Investment Insights

Corporate Credit: Turning to Cyclicals

By Renato Latini, CFA
1 September, 2020

While we see further opportunities in cyclicals, the strength of an upturn in these sectors remains highly uncertain.

The unprecedented global monetary and fiscal responses to the pandemic resulted in a swift compression of corporate credit spreads. However, we believe the progression of the economic cycle is giving way to further opportunities in cyclical sectors.

Dramatic Spread Tightening

The sudden stop to markets induced by COVID-19 caused a substantial repricing of credit risk globally, and central banks, treasuries, and ministries of finance around the world responded unequivocally. The Federal Reserve (Fed), in particular, took a page out of its Global Financial Crisis playbook—but rolled out new policy measures more swiftly and with added facilities designed to purchase corporate bonds outright. The Fed became not only a lender of last resort but also a buyer of last resort. The programs targeted investment grade issuers, although high yield issuers also were eligible for purchase via ETFs or fallen angels. As central banks eased liquidity concerns and governments alleviated solvency risks through a massive fiscal response, credit spreads tightened rapidly within more defensive sectors.

Rotation Turns to Cyclical Sectors

Corporate credit valuations are still attractive in certain segments of the market even after the spread tightening seen in the first half of the year. Liquidity is now abundant, U.S. dollar-funding pressures have abated, and capital markets have willingly received record issuance from the investment grade corporate sector. Increases in global money supply and foreign currency reserves suggest that cyclical sectors may be set to outperform going forward, providing a potential uplift to commodity producers versus defensive sectors.
Change in Global FX Reserves, 3-month annualized
Source: The MacroStrategy Partnership, Bloomberg. Data as of 8/17/20.
Change in Global USD Money Supply, 3-month annualized

Source: The MacroStrategy Partnership, Bloomberg. Data as of 8/17/20.

The focus now is on the economic cycle as basic industries, capital goods, energy, and other cyclical sectors in both developed and emerging markets are still trading at spreads wide to historical levels, particularly in the lower-quality segments of the market. As the global recovery progresses, demand resumes, manufacturing and exports tick higher, and the medical front draws nearer to resolving the COVID-19 pandemic, conditions are in place for a reflationary trade and substantial spread tightening in the more cyclical sectors of the economy.

Investent Grade - Cyclicals Less Defensives - Rolling 1-yr. performance
Source: Bank of America/Merrill Lynch, ICE Bond and Convertible Indices, Brandywine Global
High Yield - Cyclicals Less Defensives: Rolling 1-year Performance (through 7/31/20)
Source: Bank of America/Merrill Lynch, ICE Bond and Convertible Indices, Brandywine Global.

Uncertainties Remain

While we see further opportunities in these sectors, the strength of a cyclical upturn is highly uncertain at this time. Furthermore, substantially leveraged capital structures offer little in the way of covenant protection, exacerbating potential risks to investors. Because of these significant risks, bottom-up research remains a crucial pillar of our investment process. While our top-down macro research has shed light on those sectors exhibiting the greatest value proposition, we rely on rigorous bottom-up fundamental research to confirm the likelihood of catalysts for closing the valuation gap with a sufficient margin of safety. Additionally, nimble duration management and active corporate credit allocation have likely never been more important in fixed income markets.


High yield bonds are subject to increased risk of default and greater volatility due to the lower credit quality of the issues.

Definitions:

Cyclical goods (“cyclicals”) are products that are tend to be purchased frequently such as groceries and gasoline.

Global Financial Crisis refers to the economic disruption that followed the collapse of prominent investment banks in 2007-8, marked by a general loss of liquidity in the credit markets and declines in stock prices.

The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

Investment-grade (IG) bonds are those rated Aaa, Aa, A and Baa by Moody’s Investors Service and AAA, AA, A and BBB by Standard & Poor’s Ratings Service, or that have an equivalent rating by a nationally recognized statistical rating organization or are determined by the manager to be of equivalent quality.

High yield (HY) bonds, also called junk bonds, are bonds with below investment-grade ratings (BB, B, CCC for example) and are considered low credit quality and have a higher risk of default.

"Fallen angels" refers to corporate bonds whose credit ratings have declined from investment-grade to high-yield.

credit spread is the difference in yield between two different types of fixed income securities, typically between the yield of bonds in a particular credit sector and that of a 10-year Treasury security. 

"taper" refers to a gradual reduction in central bank bond-buying activity intended to hold down interest rates and support bond markets in general.

The Shanghai Accord is a reference to an unofficial agreement said to be reached during the G20 summit meeting in 2016 tfor central banks to pursue policies to weaken the U.S. dollar.

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