Global credit markets have reacted to the Coronavirus crisis with force: Credit spreads have swung from well below to well above long term averages in a matter of weeks, raising concerns about increasing debt levels in a recessionary environment, but also creating opportunities for the prudent and patient investor. In this Q&A, portfolio managers Eve Tournier and Sonali Pier share their interpretation of recent market moves, and their views on what parts of the market investors should pay attention to – and which to avoid.
Q: What were your thoughts about valuation levels towards the end of last year, when market optimism was high?
Eve Tournier: We have always favoured diversification, as that is one of the best ways to help protect investors from unexpected shocks and add resilience to portfolios. At the beginning of this year, optimism seemed to fuel markets, taking valuations to levels that we felt, in many cases, did not allow any room for disappointment. We obviously did not anticipate this black swan event, but the extreme optimism made us cautious.
Q: How have your views changed given the new environment?
Sonali Pier: Our preference for quality, caution and diversification has not changed but valuations have.
We find that the investment-grade and asset-backed security sectors provide an attractive liquidity premium, which can help compensate for the increased volatility and uncertainty.
On the other-hand, we remain prudent on high yield and emerging markets given the increased vulnerabilities and default risk. Careful sector and individual security selection is critical to finding opportunities in those markets.
We continue to be cautious on cyclical sectors and those most exposed to the crisis while favouring traditionally resilient sectors, such as telecom/cable and utilities. Pharmaceuticals and healthcare is another sector that is traditionally defensive and that could also see increased sector earnings due to this crisis. Some banks are also attractive, given their much-improved balance sheets and capital buffers brought on by tighter regulation, which makes them well equipped to deal with the impacts of a recession.
Q: Which sectors could be most affected by the recession?
Tournier: The energy sector is clearly vulnerable right now. Going into the crisis oil companies were already suffering from excess supply; it has now been compounded with an exceptional demand shock. Ongoing uncertainties around when lockdown measures will be fully lifted, the future of airline travel and a more remote-based working environment all contribute to the uncertain trajectory of oil prices.
Away from energy, other sectors such as non-food retail and leisure will face pressure depending on the duration of social distancing measures and the impact of the crisis on consumer demand. All this could lead to an escalation of defaults, although many issuers have liquidity and bank lines or other measures they can take to help avoid default in the near term.
Finally, automobile and airline companies are also heavily impacted and the inter-play of exceptional government support needs to be carefully integrated in the analysis. Bottom-up security selection has never been more important.
Q: Are current spreads fully pricing in the associated risks to earnings, leverage levels and ultimately defaults?
Pier: There is still much uncertainty about this crisis - about how quickly economies will be able to reopen, when a vaccine will be available – all of which can alter the outlook significantly. However, even after taking into account the recent rally, spreads have moved to levels that are pricing in a deep and prolonged recession and an increase in defaults to levels that are worse than any previous period in recent history. While we expect leverage and defaults to increase from present levels, historically defaults have been rare in investment grade credit. Losses have averaged 5bps per year over the past 35 years, with the worst single year being 2008 when losses on investment grade corporates reached 41bps (according to Moody’s). With the current yield of 2.0%-2.5% we believe that investment grade credit is one of the more attractive areas at present valuations and given the uncertain environment.
High yield is obviously an asset class where there is a much more real risk of permanent capital loss through defaults, which is why we believe a selective and bottom-up driven approach is essential. We do think there will be opportunities coming through in high yield as a result of “fallen angels”, which have reached almost $200bn year to date and we believe will continue to increase in the coming weeks and months, but it will be important to avoid defaults. We expect these will reach 6-9% in US high yield over the next 12 months, with energy issuers most likely accounting for the majority of defaults in the near to medium term.
Q: In terms of geography, do you see equal opportunity both in Europe and the U.S.?
Tournier: The U.S. has a higher growth potential due to its more dynamic economy. During this crisis it has also been able to implement stronger monetary and fiscal measures as it doesn’t have the same policy coordination issues that we have in Europe. This all favours the U.S. in terms of dynamics, but we also expect default rates in U.S. credit to be higher than in Europe, where companies often receive more creditor and government support to avoid bankruptcies. Again, we believe this is a credit-picking exercise, where investors need to do substantial research to find quality credit.
Q: In emerging markets (EM), has the recent oil price collapse changed your view on EM credit?
Pier: Emerging markets entered this crisis with broadly positive fundamentals, but 40% of EM countries are net oil exporters and many are heavily dependent on tourism, which will be a challenge. They will also of course be impacted by the virus and have less robust healthcare systems in place. Combined with a strong U.S. dollar, it’s an asset class where uncertainty remains high, so a bottom-up selection process is paramount.
Q: Have we seen the best part of the credit rally?
Tournier: There is a wide range of possible future outcomes and a large part of the answer depends on whether and when we will have a vaccine for the coronavirus. It is also true that some valuations are very attractive, especially within high quality IG credit. We don’t believe this is a time to be chasing risk, but investors can use this time to enter certain quality and more defensive areas across the credit spectrum. Bottom-up security selection also provides ample opportunities. In times of heightened market volatility we believe flexibility is a key factor to benefit from potential market dislocations.