Actively Selective in Junk Land

COVID-19 and high yield bonds

Actively Selective in Junk Land

Credit analysis is paramount in an environment where weak technicals have driven yields higher, even on some high yield securities with stable fundamentals.


As equities continue to sell off and credit spreads widen from historically full valuations, the coronavirus/COVID-19 outbreak and related fears of a longer than anticipated containment period and greater scope of impact remind investors just how important it is to do the work. By work, of course, we’re referring to the bottom-up, fundamentally driven credit-intensive research that Western Asset invokes into our high-yield positioning and relative value assessments we vet on a running basis.

Prices have changed in the past few days related to the COVID-19 situation as lingering uncertainty about the global effects to growth persist. Despite what were seen just last week as powerful positive technicals (retail inflows, net negative supply) in the asset class, market sentiment shifted swiftly to an old-fashioned risk-off environment (i.e., “sell it if it’s not down enough or prudent to raise cash before the outflows mount”). As a result, the primary market has closed for the foreseeable future and 4Q19 corporate earnings, specifically for those credits more global in nature, have been accompanied by either a reduction in forward guidance or, in some cases, pulled guidance altogether.

Uncertainty can turn investor sentiment on a dime—stocks follow suit as revenue generation lost, or at a minimum postponed, does not bode well for equity stories given their need to show growth at current multiples. Credit analysts need to stress their working models to capture future downside potential to free cash flow generation expectations and rerack the relevant credit metrics to assure risk is appropriately priced. Dynamic, active managers of high-yield are then presented with the opportunity to source total return investments as forced selling from passive funds pushes prices lower despite the notion that credit fundamentals haven’t changed materially over the course of a few days or even weeks.

Western Asset thrives in an environment where weak technicals override the evident stable fundamentals of bond issues noticeably higher in yield due to this new-found elevated volatility. Junk bond professionals recognize that it is the income generation—the ability for a company to service its debt—that matters first and foremost. We can look to history for relevant examples: the flash crash in 2010 which lasted about the duration of a boxing match, the downgrade of the US in 2011 which bred several days of bargain hunting and the taper tantrum period in 2013 when high-yield bonds traded down in lockstep with correlated US Treasuries, to name a few. Even though the underlying credit profiles in these instances hadn’t eroded one iota—all of these were opportunities to buy solid credits at depressed prices. In the end, we believe it’s the fundamentals that win out, which is why companies with catalysts for deleveraging and better borrowing costs remain definitively on our radar. This is clearly not the time to blindly bid and go all in on day two or three of severe weakness brought upon by the looming pandemic. However, we will do the work, screen the opportunity set at meaningfully different valuations, and be ready to add exposure as we see fit … when we see fit.


Definitions:

COVID-19 is the World Health Organization's official designation of the current coronavirus.

A credit spread is the difference in yield between two different types of fixed income securities with similar maturities, where the spread is due to a difference in creditworthiness.

The May 6, 2010, flash crash, also known as the crash of 2:45, the 2010 flash crash or simply the flash crash, was a United States trillion-dollar stock market crash, which started at 2:32 p.m. EDT and lasted for approximately 36 minutes.

High yield 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.

Junk bond is a colloquial term for a high-yield or non-investment grade bond.

Multiple is used synonymously with price-to-earnings (P/E) ratio. The P/E is a stock's (or index’s) price divided by its earnings per share (or index earnings).

“Taper tantrum” refers to the financial markets’ reactions, in May-August 2013, to the announcement by the Federal Reserve that it was planning to decrease, or “taper” its $70 bn per month bond buying program.

U.S. Treasuries are direct debt obligations issued and backed by the "full faith and credit" of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.

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Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.

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