High yield bonds have been resilient throughout the market turmoil caused by the coronavirus pandemic.
The first half of 2020 has been a challenging period for investors. The global Covid-19 pandemic brought severe stress to financial markets, with global equities falling by around 35% (peak to trough) in just six weeks. Credit markets were also affected and high yield (HY) bonds fell by around 20% (peak to trough) over the same period.
They have in the meantime recovered almost fully – since the start of the year US and European HY markets have returned 0.4% and -2.6%, respectively. Credit spreads (the difference in yield between corporate and government bonds) have regained 70–90% of the widening that occurred earlier in the year. Notably, investor fears during the correction around fallen angels and illiquidity did not materialize, and corporate bond markets have continued to function reasonably well.
Fallen angels are companies the rating agencies have downgraded from investment grade (IG) to HY. Most years some companies will migrate from IG to HY, while others, known as rising stars, will shift from HY to IG. Typically, these two movements will cancel each other out and the proportion of fallen angels in the HY market will hover around zero. However, in years when markets are severely stressed, this figure can rise above 10%.
In other words, the HY market can expand suddenly in size when the number of fallen angels exceeds the number of rising stars. This situation has happened over the first half of 2020, which raises questions about whether there will be sufficient demand from investors for these bonds. If there isn’t then HY bond prices are likely to fall owing to the additional supply.
Source: Bloomberg - Quintet
Source: Bloomberg - Quintet
One of the risks involved when investing in corporate bonds is liquidity – how easy it is to sell your asset when you want to at the quoted price. In return, investors should profit from the additional returns bonds offer relative to more liquid investments. When fixed income markets are stressed, corporate bonds tend to become more illiquid.
In the past, they have stopped functioning normally, including during the Global Financial Crisis (GFC) when it was not possible to sell certain bonds, regardless of the price you were willing to accept. Given the severity of the Covid-19-induced stress in financial markets, investors have been concerned about a repeat of conditions following the GFC.
As the Covid-19 financial crisis unfolded and financial markets became increasingly stressed, central banks acted decisively to stabilize the situation. Policymakers coordinated their support to ensure markets continued to function, which we believe was the key reason asset prices recovered so quickly.
As well as cutting interest rates, many central banks launched or expanded their existing asset-purchase programmes, targeting corporate bonds specifically. In particular, the US Federal Reserve played a crucial role by including corporate bonds downgraded to HY in its investable universe as early as March. The aim of the purchase programmes is to provide adequate liquidity and enable financial markets to work properly.
To determine how central bank policies affected liquidity in the corporate bond markets, we analyzed the difference between exchange-traded fund (ETF) prices and their underlying net asset values (NAVs). Under normal circumstances, ETF prices and NAVs tend to follow each other closely and investors are willing to buy or sell the ETF at the market price of underlying assets. However, when markets are under stress, investors tend to demand a material discount on the ETF price relative to the NAV. This situation happened in March 2020 but was only temporary and markets have readjusted since then.
Source: Bloomberg - Quintet
Corporate bond markets have mostly recovered from the March lows, and the fears around fallen angels and illiquidity have not materialized. A period of severe stress soon passed, and both the liquidity premium and the default premium embedded in corporate bond spreads have compressed since then. As a result, prices have risen across the spectrum, most notably in HY and emerging market hard currency bonds.
Relative to our long-term strategic asset allocation framework, we are overweight European HY, which we believe remains attractive at current prices. One of the reasons we like this asset class is because we expect the ECB to continue to support the market through its asset purchase programme. If required, we think it would follow the Fed and become active in the fallen angels market.
Additionally, the positive steps Europe has made in containing the spread of Covid-19, combined with the positive impact of the European Recovery Fund, should keep default rates at manageable levels. We expect European HY default rates to average 3.7% in 2020, which would be well below the 13.1% rate during the GFC. The current spread of 470 bps over government bonds more than compensates investors for expected defaults, and implies a return of 6.4% over the next 12 months.
Europe’s HY bond market is made up of many issuers with different credit ratings across a wide range of industry sectors. We believe a diversified investment approach is important in order to achieve attractive risk-adjusted returns, and reduce the impact of any individual defaults on overall performance.
Source: Bloomberg - Quintet
Global confirmed cases of Covid-19 have now exceeded 21, 5 million, up from approximately 20 million seven days previously.
In order to support our investment analysis, we believe it is important to contextualize and validate reported data related to tests, cases and deaths with alternative data sources.
One such source, which we first published in our Counterpoint Weekly on 18 May, is mobility data provided by Google. Mobility data gives an evidence-based view on economic activity and citizens’ movements. For example, when we track mobility at European retail and recreation locations, we observe that footfall plunged by approximately 80% compared to the baseline (the five-week period ending 6 February) in March and April.
Looking at case data, we can see that the UK experienced difficulty in containing Covid-19 compared to continental Europe. This is shown by the elevation of new cases (adjusted for population and smoothed via a seven-day moving average) throughout April and May. In contrast, France’s new case figures were declining as the country effectively dealt with the pandemic.
We can validate our assessment with mobility data (smoothed via a seven-day moving average). We observe that the UK population was slower in returning to retail and recreation locations than France.
The UK’s experience of Covid-19 in terms of new cases and economic activity can be visualized in a chart, which displays a high degree of symmetry.
Sources: Ourworldindata.org, CDC
Sources: Ourworldindata.org, CDC
Sources: Ourworldindata.org, CDC
However, applying the same techniques for Spain triggers a warning. Spain is experiencing a second wave of cases, with daily infections surpassing 75 per million inhabitants. This figure is approximately 50% of the peak Spain experienced at the end of the first quarter. However, despite the surge in new cases, the mobility data indicates the population appears hesitant to readopt the previous social distancing measures, as visits to retail and recreation locations remain at levels observed before the start of the second wave.
As investors, mobility data provides insights into behavioral patterns and thus future Covid-19 dynamics. In the absence of additional measures, it is likely that Spain’s Covid-19 confirmed cases will continue to rise. This may ultimately result in more draconian actions from the Spanish authorities, leading to negative economic effects and downward pressure on some Spanish financial assets.
Sources: Ourworldindata.org, CDC
Bill Street Group
Chief Investment Officer
Carolina Moura-Alves
James Purcell
Lionel Balle
This document has been prepared by Quintet Private Bank (Europe) S.A. The statements and views expressed in this document – based upon information from sources believed to be reliable – are those of Quintet Private Bank (Europe) S.A. as of August 17, 2020, and are subject to change. This document is of a general nature and does not constitute legal, accounting, tax or investment advice. All investors should keep in mind that past performance is no indication of future performance, and that the value of investments may go up or down. Changes in exchange rates may also cause the value of underlying investments to go up or down. Copyright © Quintet Private Bank (Europe) S.A. 2020. All rights reserved.
