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INVESTING
January 29, 2021

Surveying the Corporate Credit Landscape—There’s More Room to Run

By Robert O. Abad

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With corporate credit spreads moving closer to trading through pre-Covid crisis lows, many clients are looking for insight on potential market vulnerabilities. We surveyed our Global Credit Team worldwide for their responses to the most frequently asked questions we’ve received to date.

Did the Covid selloff in 2020 have the effect of delaying or resetting the global credit cycle?

It’s difficult to discuss the credit cycle in light of the massive global macro turbulence caused by COVID-19. However, we do think these developments have helped to further extend the credit cycle, especially following the sharp repricing of assets, the steps management teams have taken to shore up their balance sheets and the unprecedented monetary and fiscal policy responses worldwide, which have helped to support corporate and consumer fundamentals. In 2019, we published a paper that discussed this global credit cycle dynamic at length.

On this topic, the area of the market that always seems to draw the most questions is high-yield (HY), and that’s fair considering the sharp rally we’ve observed since the March 2020 lows. On one hand, we’re seeing a rise in M&A-related financing making its way onto the primary calendar—a subtle shift from 2020’s liquidity-bolstering deals—and we also expect LBO activity to pick up moderately throughout 2021. On the other hand, we’re not seeing a pickup in the kind of less-bondholder-friendly activity that raises alarm bells for us such as share buybacks, dividend deals and over-levered, low-quality issuance. These days, CCC paper is a smaller part of the market. If anything, we expect more opportunistic refinancings to occur as management teams watch the US Treasury curve move higher and fret about locking in historically low coupons; this will only serve to push out maturities in the HY market.

Emerging market (EM) corporates actually entered the pandemic with fairly conservative balance sheets, resulting in HY defaults that were materially lower than that of US peers. While we believe that EM countries have unique Covid-related challenges that could weigh upon growth going forward, EM corporate fundamentals should remain resilient and are less susceptible to excesses often seen at the top of the developed market (DM) credit cycle (e.g., LBOs, M&As, etc.). That stated, we are keeping our eye on the sovereign risk of Mexico, Colombia and India. If those countries are downgraded to HY over time, it could automatically result in a number of corporate downgrades.

With rates exhibiting more volatility at the start of the year, do you expect credit spreads to continue tightening over the coming months?

Rates across global government bond markets are certainly readjusting to reflect a post-Covid world, and so are credit markets. As we highlight in our latest Global Credit Monitor for 1Q21, investment-grade (IG) credit valuations (both in the US and Europe) look fairly valued, but more vulnerable to higher rate moves given today’s tighter levels. However, demand for IG credit, especially in US dollars, remains strong, driven by the relative attractiveness of yields in a global fixed-income context. For the US, we expect a slower pace of spread tightening mainly driven by sectors that have lagged the rally. European IG looks fairly rich in a historical context, but should be well supported by European Central Bank (ECB) purchases and expectations of limited net supply.

Meanwhile, HY spreads have tightened as rates have moved higher. We’re currently not at the historical lows, but spreads are on the tighter end of the range, which we feel is reasonable given the macro backdrop for 2021. Keep in mind we saw defaults jump to north of 8% on a last-12-months basis throughout the COVID-19 pandemic. Combine that with the material fallen angel wave we saw in April 2020 and that leaves you with 8% of the weakest credits exiting the HY universe. This is approximately $170 billion worth of IG paper moving into HY land. At the end of the day, we’re left with the highest credit quality HY asset class we’ve ever seen.

Similar to activity in DM credit, EM spreads tightened significantly over the last nine months of 2020, leaving absolute valuations toward the low end of historical ranges. As a result, we expect 2021 EM corporate returns to come more from carry than spread compression, supported by EM’s continued yield premium to DM credit, as discussed in our recent blog post about EM as an extension of US credit.

Are you still seeing signs of weak credit standards in HY credit?

Yes and no. Covenant packages for better credits are generally light in terms of bondholder protection and more levered, first-time issuers will have the standard HY clauses such as maintenance tests and minimal carve-outs. However, there’s been a growing bias for more protection against higher rates (e.g., call protection) than credit deterioration. On the flip side, we’re reassured to see management teams maintaining a proactive, conservative stance by focusing on building high cash balances, retiring front-end debt and extending maturity schedules. It also gives us comfort to see issuers in reopening sectors sell equity to raise capital. We’ve also seen issuers reduce or completely shut off dividend payments. All of these initiatives are healthy for the corporate credit outlook.

Are you concerned about the continued growth in the BBB segment of the markets due to M&A activity and the increasing use of leverage?

On a gross basis, leverage has been moving higher, but on a net basis, leverage has been relatively stable as firms have kept a material amount of the cash they’ve raised in the last year on hand. We also don’t see reasons to be worried about BBBs being a larger part of the overall market. The broad risk with BBBs is that some may become fallen angels when a recession hits (which is not our view over the next year), but BBB corporates typically want to hold the line and maintain their IG ratings. In the US, our concern is less about BBB corporates and more with single A rated issues that know they have margin to take on additional leverage when the macro backdrop is favorable. In the European IG space, BBB paper growth as a percentage of the benchmark has been glacial, increasing by about 1% each year over the last five years. In the case of Asia, the growth in BBBs is not mainly due to M&As or an increase in leverage, but more as a result of debt issuers tapping the Asian USD-denominated credit markets, especially as a result of the plethora of bond issuance from Chinese local government financing vehicles (LGFV) which are almost exclusively rated BBB. We believe this is less of a concern given that the investors who participate in the Chinese IG LGFV space are more likely going to be Chinese investors. This segment of the Asian credit market has its own technicals, which are usually distinct from the rest of the Asian IG credit space. The BBB space in the Australian/New Zealand market has also grown of age over the past few years, with infrastructure and regulated utility issuers leading the charge. This growth, while increasing the leverage within the domestic BBB sector, has not come at the cost of heightened volatility, given the inherent stability of cash flows across many such issuers. With most issuers being privately held by sovereign wealth and domestic industry funds, access to liquidity remains strong.

What risks concern your credit analysts the most—higher corporate taxes in the US, extended Covid-related lockdowns, more new-issuance supply or some other risk?

An extended shutdown is probably the most meaningful risk to credit markets with higher rates (perhaps due to higher inflation or a technical catalyst) as a distant second (see our Global Outlook for our views on rates across DM and EM). If, for some reason, the current slate of vaccines were to fail, we would expect reopening sectors such as airlines, cruise ships, gaming and hotels to retrace some of the positive momentum we’ve seen thus far. Our analysts are aggressively vetting the collateral backing the 1st Lien deals we’ve financed in these subsectors. While locking in high-yielding paper is certainly a temptation in this low-rate environment, we have a clear focus: prioritizing the quality of the assets backing the debt over the yield offered by these opportunities. Looking ahead, we expect to see issuers in these subsectors come back to market in 1Q21 (in both secured and unsecured forms) as the vaccine rollout continues and revenue generation grinds higher.

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