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Rising stars and ratings upgrades: Why economic recovery is a boon to high yield

Covid-19’s emergency measures are rolling back in many countries, and we are at last on the road to economic recovery. In the US and in Europe that should on paper be very supportive of risk assets. However, to a large extent the defensive actions of central banks and governments helped markets pre-empt the economic recovery.

Equity and credit markets have already more than recouped the ground lost since the Covid-related market crash of March 2020. Some now question whether valuations have become extended. While it is difficult to make a definitive call on that, we think a close look at how dynamics are shifting within the credit markets gives cause for some optimism.

Fundamentals strengthening on economic upswing

As the economy improves, the recovery in earnings means many corporate bond issuers are experiencing an improvement in credit fundamentals. Assuming that companies are not taking on significantly more debt, the improved earnings will dilute leverage, improving balance sheets. Therefore, in the economic upswing, we should see an increase in the number of credit ratings upgrades, relative to the number of downgrades, the “upgrade/downgrade ratio”.

The upgrade/downgrade ratio is normally tied to the economic cycle, both for investment grade and high yield. However, following the 2008 Global Financial Crisis and the eurozone crisis, investment grade credit upgrades remained subdued, while high yield was more closely aligned with what one might expect to see. The two charts below show how the different markets performed. 

Euro-investment-grade-upgrades-to-downgrades.png

Euro-high-yield-upgrades-to-downgrades.png

One thing that is evident from these charts is that the decline in the upgrade/downgrade ratio during the pandemic has been shallower than previous market crises since 2000.

This may be partly due to the swift actions by central banks and governments to support economies and mitigate some of the negative impact on businesses. Ratings agencies may also have been willing to allow companies time to see the worst of the crisis through before acting.

What the charts also show is that the ratios are correlated to economic upswings with around a 6-9 month lag. This reflects the rating agencies’ need for confirmation of earnings improvement. 

The charts below illustrate the link between economic activity and agency rating actions in high yield more clearly. Intuitively, increased economic activity drives improving earnings, reduced leverage and improved credit ratings, and we can see this effect below.

We are already seeing improved economic sentiment in the purchasing managers’ indices (PMI) data, and therefore should expect the upgrade/downgrade ratio to improve. We are seeing this play out in the US credit markets, but not so much in Europe, as yet.

Euro-high-yield-upgrades-to-downgrades-versus-PMIs.png

 

US-high-yield-upgrades-downgrades-versus-ISM.png

What does this mean for high yield investors?

The potential for continued improvement in credit rating ratios is good news for high yield investors who focus on issuer selection, as the market begins to price in ratings upgrades for individual companies. Those funds that have flexibility to own investment grade bonds can hold on to “rising stars” (bonds upgraded from high yield to investment grade) as long as they see further upside potential. 

There should also be fewer downgrades, and so overall, the market is supportive for investors from a credit fundamentals perspective. This should be a positive factor for high yield funds, and we also expect particularly good opportunities in the crossover area, comprising higher rated high yield and lower rated investment grade bonds. 

Furthermore, investment grade funds that have the flexibility to invest in high yield – to a limited degree – should also benefit, given the potential to capitalise on early investment into “rising stars”.

Quantifying the upside potential that would result from the described relationship is not easy. However, should euro BB rated names tighten 50 to 80 basis points (bps), relative to investment grade, this would return valuations to previous-cycle “tights”. This would translate into potential excess returns of 4% to 6% over government bonds, depending on the current valuation level. 

Euro-crossover-valuations.png

For US dollar BBs the same analysis suggests excess return potential of around 3-5% if valuations, measured by spread levels relative to BBB, return to the tights of recent years. Again this is dependent on the current valuation level.

US-dollar-crossover-valuations.png

Improving fundamentals, coming on the back of the ongoing economic recovery, look set to provide support to high yield corporate bonds and in particular an increasingly positive trend of ratings upgrades. There is also potential for more rising stars. From current valuation levels, there is is potential for high yield to produce appealing returns.  

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