Perspective

Managers' views

Our current view on global credit and the opportunities


Patrick Vogel

Patrick Vogel

Head of Credit Europe

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Martha Metcalf

Martha Metcalf

Head of US Credit

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The Covid-19 crisis is a global emergency of a magnitude very few of us have ever experienced. With no vaccine available yet, the global response has been one of containment so far, and for most of us, this includes a complete shutdown of our normal daily activities. Unsurprisingly, this is having a profound effect on the global economy, including credit markets. Many companies have effectively suspended operations, going into hibernation. Financial markets have responded with significant and rapid re-pricing of risk, and at a pace rarely seen before.

We feel that credit markets may now be entering a second phase. The first phase was characterised by maximum pain and indiscriminate selling that was met by policy support, and now we are entering phase two where we will still have periods of volatility, and we will have downgrades and defaults, but will we see greater distinction between winners and losers.

Central banks providing swift and significant support

If the developments of the last few weeks are anything to go by, central banks appear to have learnt many lessons from the 2008 financial crisis. It’s apparent they have a much greater understanding of how to support the functioning of the financial system, by ensuring liquidity for banks and businesses in times of great stress. We therefore think systemic risk, from a financial perspective, should be quite low. While this is not an absolute solution, this is helping to keep the wheels of the financial system turning, which is vital in this times of such great stress.

Central banks balance sheets are expanding again

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Source: Schroders, March 2020

Governments globally have also stepped in quickly and decisively with various stimulus measure to support businesses and families. This represents an unprecedented pro-active level of support which should help cushion the longer term economic impact of the crisis. Additional support is quite likely.

The credit market correction has been extraordinary

Over the last month or so, we have seen a complete change of tune in the global credit markets. Back in February, the reaction was fairly muted suggesting markets were expecting the crisis to be over in a couple of months. That has changed completely. Markets have fallen sharply and volatility has been extreme. At the worst, we saw credit markets frozen for over a week with large intra-day swings in equity markets, several times triggering the suspension of trading.

As the charts below demonstrate, we have witnessed one of the fastest ever increases in credit spreads, back to similar levels to the European government crisis in 2011, though we haven’t reached the levels of the 2008-09 financial crisis. The speed of the response from the central banks has been impressive, especially from the European Central (ECB), which has often lagged in the past. On this occasion, the ECB rapidly convened an emergency meeting and took more decisive action that in the past.

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Source: Schroders, BofAML, as at 22 March 2020

Re-pricing has been indiscriminate

As we said, we think the scope of central bank support means that systemic risk is relatively low, and that we may be towards the end of the widening in European credit spreads. One thing that has not happened to a large degree in our view is differentiation in the market. In fact, the sell-off has been highly indiscriminate. We will see some companies go through this crisis relatively well. If we think about utilities as an example, power demand will be down 10% -15% across Europe, but ultimately there is still cash flow to be earned and private consumers pay more for their energy than industry.

The table below shows the ‘Z-score’, or the change in spread normalised. And you can see the normalised spread change is very similar across the USD investment grade universe, and there is not a whole lot of differentiation across sectors. In some sectors, we will see revenues and cash flows go close to zero, most likely in hotels, airlines, restaurants, other sectors could actually benefit from the crisis, such as food retailers and telecoms. We should expect much more differentiation over time.

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Liquidity dislocations in high quality, short-dated bonds

Another feature of this crisis has been the pronounced illiquidity.  We can see this in the chart below showing that spreads on some of the highest quality short-dated corporate bonds have spiked. These spreads have historically been very stable. This shows just how illiquid the market has been and how badly the central bank support was needed.

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Source: Schroders, BofAML, as at 24 March 2020.

Liquidity has been seriously challenged over the past few weeks and it has felt worse at times than in 2008. This is likely reflective of regulatory change that has permanently altered the role of banks and fixed income dealers meaning that they no longer serve the same role to smooth dislocations between buyers and sellers. That is compounded today by the fact that almost everyone is working remotely.

Liquidity has improved over the last week, however, in both investment grade and high yield markets, albeit, there are still issues. It is notably causing difficulties in trying to deploy capital especially in US high yield. Whilst we’ve continued to see issuance in US investment grade, in fact issuance has bounced back remarkably well in IG, the US high yield market, by contrast, remains shut. There is also no dealer inventory, so if you want to put a large sum of money to work, that can be challenging right now. As policy response has started to take shape, there are fewer forced sellers. So whilst liquidity in credit markets is starting to normalise, and as we grow more constructive about being able to acquire exposure, the ability to buy remains challenged. A final point in liquidity is that the energy sector remains under massive pressure and not somewhere we’d be looking to add to at this point.

The European credit opportunity

In the violin charts below we can see spreads on BBB rated European bonds (blue violin on the left hand chart) range from 50 to around 400bps. It also show that a decent proportion of the market is now trading at above 200bps, certainly more so than over in the past five years or so. So we can buy very healthy yields in investment grade.

In European HY, a significant proportion of  BB and B-rated bonds now trade on spreads of over 1000bps. In BB, we can see that from 2017 onwards the market has mostly traded at around 250 bps, but had shifted to much closer to 750.

The compensation for risk is now very high

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Source: Schroders, Bloomberg Barclays, as at 24 March 2020.

If we also look at what the market is stress telling us about levels of stress, this too looks extreme. For investment grade we would characterise “stress” as at least 300bps and over, and for high yield 800bps and over. For both US dollar and euro, roughly 50% of the market is at that stressed spread level. Within investment grade, 20% of the euro debt market trades at over 300bps, while in the US market it is 70%.

Rare cycle opportunities within credit

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Source: BofAML, as at 22 March 2020.

The US credit market correction has been extraordinary

The move in US credit valuations has been astonishing over the past few weeks, with the US IG yield now around 4%. We consider these valuations for this asset class very attractive. It is already pricing in a recession. There are concerns in the market around the high level of corporate leverage we had going into this crisis but margins were also very high, so too companies’ ability to service debt. Investment grade bond defaults are not a significant concern to us, but again to give a sense of the magnitude of this move, BBB rated bonds are pricing in a 10% cumulative default rate over the next four years. So even taking into account the fact that fundamentals will be challenged, valuations look attractive. For the US high yield market, we’ve seen yields hit north of 11%, with current valuations implying a 15% default rate, which also looks too high.

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Source: Schroders, BofAML, as at 22 March 2020

There is no doubt that downgrades are going to rise as we see earnings and cash flow come under pressure and there is still a lot of uncertainty. The ”fallen angel” risk is a concern – estimates are for up to up to $200 billion of potential downgrades. However, this $200 billion is a notional amount. Many of the names expected to be downgraded are trading at large discounts so the real amount will likely be smaller.

There are some sectors that will be more badly impacted such as energy and consumer discretionary and overall we see downgrades as likely being more of an idiosyncratic story, rather than a systemic risk. The US Fed buying corporate bonds is a game changer in our view, not only in terms of improving the liquidity picture for investment grade, but it also gives much greater incentive for these companies to maintain their investment grade rating. Currently, it’s very expensive for a company to drop from BBB to BB – with the difference between those spreads at their widest levels since 2014. It could amount to around 400bps more in borrowing costs. And more importantly, the US high yield market is not open for new issuers. So companies are going to do everything they can to avoid being downgraded. Many of these investment grade companies do still have quite a number of levers to pull in the form of holding their stock buy backs, halting dividends and selling assets.

The US credit opportunity

Firstly, the US investment grade market has functioned remarkably well, even despite the shock we’ve experienced over the past three weeks or so. The new issuance market did not even really close. March is on track to have close to $169 billion of new issues priced. We have also seen record amount of demand for US investment grade coming from Asia and from insurance companies.

In US high yield, we have seen a material structural shift, in a number of ways. Firstly, we have convexity in the market again. At the types of spreads earlier this year, two thirds of the US high yield market, 87% of BB rated issuers, was at or above its first call price. This meant there was no upside left. Today, with an average US dollar price of 83, there is once more a material prospect for capital appreciation.

Secondly, we also note the breadth of the opportunity now in high yield. We believe that dispersion has normalised in the US high yield. Much of the selling has been indiscriminate. If you go back earlier this year, a relatively small proportion of issuers traded at more than 100bps over the index. The market was essentially comprised of very cheap stressed energy and very rich other sectors. Now, there seems to be a much broader opportunity set and real opportunity for both security and sector selection going forward.

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Source: Schroders, Bloomberg Barclays, as at 24 March 2020

We are at a new starting point across credit markets with much healthier return prospects. Historically, when we’ve had these types of starting points in spreads, excess returns in the investment grade market have averaged between 15[(-25) was not found] over the following 1, 3 and 5 year periods, and between 15% to 45% in high yield. So there is real opportunity to generate return from these levels, especially in high yield.

Schroders Global Credit Income strategy

The Schroders Global Credit Income team remain very excited about the opportunities within global credit markets with healthy yields and additional capital appreciation upside available to investors over the longer term.

The team have remained active within the strategy and have been looking to take advantage of opportunities that have been created in high quality investment grade names across both the US and Europe. Transaction costs continue to remain on the high side, so we have remained active in the primary market taking advantage of attractive yields in even high quality issuers. The team’s preference remains to invest in more defensive sectors and then to look for more issuer specific opportunities in the high yield space. An example of this is a French telecommunication service provider which retains an attractive business model – with a greater number of people working from home, the demand for their broadband services has exponentially increased. This bond traded as high as 10.5% in USD for a BB issuer with very healthy fundamentals. There are some truly amazing opportunities that we as active managers are aiming to take advantage for our clients.

Summary

Notwithstanding the severity and unprecedented nature of the challenges from Covid-19, we’ve seen an extraordinary response from financial markets, driven by fear and uncertainty, resulting in a high degree of correlation and little differentiation. There will be opportunities that come out of this as investors have more time to assess the implications across different areas of the market and different sectors and companies. Central banks have been bold in their response, as a result of which, we think systemic risk is low.

The situation is still highly uncertain and we don’t know how long the crisis will last. There are many companies that simply cannot operate. However, there are a lot of very resilient companies.

We feel that the market may now be entering a second phase. The first phase was characterised by maximum pain and indiscriminate selling that was met by policy support, and now we are entering phase two where we will still have periods of volatility, and we will have downgrades and defaults, but will we see greater distinction between winners and losers. This is a great opportunity for security selection, and this is our primary focus at Schroders. We believe in our ability to navigate such an environment for our clients and in our ability to distinguish risk from opportunity.

Schroders has a bottom up approach to our credit strategies and we have an integrated global framework of research analysts and fund managers that enables us to dig deep into business models. Those business models and the external environment are changing rapidly, and we are actively and rigorously stress testing business models of companies we invest in.

We will not add risk indiscriminately. We remain strongly focused on company analysis and seeking the best balance between risk and return. Our analysts are spending a great deal of time evaluating businesses to identify those which can be most resilient and emerge from the crisis in good shape. We remain focused mostly on high quality and non-cyclical sectors adding to existing holdings at attractive levels or picking up new issues at attractive concessions to the secondary market.

Key questions are does the company have maturity run way? Are they drawing on their bank credit facilities to supplement liquidity? Another point that is so important at this stage is keeping the dialogues with management – those are relationships that we’ve build over the years.

As the situation continues to evolve rapidly, it’s important to keep dialogue with companies so that we really understand what’s happening inside the business, be that with supply chains, for example, or importantly how well supported their balance sheets are.

With our global network of analysts and fund managers across fixed income and credit, not to mention various other asset classes, all of whom we can draw on, we think we are in a strong position to identify and capture the opportunities now opening up.

 

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