These have been turbulent times for markets, and the bumpy ride is likely to continue over the coming weeks. But amid the coronavirus-related volatility, high yield valuations are looking cheap – generating some attractive opportunities for those who are willing to take the risk. In the last month we’ve seen negative returns of -12.7% for the global high yield market and – following a weak February – a Q1 return of -13.5%. It has been the second worst month and second worst quarter since 1998, and valuations have repriced to levels not witnessed since the 2008 global financial crisis.
The sharp move last month was driven by a cocktail of different factors. Countries across the globe battened down the hatches and imposed national lockdowns in a bid to curb the outbreak of Covid-19. Meanwhile, there was a big drop in oil prices; a significant development given that the energy sector makes up more than 10% of the global high yield market. The pandemic prompted income-hungry high yield investment ‘tourists’ to scarper, thus accelerating the selling pressure.
And, yes, it could get worse – though probably not that much worse. Over the long term, spreads have been wider (topping out at more than 2,000 basis points following the Lehman Brothers bankruptcy – see the chart below) and they are currently hovering at just under 1,000 basis points.
It’s hard to pinpoint the bottom of this particular market cycle. It may have been a few days ago, or it could be in a few months’ time. But there are two reasons to be hopeful.
- Firstly, the policy response has been swift and hard hitting, much more so than during the global financial crisis of 2008. Governments have acted faster to support markets and provide direct fiscal support for companies and individuals. Remember, the last time spreads reached 2000+ was before the US passed the Troubled Asset Relief Program legislation, introduced to stabilise the country’s financial system following the financial crisis.
- Secondly, this coronavirus crisis has a definitive cause and should therefore have a definitive end. Once infection rates subside considerably and life returns to a semblance of normality, the world will move on. Of course, there will be long-lasting economic impacts, but this will not be forever. And given the action by policymakers, we’re not looking at an existential crisis for the high yield markets.
Winners and losers
We will see more defaults – there is no doubt about that. Global default rates were in the low single digits for high yield coming into this. Companies will be restructuring their debts and in some cases failing altogether and going into liquidation. There will be a huge dispersion in defaults between sectors. For example, investors are bracing for downgrades and higher defaults in leisure and energy sectors, which have taken a battering by Covid-19 disruption. Other vulnerable sectors include automotive, transportation, non-food retail, consumer cyclicals and basic industries.
On the other hand, there will be a relatively limited businesses impact on food retailers, pharmaceutical, packaging businesses, technology, media and telecom companies, and healthcare operators – which are all big parts of the high yield market. For some, there will even be an upturn. It’s important to bear in mind that defaults don’t always mean a permanent destruction of capital. A business may default on its debt in the short term, but if bondholders receive equity as a result and the business is otherwise viable in the long term, then riding out a restructuring in this situation can often be the optimal strategy for recouping losses. This is the time when distressed debt expertise will really count.
So, defaults are going to rise, but what is priced in with regard to default rates? Well, quite a lot of the bad news is priced into spreads – and then some. Let’s look at the chart below. Five year cumulative default rates of a little over 50% are now priced into the market (assuming a 40% recovery). For investors focused on senior secured debt, the implied default rate in spreads is even more pessimistic at just under 70% over five years, assuming a 60% recovery.
Historically, the peak for five year default rates has been 31%. I would argue that the market is already pricing in a very extreme and painful scenario for defaults. Of course there will be losses for bondholders, but I struggle to see losses of this magnitude. Consequently, high yield valuations currently look cheap. It’s impossible to say what the potential upside is for investors. The market is still very volatile and fairly illiquid. We could well see more short-term losses rather than gains.
However, in the medium to long term – a time horizon of say two years – the potential returns could be meaningful. Again, if history is any guide, the next chart shows the subsequent two year returns from the global high yield market following a quarterly drop of 4% or more. Over the past two decades, this has always generated a positive return, and indeed over the last six such dips, the returns have been in excess of 20% over the following two years. This is not inconceivable either at this point in time.
If, for example, the market has a spread of 1,000 basis points, and in two years’ time this normalises to around 400 basis points (a level consistent with more recent history) with four years of spread duration, that would mean a potential capital gain of 24%.
So, all in all, it’s an opportunity that is certainly not without risk, volatility and defaults, but also one that that could potentially be very rewarding.