June 2021 / VIDEO
Credit market outlook in brief
Fundamentals, valuations and technicals
To begin, I thought it would be helpful to give you a quick recap of the themes we presented last December. Overall, we were bullish and believed that there was still room for spread tightening and reasonable income opportunities within corporate credit.
Emerging markets (EM) had stable fundamentals and supportive technicals, which delivered a favorable backdrop. Similarly, the asset class offered risk diversification and spread premium over other asset classes. Asia credit was a specific callout on its attractive risk-adjusted return profile.
Investment grade was a little more mixed, with supportive technicals, stable fundamentals, but valuations that were fair at best. The preferred approach was focusing on specific industries or rating categories to find idiosyncratic opportunities.
Lastly, within high yield, we had a very constructive view on the asset class. Value was the highest in cyclical or out-of-favour industries that would benefit from the reopening post Covid, and we also zeroed in on loans as being the best risk-adjusted opportunity.
Where are we today?
I'd say overall valuations are certainly less exciting, and while there are pockets of opportunities that still exist they're certainly not as prevalent.
I would highlight both high yield and EM corporates as being our preferred methods of investing in credit, and both asset classes continue to have positive fundamental trajectories.
On the other hand, investment grade has headwinds to contend with on multiple fronts. Valuations are now at all-time tights and when you combine that with increasing supply, increasing duration and weakening fundamentals it's a difficult picture and certainly we don't have near-term optimism.
Investment grade headwinds
What is happening within the investment grade asset class? First is the continued trend of weakening credit metrics as defined by net leverage. This has pushed the index composition of triple Bs to roughly 50% over the past several years.
Interestingly enough, our analysts have studied the cash balances of over 300 companies and the overall expectation that was these cash levels at the end of 2020 should go down by approximately 80% by the end of 2021. This could occur through multiple channels: we think increased share buybacks or certainly an increased cadence of M&A. These activities would be palatable if valuations compensated you, but those are stretched as well, particularly if you look at triple B versus single A spreads.
So what should you do? We would advocate rotating up in quality and out the curve, so focusing on single As and maybe going out a little bit within the single A asset class from a maturity standpoint. You should maintain carry in the intermediate maturities but overall maintain an underweight position in duration. Sectors of interest for us are banks, telecom, media and technology. And that's both from a fundamental perspective, but also from a technical perspective, specifically focusing on liquidity.
High yield ratings trajectory is improving
The Covid-19 pandemic led to a record level of fallen angels, and a very depressed upgrade:downgrade ratio. However, as the global economy opens up, it provides high yield investors with not only an upgraded opportunity set, but the ability to generate outsized returns in future rising stars.
The fallen angel roster was concentrated in sectors who had sizable impacts on the pandemic. Energy entertainment, leisure and transportation all had greater than 75% of their issuers downgraded in 2022. But with a rebound in earnings for these sectors, ratings momentum should improve.
Our analysts are focused on identify companies that can migrate back to investment grade status over the next several years, either from secular trends, improving cyclical results, debt paydown, improved capital structures and/or high free cash flow. We would highlight names like Netflix, T-Mobile, HCA and Ford that exhibit several of these characteristics and should experience significant spread tightening as they again migrate from fallen angel status to rising star.
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