bond strategies, about how with credit spreads gradually tightening, returns will likely become less about market direction (beta) and more about identifying individual opportunities (alpha).
- Credit spreads have taken a round trip, having widened dramatically at the start of the coronavirus crisis but have since narrowed significantly. A recovery should squeeze spreads tighter, but investors will need to rely more on identifying opportunities through good credit analysis and security selection.
- Effective vaccines should allow economies to reopen and earnings and cash flows to recover. This should accelerate as 2021 progresses, allowing balance sheets to begin to improve.
- Companies in the energy sector may have to run with more conservative balance sheets not just because the oil price may remain low, but also because the costs of financing are likely to rise as more environmental, social and governance (ESG)-led investors refuse to lend to these companies.
- Inflation is a potential concern. While modest inflation is often good for corporate revenues, the very low yields on government bonds means inflation may cause volatility in the underlying government bond market that could feed into volatility among corporate bonds.
Adam Hetts: Welcome to Global Perspectives and our last episode of 2020. Today we're going to dig into high yield, and I couldn't think of a better topic to finish off the year. High yield has, of course, had an amazing rally since March, and now it feels like there's more investor interest than ever given the ridiculously low yields we're seeing on the sovereign side of the bond market. I'm your host, Adam Hetts, Global head of Portfolio Construction and Strategy here at Janus Henderson. And our guests are Seth Meyer and Tom Ross. Seth is based here in Denver, Tom is in London, and they're both portfolio managers covering high yield and investment grade across quite a few of our strategies. So, guys, thanks for joining us today. I'm looking forward to getting your thoughts on where high yield goes in 2021. But I think we have to start by reviewing what's happened in this crazy year of 2020. So can you catch us up to date on spread levels starting back in March? What we've seen since then and where we're at today.
Tom Ross: So global high yield spreads started the year around sort of 375 [basis points] over governments, and then obviously we had the sharp widening in March where we actually hit levels close to 1,100 in spread. And as you say, we're rallied back incredibly strongly since then. And current levels for global high yield is around 425, which is still a little bit inside of the three- or five-year averages, but still clearly has room to go relative to where we started the year, and certainly if you look back to the [credit spread] tights we saw in 2018.1
Hetts: Thanks, Tom. How does that 375 to start the year up to 1,100 then this round trip back to 425, has that been sort of symmetrical globally or has there been a much different journey in the U.S. versus, say, parts of Europe or elsewhere?
Ross: It was very … it was fairly broad brush when we looked in March. The U.S. probably underperformed a little bit more because it was two crises, right? It was the COVID crisis, but it was also an energy crisis as well. And the high weighting of energy in U.S. high yield caused some underperformance there. But to a certain extent, I mean, all of the markets have come back incredibly strongly. So, yeah, there were some little movements as there were as everything was going on. But generally, we've all got back to a place where most of the markets are sort of in line to where you'd expect them to be during the recovery.
Hetts: Okay, thanks. And that blowout we saw back in March came hand-in-hand with some ugly predictions about default rates. So at the time, thinking back to March, you know, that seems like a lifetime ago. What kind of default rates were expected, do you think? And what have we actually seen so far this year?
Seth Meyer: Yeah, I think that that's been, frankly, the bigger surprise of what has happened since the sell-off in March and the subsequent recovery. What really changed things was the first week in April when the Fed made announcements to start getting involved in below-investment-grade credit, either through ETF [exchange traded fund] buying or direct fallen angel purchases. And frankly, is one of the reasons I think the default rate never met those doom and gloom estimates. Now, that's not to say we didn't experience our percentages of defaults. We certainly have in the U.S. We expect to end 2020 in the high single-digit number. In Europe and in emerging markets, it's been less so, you know, low single digit type numbers. But when you think about the sectors that have been under such significant stress in the U.S., it really has been the energy sector, which has been driving a lot of that higher than other region default rates. But, you know, the actions were swift, the actions were strong by central banks around the world, frankly, which allowed default rates to not really hit those aggressive numbers that we were thinking could have transpired in March and really keep things in the high single-digit range in the U.S. and low single-digit range elsewhere.
Hetts: And you mentioned that U.S. central bank backstop on investment grade and fallen angels, and that came on kind of suddenly and surprisingly. And then over the last month, the announcement came out that that's going away sort of suddenly and surprisingly. But I guess with that, it wasn't really used very much. It was more of an emotional backstop for everybody that just got more confidence in the market. And I don't think we've seen that confidence get sapped with them removing that backstop. Do you have any concerns there, or what do you think happens going forward as far as central bank support for investment grade?
Meyer: Yeah, we don't we don't expect much. I mean, like you said, it wasn't utilized all that much. You know, as a percentage of purchases, it just wasn't anywhere near what the initial program was set up to be. It's not about how much they utilize, it's about their willingness to utilize, which is what you said. You know, you hit it on the head. It's more about providing the market confidence that in the event that things were to get significantly worse, the Fed was going to provide some level of backstop.
I think if you reverse back to why they felt they needed to do so was there's just an awful lot of debt in the BBB category that's on negative watch. And when you think about that, just the quantum of debt, just the pure amount of debt that could have been downgraded into the high yield space. If this would have continued for periods of time, would have been pretty significant and would have to some degree overwhelmed the high yield asset class. So the Fed providing a backstop per se, and their willingness to buy corporate bonds and not just investment grade corporate bonds, but high-yield bonds, really is it's more of a vote of confidence for the asset class. And one of the reasons that you can feel, despite the fact that the program has been temporarily or maybe permanently, we don't know, paused, it's more about their willingness to actually come back and do something along those lines rather than the execution and actual outright purchases.
So, the other thing to remember is the aggregate asset size of the high yield market and even the investment grade corporate market relative to the markets that they are playing in in the investment grade category, meaning treasuries and MBS [mortgage backed securities], is relatively small. So it doesn't take a lot of direct asset purchases to provide a floor in the corporate bond market relative to what you would be doing in mortgage-backed securities or even Treasuries, which are massive markets.
Ross: I think as well, because monetary stimulus has two impacts, you know, it's those direct purchases are one, but it's the indirect effect of lowering overall yields and forcing investors to grab for higher yields. I mean, Europe's been a great example of seeing that for a number of years now with the ECB [European Central Bank] Corporate Sector Purchase Program. And, you know, also when there are purchases of corporates, it doesn't necessarily mean that spreads don't go wider. But generally, we believe that the biggest impact on spreads is that indirect effect. It is that crowding out effect of forcing investors into higher yielding assets that has the bigger impact on spreads than direct purchases. And, you know, quite frankly, at the moment, you know, it's hard to find bonds at the moment within the market anyway. So, you know, we don't necessarily need central banks to be hoovering up anymore because, you know, investors are struggling to find that yield.
Hetts: Yeah, the search for yield continues, and it feels strange to recap 2020 like that, because it sounds pretty optimistic overall. We had this huge journey in credit spreads going from the 300s to over a 1,000 and back to around the 400s now. And you have this direct and indirect support from central banks, in the investment grade and some high yield markets. Spreads are relatively low now, but there's still room to compress. Default rates are low and expected to stay low. And we've got the vaccine now and already being received in the UK. So then going away from 2020 and looking forward to 2021, what does this mean for you guys as far as what the next stage of the credit cycle looks like? I'm guessing pretty good.
Meyer: Yeah, I mean, I think we both feel relatively optimistic because we're looking at 2021 from the perspective of corporate credit. Now, you know, valuations aren't nearly as forgiving as they were early on in 2020 and you have to be mindful of that. So when we think about the outlook and where we think we are in the cycle, you know, Tom and I, when we were meeting or discussing with clients in January and February, it was about the end of the credit cycle and when it was going to happen and how it was going to happen and, you know, what was going to be the trigger to have things actually start to begin to sell off. And now obviously we know what that was. It was something that was unforeseen and typically it is.
So now we're in the early innings of an economic expansion. Global economies, both developed and emerging will be coming out of this crisis with growth rates that will be accelerating. We expect that over the next couple of years here as we look forward, we expect to start seeing corporate balance sheets go through a repair mode. You can't ignore the fact that a lot of these companies, despite the fact of all the good news of what we just said, the bad news is you've had some destruction of balance sheet metrics, whether that be in the investment grade or in the high yield category. You can't ignore the fact that many of these companies went through a long period of time where they had no earnings, where cashflow was effectively zero and they were burning what they had on their balance sheet in order to keep themselves alive. Whether raising debt or using revolver availability in order to continue to make interest payments and, frankly, just to keep themselves above water.
That repair, it will start, and as we look forward, we expect that repair to accelerate. You know, you think about year-over-year growth rates on cash flow should be pretty meaningful, considering Q2 was effectively zero. With that cash, what do we expect corporations to be doing? It would seem very unlikely, particularly in the levered space, that companies do something that is balance sheet destructive. With that, you would expect metrics to improve and, going even further, one step further, you would expect default rates to continue to decline.
So those are reasons to be optimistic as you look forward into 2021, particularly as it pertains to balance sheets, balance sheet repair and default rates. But you have to also balance that with where valuations are. And a lot of this good news has been reflected in what we're seeing in high yield spreads today. That doesn't mean we don't believe that there's room for tightening because we certainly do. It just means the way to think about this asset class is it's going to be less about a beta grab. It's going to be less about just buying the asset class and watching spreads tighten. It's going to be about finding the individual bonds and individual stories and, you know, doing really solid bottom-up work, buying individual names and allowing them to outperform. And this is where an active manager versus buying an ETF or just getting direct exposure to the high yield asset class really matters. When you need to do bottom-up fundamental work and find those names that we expect to outperform over the next period of time, that's when you want to have a team of analysts doing bottom-up work and finding these individual ideas for you. So I think what's going to be happening over the next 12 to 18 months is really the hand-off from a beta trade to more of an alpha trade where you're finding those really good individual names to, you know, overweight in your portfolio and outperform markets as we look forward.
Hetts: Yeah, well said, Seth. I imagine as a portfolio manager back in March, when spreads were so wide, it was more about timing, beating everything in a sense. And as you say, moving towards alpha more so and less beta. As spreads get tighter, it's more about security selection and sector weightings. So can you guys give us some examples of maybe within the global high yield space, across regions and across sectors, maybe a sector that you're very optimistic on, and then the other end of the spectrum, someplace that you're very negative.
Ross: I guess on the optimistic side, as far as sectors and themes, we've already mentioned about compression. So it is some of those areas where we do still believe there's value. So whether that be in some parts of the financial sector … and if you start going down into the more subordinated bonds, whether that be, you know, additional tier ones [AT1s], that's where actually you get some pretty good valuations relative to the corporates. And I think what's clear is, if you take European AT1s through the crisis, you know, the regulator stopped banks paying dividends, but they didn't stop them paying coupons on AT1s. So, we like them, even though they're the subordinated parts of the capital structure, they're more debt-like than necessarily equity-like.
And another one would be real estate. And that's an area where we look. Within Europe, and certainly areas more on the commercial side, that's obviously been hit. But we believe they should recover quite strongly with that improving growth trajectory. And then also, if we look in emerging markets, if you take some of the Chinese homebuilders, you are getting significant yield there for companies that have very good visibility on their order books out to a handful of years. Most of these are shorter-dated bonds that are, two-, three-, sometimes four-year bonds. But bonds that are yielding high single digits and, in some cases, low double digits. So, that looks really attractive relative to the broader market.
Hetts: Maybe on the negative side, I'm not sure … Seth, you mentioned some sectors, particularly in the U.S., with the higher energy weight. Between COVID and oil prices, the energy sector sort of got it on both ends earlier this year. Are you seeing any value there in energy or is this still more of a 10-foot pole kind of situation?
Meyer: Energy is always a tougher sector because you are making an indirect call on the direction of the commodity price. But we tend to focus on… within that space, we look for companies that kind of exhibit three things: Number one being a really strong asset base; we would want the company to have assets located in low-cost basins, particularly if you were a U.S. shale player. Number two, we want a company with a management team that's focusing on deleveraging and not overspending. So in other words, we don't want them to be to be out spending their cash flows on a year-to-year basis. We'd rather they have a conservative profile, which leads us to number three, which is really to be free cash-flow positive or break even if possible.
We're finding some opportunities within the space today, significantly more than we were a year or so ago. You think about the management teams right now, their focus has been on breakeven cash flow profiles, less about growth capex and more about maintaining cash on the balance sheet. So there have been some opportunities within the oil space. And oil prices are starting to rebound and we're starting to see some positives within the oil markets. And that's largely driven just off of rising growth rates in 2021 relative to 2020. And the consumption of oil will certainly be higher in 2021 than it was in 2020. But you still have a supply demand imbalance and that's what the market is really trying to work itself through. We're not overly optimistic on oil in general. But I would say we're frankly not as negative as we were, just because of the outlook as we look into 2021 and we anticipate stronger growth, which should lead to stronger overall demand for oil and natural gas.
The interesting part about what we've seen over the past couple of months has really been a significant rally in the commodity markets. I think one of the areas to really point yourself and look at if you really want to look at kind of perhaps an acceleration of global growth is really the copper markets. Generally speaking, it's a pretty good leading indicator of global growth. And demand in that market is a positive sign that could lead itself to higher oil prices just as we start to see some cyclical recovery in 2021. So, yeah, there's definitely opportunities. And, you know, we try to keep our eyes wide open to those opportunities within that sector. But I'm mindful that, you know, there's still a lot of weak companies within that that sector and a lot of companies that frankly, even at your $50 oil, may have a hard time surviving. So it's again, you know, bottom-up fundamental work and finding survivors within this difficult market is key.
Ross: I was going to say what would be really interesting going forward as well is, obviously, the interest in whether it be ESG [environmental, social and governance] type products or more sustainable financial products going forward is, you know, how a tough sector like energy is going to be impacted potentially by even less financing opportunities and therefore higher high costs of financing if, and as we expect, the ESG train and interest really continues. So, you know, we're starting to hear much more interest in mandates that have less exposure to sectors such as energy. As we say that only feels like that's increasing in the moment. So that's potentially another headwind that the energy sector might be facing over the coming years.
Meyer: Yeah, that's actually a great point, Tom. I think that if you're a CFO of an energy company, your perception of what the right level of leverage for your balance sheet is today relative to what it was three or five years ago, is probably significantly lower. In other words, a much more conservative balance sheet as you look forward. The energy markets, not only are more challenging to finance, given what Tom was just alluding to with ESG demands that we're seeing from the end client, but are significantly more challenging to finance on the equity side of the market. The S&P 500 energy sector, part of the S&P 500, has dramatically underperformed over very long periods of time, just making it significantly more challenging for these companies to access not only debt markets, but equity markets.2 So, cost of capital is definitely higher within these companies, which should lead itself to more conservative balance sheets going forward. Which is one of the reasons that, again, where there are opportunities, we will exploit them, but we need to see management teams that are aware of what's going on around them.
Hetts: Do you two worry about any conflicts as portfolio managers when it comes to ESG? So in that example, let's say you do have an energy CFO that can finance their debt and you see a lot of value in energy, but as portfolio managers for your strategies, you're feeling like you need to underweight the sector because of ESG considerations. Has that happened or how does that fit into your ESG framework, in balancing taking advantage of value versus having the ESG balance across the strategy?
Ross: The majority of our products involve an integrated ESG approach, and by that we mean the credit analysts that are analyzing the fundamentals of the company are also considering the risks in terms of environmental, social and governance as well. And then there is an overall view on whether we believe that company is going to outperform or underperform based upon all of those risk factors. And then specifically with looking at ESG risk factors, if those risk factors are material and we also believe they are deteriorating, then those are the companies where we put an avoid recommendation and we simply won't own. And that overrides any recommendation we have on the fundamental side. And effectively, that's similar to how we look at companies anyway, companies with high leverage – a material risk. If that leverage is likely to go up in the future, it probably means its cost of capital is going up and we don't want to invest there. And it's the same if a company has a material ESG risk and it's deteriorating.
But then on the flip side, ESG isn't just about avoiding the losers in our view. That's why we have this integrated approach. Because if we can find those companies where they're improving their ESG risk factors, those are typically the companies that you're probably going to expect a lower cost of capital going forward, and therefore that means [bond] prices are going up. So in the same way as a company with high leverage, and then that leverage is coming down is exactly the same as investing in a company that does have environmental risk factors but they are addressing those in a way that is going to be less of a risk on the balance sheet of that company in the future.
So, it's about picking winners as well as avoiding losers. And it's really that forward looking approach. And effectively, I mean, that is the skill of a corporate credit analyst. You know, it's not just saying what leverage is now or what risks there are now. It's trying to consider what they're going to be in six months’ time and maybe 12 months’ time. So, it's really that forward looking approach and that's how we consider ESG. And the really key aspect of this, if you're trying to find companies with improving environmental, social and governance factors, that's why engagement is so key, because if we can engage with the companies to get them to improve, to get them to disclose more measures around diversity or around their environmental outputs, whatever it might be, that's then when we can start to get them to improve on those risks.
Hetts: That makes sense, I think my main premise is wrong in a way, because if you have a cohesive philosophy in your ESG approach, you're not going to have that conflict where there is value, but for an ESG constraint, because it's the ESG that is a big part of the value in the process. So that makes a lot of sense to me. Thanks. So, I think last thing would be then going into next year, what do you guys see as the biggest opportunity in your markets and what's going to be the biggest risk you'll be losing sleep over?
Ross: I think as we look into 2021, we still believe there's opportunity for some spread tightening. Spreads have come back a long way. But given the level of monetary support, given where we believe we are in the early part of a credit cycle, given we've got an improving growth trajectory we believe over the coming months, and possibly year, there's still room for spread tightening.
But then as well, obviously, that one of the things that comes out of crises is that you just get so much more dispersion, you get more companies trading at different levels. And so I think, 2019 was a security selection year. It wasn't a beta year. 2020 has been more you needing to get the beta call right. And then I think as you go into next year, it's going to be more about that security selection again. It's going to be about those companies that do have the ability, that have better business models, that can generate more free cash flow, that can repair their balance sheets, that can really express themselves best in the early part of the cycle. Those are going to be some of the opportunities that we continue to look for from the bottom-up perspective. And I think the other thing, 2020 has been such a massive year for fallen angels. And, you know, investing in fallen angels has been one of the best trades so far in 2020. And as we go into 2021, I don't necessarily think you're going to get all of those fallen angels coming back to being rising stars straight away. But as we start looking further out, it might be 12 months, maybe sort of 18 months out, maybe 24 months out. We're going to see a lot of those high yield companies, those fallen angels, look to get their investment grade ratings back. And the opportunity for rising stars, we believe, is going to be quite significant. And that's obviously such an attractive trade because you've got the capital appreciation of the spreads coming tighter as they improve their ratings. But it's also the case you're then investing in an asset that is becoming less risky over time as well. So, I think that's going to be a real theme as we go over the next two years.
And that's one of the reasons why we have a credit research team where the analysts are covering the whole way up and down the investment grade and high yield structure. So, there's no hand-over of coverage when a company goes between IG [investment grade] and high yield. But they also really understand the relative value about where a rising star can go relative to the comps that they also see within other sectors within the investment grade space. So, I really expect, I mean, investment grade is effectively now a policy tool for central banks and will continue to be probably for quite some time. The opportunity for those CFOs of those fallen angels to get back investment grade status, I think is going to be really strong. And I think that's what most of those companies are going to be striving to do over that period.
Hetts: What’s really interesting to me there is that you're talking about going into next year and there is this big recovery phase we're entering into and you're looking for that balance sheet repair and the free cash flow and then even this recovery of fallen angels has its own piece of the market as well. All in the face of spreads, as you talked about earlier, being relatively tight. So, it's interesting that spread levels themselves aren't really an indicator of where we're at in the cycle. Spread levels can be relatively low. They're not at their lowest. But that doesn't mean that we're far along an upswing of a credit cycle.
Meyer: I think that's exactly true and I think that we're going to be presented with opportunities throughout 2021 to take advantage of short-term sell-offs that we view as buying opportunities in this market. So, largely, if you think about 2020, spreads have been kind of a one-way trade from March, the wides of March to the tights of where we are today. We still do expect volatility as we look into 2021, whether it be how the vaccine is rolled out, how the virus progresses, how quickly growth really comes back. And when you look into Q1, Q2 of 2021, I think it'll be really important to see what the earnings trajectory of a lot of the companies we follow is going to be in 2021. We obviously expect fairly significant earnings growth as you look into 2021 relative to 2020, but that's a relatively small hurdle that companies need to jump over. It's going to be more about how the economies are recovering, how quickly they're recovering. I think that the recovery out of what happened in the month of March, it's very clear that we are in a V-type recovery, yet the slope of the other side of that V is still in question.
I think we all feel pretty confident in our ability to say there will be growth in 2021, and it will be higher than it was in 2020. The question is, you know, how quickly that growth really transpires in 2021 and what companies are telling us as they're coming out of Q1 and Q2 of next year. So I think we'll be presented with opportunities to take advantage of dislocations in the market. And like most years, 2021 will probably be no exception to that.
Ross: I think it has to be anything that causes volatility in the underlying government bond market and, you know, wider yields there. So, I mean, the obvious one is inflation and any sort of pick-up in inflation, which isn't really priced in at the moment, you know, that's going to cause more rate volatility and credit spread volatility tends to be a function of that rate volatility as well. And given that the overall positive technical we have in the market for the grab for yield obviously is predicated on those government bond rates staying at very low levels. Central banks have been trying to get more inflation into the market for a number of years now, and they've failed, obviously we've seen an absolutely unprecedented amounts of stimulus, both on the monetary and now also the fiscal side as well. Obviously, lots of spending that has to be funded from government balance sheets as well. So, you know, this is certainly an area we really have to worry about and we have to think about. But I guess our base case is that, as we say, they've tried so hard and haven't managed to generate any inflation. So it's not our base case that we do get those high levels, but it is absolutely something we have to worry about because it's the one thing that undoes every part of this and certainly puts the brakes on that monetary support that the credit markets have benefited from for such a long time now.
Hetts: Yeah, that's a good point. Inflation is that big risk that seems to be kind of sleeping in the background and I guess it says something that we made it this far in the recording without even mentioning inflation up until now. And to your point, it's a mysterious force. It doesn't show up until it does. You said that when it does, it's going to cause a lot of volatility in the sovereign bond market yields. And then that will in turn create volatility in the spread markets. But can you just walk us through that relationship, so that in a simplified sense, if inflation does pick up what happens to government bond yields and prices there and then how that then transfers into spreads.
Ross: Well, I mean, as far as government bond yields rise and their prices go down, that will reflect through as a direct consequence onto the yields of high yield bonds, because they are a function of both the underlying risk-free rate and also the spread. So a widening in that risk-free rate will itself drive the price of high yield bonds down. But high-yield bonds tend to have a much shorter duration than you have within government bonds. So you don't have you don't have that same sensitivity, so you tend to get high yield for that reason outperforming a little bit in that scenario.
And it's also the case that it depends what type of inflation it is. And obviously, if it's there alongside growth, obviously that's generally good for corporates being able to generate revenues. So that also is a reason that you then tend to see high yield do slightly better than government bonds in that scenario. But obviously, you know, everything's good in moderation, right? And if you have too much inflation, it's that volatility that really causes your real risk shocks. That's clearly the scenario where high yield doesn't like that quite so much. So, yeah, a little bit of inflation is ok. Steady inflation is ok if it's with growth. Obviously, a significant bounce of inflation, you know, that potentially is a bit more risky.
Hetts: I think that goes back to the high-level characteristics of where high yield fits into a portfolio. It has that duration risk component where it doesn't like rising interest rates. But maybe the biggest risk factor it has is more of that equity-like risk factor. And if you have inflation going up because of broader global growth, you'll feel that duration and interest rate risk pain in high yield. But the dominant risk factor would be that equity-level growth kind of risk factor, hopefully determining the broader outcome of the asset class over the medium to long run, barring any short-term shocks, to your point.
Okay, we covered plenty. Seth, Tom, thanks for joining us. As always, the views of Janus Henderson's investment teams and thought leaders are freely available within the Insights section of our website. We look forward to bringing you more conversations in the near future.
1Source: Bloomberg, ICE BofA Global High Yield Index, Govt OAS (option adjusted spread). Govt OAS spread is the additional yield of the corporate bond over government bonds adjusted to take account of option elements such as the ability to redeem the bond early.
2Source: Refinitiv Datastream, the S&P Energy Sector relative to the S&P500 Composite has underperformed the broader market for most of the last 13 years, June 2008 to December 2020.
Credit quality ratings are measured on a scale that generally ranges from AAA (highest) to D (lowest).
Fallen Angels refer to bonds that were downgraded from investment grade to junk status.
Rising stars refer to bonds that are improving in credit quality from junk status toward investment grade.