Macro Perspective

Western Asset’s base case outlook is for a U-shaped global economic recovery, with an expectation that short-term growth challenges will be followed by a continuation of the global rebound thereafter. The recent sharp increase in new COVID-19 cases has led to tighter restrictions in many countries and this is likely to weigh on growth in the near term. However, recent regulatory approvals of various vaccines and an acceleration of the rollout in many countries together with significant ongoing policy support should boost growth in 2H21. Given this backdrop, we expect central banks to remain extraordinarily accommodative, especially given ongoing subdued inflation pressures, a recognition that global growth remains fragile and the persistence of downside risks. Our portfolios are positioned to withstand further market volatility, yet remain flexible enough to capture value opportunities as they appear. Here, we provide a summary of the key drivers behind our global credit outlook and details about where we see value across credit markets.

Spotlight: Bank Loans and Collateralized Loan Obligations (CLOs)

One of our top sector picks for 2021 is the bank loan market. Activity in both the US and European markets is expected to continue the march higher, driven primarily by a strong technical environment. For instance, in the US, as the cost of financing for collateralized loan obligations (CLOs) has tightened significantly to pre-Covid levels and appetite for the paper continues to grow, we anticipate significant CLO formation during 1Q21, with over 100 CLO warehouses currently open. We expect this to be the primary driver of demand for bank loans in the quarter. Further to this technical, investors have realized that banks will have less new loan supply during the quarter than anticipated, thus driving less new loan supply to soak up the incremental demand. Moreover, investors received higher than expected loan repayments and amortization at the end of 4Q20, resulting in high cash balances that need to be reinvested in the secondary market.

We believe retail funds will also be an important catalyst driving US bank loan demand. As more of the market speculates potential rate moves in the coming quarters, market participants concerned about potential rising rates have caused positive inflows to loan funds. If this momentum builds, demand in the asset class could increase exponentially as retail is only 5% of the market today versus over 20% in the previous rising rate period. This has already started to take place in early 2021 as investors added $1.1 billion of cash to loan funds during the week ended January 13, according to Lipper.

The European loan market is expected to normalize somewhat in 2021, after a year marked by record volatility and increased defaults. Indeed, despite the strong recovery in 2H20, spreads on leading European loan indices are still wider than at the start of last year, but dispersion has increased materially. Finding credits with convexity might be challenging without exposure to weak, short-term outlooks. Therefore, portfolio rotation in the secondary market might not be as accretive to returns as it was in 3Q/4Q20. We would note that some uncertainty remains for sectors directly impacted by the pandemic, but overall loan investors have taken comfort that issuers will have sufficient liquidity in the short to medium term.

We are also constructive on both the US and European CLO markets. While spreads across US CLOs had largely retraced their March 2020 widening through 3Q20, we believed investment-grade spreads still looked attractive with BBB and select BB CLOs looking especially compelling. With such a fundamental shift in the near to midterm outlook for US growth, the CLO market saw a massive flattening of its credit curve as election clarity and vaccine news were perceived to have removed a large amount of tail risk from many of the existing CLO portfolios.

Looking ahead to 1Q21, while we agree with most projections on the new-issue side, our view is that many of the aggressive projections from the Street with respect to refinancings and resets for 2021 will fall short of expectations, as CLO managers will likely focus on new asset gathering opportunities. In the near term, we see a heavy calendar for the first quarter of this year. Rumors of Japanese and US banks—both of which were largely absent from the CLO market in 2020—coming back with renewed appetite for CLOs would be a very strong tailwind for demand and a catalyst that would drive 2021 issuance projections. We expect CLOs to remain well-bid with demand that continues to ebb and flow with underlying bank loan fundamentals/demand/supply as well as the macro backdrop around growth and COVID-19.

In Europe, while new loan warehouse openings were put on hold during the first wave of European lockdowns last year, CLO managers still had ample capital ready to seed new deals. When signs that defaults and CCCs, albeit higher, would have a lower impact on deal performance than initially thought, banks reopened financing capabilities and managers started to ramp up portfolios again, taking advantage of attractive discounts. That renewed optimism was reflected in the €7.1 billion of notes issued in 4Q20, only a 6.5% decrease from 4Q19, versus a 26% full-year contraction. At the start of 2021, early indication is that CLO liabilities will continue to tighten, which will help mitigate the expected pressure on loan spreads. The CLO primary market is poised to revert to pre-Covid new issuance volumes, which is expected to help sustain strong technical demand for loans. We also expect to see a strong pipeline for CLO refinancings and resets, as market conditions for most of last year did not allow deals coming out of their non-call period to exercise the option.

EM Corporates: Are Risks Overstated?

The attractive attributes of emerging market (EM) corporate credit (e.g., income, diversification and total return potential) are well known to many institutional investors. However, we believe investors’ perceptions of the sector’s risks are likely overstated and misunderstood, particularly in higher quality ratings categories. A common investor concern is the likelihood of downgrades and impairments in the EM sector relative to the developed market (DM) sector; however, data suggests such occurrences in EM are no more frequent than in DM. Exhibit 1 shows S&P’s cumulative historical default rates by ratings for EM and US credit. As the table illustrates, EM has a lower default rate in A and BB ratings categories and relatively equivalent rates in the BBB category.

Exhibit 1: Cumulative Default Rate by Ratings Category: 1980 to 2019
(Select the image to expand the view.)
Exhibit 1 Source: S&P. As of 29 Apr 20.

From a returns standpoint, EM corporate debt outperformed EM sovereign debt and generated both positive total and excess returns for investors during 2020’s extreme market conditions. Despite there being a perception among investors that EM is a more volatile asset class, the drawdown chart in Exhibit 2 shows that BBB rated EM debt has performed comparably to US BBBs under stressed market conditions.

Exhibit 2: EM vs DM Drawdown Comparison
(Select the image to expand the view.)
Exhibit 2 Source: Bloomberg and Western Asset Calculations. As of 15 Dec 20

Given equivalent credit/default risk and a current yield premium versus US credit of approximately 80 basis points (bps) for investment-grade-rated EM corporates, investors can take advantage of the diversifying and yield-enhancing benefits of EM corporates through partnering with an active EM investment manager such as Western Asset.

Global Credit Markets: Relative Value Round-Up

Active management in fixed-income is essential to identify and exploit value opportunities and to manage downside risk. Here, we present our Investment Team’s high-level views across global credit markets. In the Global Corporate Credit Sector Views section, we provide our Investment Team’s latest views including an assessment of industry vulnerability to Covid-related risks.

Investment-Grade (IG) Credit

We are ultimately optimistic on credit fundamentals even as the ongoing recovery will still be dependent on the path of the virus. But with multiple vaccination programs already in progress and more to come, the left tail has been truncated. The path forward now partly rests on how quickly economic activity is allowed to resume and partly on how companies handle the war chest of liquidity—raised to weather an extended lockdown—that will likely not be needed. The favorable technical backdrop does endure; however, valuations have already returned to pre-Covid levels for many sectors. With overall valuations near fully recovered alongside a technical backdrop that is still highly supportive, we look to get overall portfolio risk closer to the index. Our bias now is to sell into further strength for those sectors where valuations have returned to pre-Covid levels while maintaining overweights to banking, select reopening industries where valuations have yet to fully recover, and rising star candidates where allowed.

High-Yield (HY) Credit

During the quarter, we continued to take advantage of our ability to help structure certain high-quality secured transactions largely in cyclical sectors and anticipate this will likely continue moving forward. Given the regulatory approvals of various vaccines, significant ongoing policy support as evidenced by the recent $900 billion relief package along with clarity over US elections, we have become more constructive on the economy’s ability to clear any remaining hurdles sooner than initially expected. We continue to position for a “reopening trade” and remain overweight certain cyclical sectors including airlines, cruise lines and select retail segments complemented by a higher quality bias in those less cyclical subsectors providing ballast in the portfolios.

Municipals

Municipalities will continue to grapple with the economic impact of the pandemic and the need to address sizable budget gaps through the first half of 2021, as large parts of the US remain quarantined and we do not anticipate vaccine rollouts to materially impact growth ahead of the second quarter. While states and locals did not receive the well-publicized stimulus needed to address revenue shortfalls, we expect the muni market to still benefit either directly or indirectly from the $900 billion bill passed through Congress at the end of 2020. As we have received additional clarity surrounding the US elections, we believe the increased prospects for higher tax rates and additional stimulus measures will lend support to the asset class in the first quarter. We continue to favor revenue-backed securities versus general obligation-backed liens. From a quality perspective, we are maintaining an overweight to lower investment-grade segments of the market that remain attractive relative to pre-pandemic tights and comparable corporate valuations.

Emerging Markets

We continue to favor high-quality hard currency bonds from both a carry and total return standpoint, while being observant of ongoing fundamental growth challenges in EM. We also favor local rates, as they offer more favorable risk/reward potential. We are trading EM currencies opportunistically and seeking to avoid currencies that are susceptible to oil-related or virus-induced growth setbacks, given EM currencies’ higher volatility and role as a pressure relief valve. Our convictions during this crisis continue to center on select EM countries with ample foreign exchange reserves, low external economic dependency, lower political uncertainty and effective policy executions. A focus on credit differentiation is paramount, investing in countries that we believe are better positioned to weather the growth slowdown. Finally, we continue to exercise caution and remain selective on debt issued by lower-rated frontier market countries that face an uphill road ahead.

Structured Credit

The reopening of economies supported by the release of multiple effective Covid vaccines should be a positive catalyst for sectors such as mortgage and consumer credit, which have lagged other credit sectors in the rebound since March. The combination of solid fundamentals with attractive valuations suggests significant potential for the asset class to generate strong performance. The largest dislocated opportunities are in residential and commercial mortgage credit, which are sectors that have not received the benefit of a Fed backstop.

Spotlight: Bank Loans and Collateralized Loan Obligations (CLOs)
Bank Icon

Activity in both the US and European markets is expected to continue the march higher, driven primarily by a strong technical environment.

One of our top sector picks for 2021 is the bank loan market. Activity in both the US and European markets is expected to continue the march higher, driven primarily by a strong technical environment. For instance, in the US, as the cost of financing for collateralized loan obligations (CLOs) has tightened significantly to pre-Covid levels and appetite for the paper continues to grow, we anticipate significant CLO formation during 1Q21, with over 100 CLO warehouses currently open. We expect this to be the primary driver of demand for bank loans in the quarter. Further to this technical, investors have realized that banks will have less new loan supply during the quarter than anticipated, thus driving less new loan supply to soak up the incremental demand. Moreover, investors received higher than expected loan repayments and amortization at the end of 4Q20, resulting in high cash balances that need to be reinvested in the secondary market.

We believe retail funds will also be an important catalyst driving US bank loan demand. As more of the market speculates potential rate moves in the coming quarters, market participants concerned about potential rising rates have caused positive inflows to loan funds. If this momentum builds, demand in the asset class could increase exponentially as retail is only 5% of the market today versus over 20% in the previous rising rate period. This has already started to take place in early 2021 as investors added $1.1 billion of cash to loan funds during the week ended January 13, according to Lipper.

The European loan market is expected to normalize somewhat in 2021, after a year marked by record volatility and increased defaults. Indeed, despite the strong recovery in 2H20, spreads on leading European loan indices are still wider than at the start of last year, but dispersion has increased materially. Finding credits with convexity might be challenging without exposure to weak, short-term outlooks. Therefore, portfolio rotation in the secondary market might not be as accretive to returns as it was in 3Q/4Q20. We would note that some uncertainty remains for sectors directly impacted by the pandemic, but overall loan investors have taken comfort that issuers will have sufficient liquidity in the short to medium term.

We are also constructive on both the US and European CLO markets. While spreads across US CLOs had largely retraced their March 2020 widening through 3Q20, we believed investment-grade spreads still looked attractive with BBB and select BB CLOs looking especially compelling. With such a fundamental shift in the near to midterm outlook for US growth, the CLO market saw a massive flattening of its credit curve as election clarity and vaccine news were perceived to have removed a large amount of tail risk from many of the existing CLO portfolios.

Looking ahead to 1Q21, while we agree with most projections on the new-issue side, our view is that many of the aggressive projections from the Street with respect to refinancings and resets for 2021 will fall short of expectations, as CLO managers will likely focus on new asset gathering opportunities. In the near term, we see a heavy calendar for the first quarter of this year. Rumors of Japanese and US banks—both of which were largely absent from the CLO market in 2020—coming back with renewed appetite for CLOs would be a very strong tailwind for demand and a catalyst that would drive 2021 issuance projections. We expect CLOs to remain well-bid with demand that continues to ebb and flow with underlying bank loan fundamentals/demand/supply as well as the macro backdrop around growth and COVID-19.

In Europe, while new loan warehouse openings were put on hold during the first wave of European lockdowns last year, CLO managers still had ample capital ready to seed new deals. When signs that defaults and CCCs, albeit higher, would have a lower impact on deal performance than initially thought, banks reopened financing capabilities and managers started to ramp up portfolios again, taking advantage of attractive discounts. That renewed optimism was reflected in the €7.1 billion of notes issued in 4Q20, only a 6.5% decrease from 4Q19, versus a 26% full-year contraction. At the start of 2021, early indication is that CLO liabilities will continue to tighten, which will help mitigate the expected pressure on loan spreads. The CLO primary market is poised to revert to pre-Covid new issuance volumes, which is expected to help sustain strong technical demand for loans. We also expect to see a strong pipeline for CLO refinancings and resets, as market conditions for most of last year did not allow deals coming out of their non-call period to exercise the option.

EM Corporates: Are Risks Overstated?
Emerging Markets Icon

We believe investors’ perceptions of the EM corporate credit sector’s risks are likely overstated and misunderstood.

The attractive attributes of emerging market (EM) corporate credit (e.g., income, diversification and total return potential) are well known to many institutional investors. However, we believe investors’ perceptions of the sector’s risks are likely overstated and misunderstood, particularly in higher quality ratings categories. A common investor concern is the likelihood of downgrades and impairments in the EM sector relative to the developed market (DM) sector; however, data suggests such occurrences in EM are no more frequent than in DM. Exhibit 1 shows S&P’s cumulative historical default rates by ratings for EM and US credit. As the table illustrates, EM has a lower default rate in A and BB ratings categories and relatively equivalent rates in the BBB category.

Exhibit 1: Cumulative Default Rate by Ratings Category: 1980 to 2019

Exhibit 1 Source: S&P. As of 29 Apr 20. (Select the image to expand the view.)

From a returns standpoint, EM corporate debt outperformed EM sovereign debt and generated both positive total and excess returns for investors during 2020’s extreme market conditions. Despite there being a perception among investors that EM is a more volatile asset class, the drawdown chart in Exhibit 2 shows that BBB rated EM debt has performed comparably to US BBBs under stressed market conditions.

Exhibit 2: EM vs DM Drawdown Comparison

Exhibit 2 Source: Bloomberg and Western Asset Calculations. As of 15 Dec 20. (Select the image to expand the view.)

Given equivalent credit/default risk and a current yield premium versus US credit of approximately 80 basis points (bps) for investment-grade-rated EM corporates, investors can take advantage of the diversifying and yield-enhancing benefits of EM corporates through partnering with an active EM investment manager such as Western Asset.

Global Credit Markets: Relative Value Round-Up
Pie Puzzle Pieces

We are ultimately optimistic on credit fundamentals even as the ongoing recovery will still be dependent on the path of the virus.

Active management in fixed-income is essential to identify and exploit value opportunities and to manage downside risk. Here, we present our Investment Team’s high-level views across global credit markets. In the Global Corporate Credit Sector Views section, we provide our Investment Team’s latest views including an assessment of industry vulnerability to Covid-related risks.

Investment-Grade (IG) Credit

We are ultimately optimistic on credit fundamentals even as the ongoing recovery will still be dependent on the path of the virus. But with multiple vaccination programs already in progress and more to come, the left tail has been truncated. The path forward now partly rests on how quickly economic activity is allowed to resume and partly on how companies handle the war chest of liquidity—raised to weather an extended lockdown—that will likely not be needed. The favorable technical backdrop does endure; however, valuations have already returned to pre-Covid levels for many sectors. With overall valuations near fully recovered alongside a technical backdrop that is still highly supportive, we look to get overall portfolio risk closer to the index. Our bias now is to sell into further strength for those sectors where valuations have returned to pre-Covid levels while maintaining overweights to banking, select reopening industries where valuations have yet to fully recover, and rising star candidates where allowed.

High-Yield (HY) Credit

During the quarter, we continued to take advantage of our ability to help structure certain high-quality secured transactions largely in cyclical sectors and anticipate this will likely continue moving forward. Given the regulatory approvals of various vaccines, significant ongoing policy support as evidenced by the recent $900 billion relief package along with clarity over US elections, we have become more constructive on the economy’s ability to clear any remaining hurdles sooner than initially expected. We continue to position for a “reopening trade” and remain overweight certain cyclical sectors including airlines, cruise lines and select retail segments complemented by a higher quality bias in those less cyclical subsectors providing ballast in the portfolios.

Municipals

Municipalities will continue to grapple with the economic impact of the pandemic and the need to address sizable budget gaps through the first half of 2021, as large parts of the US remain quarantined and we do not anticipate vaccine rollouts to materially impact growth ahead of the second quarter. While states and locals did not receive the well-publicized stimulus needed to address revenue shortfalls, we expect the muni market to still benefit either directly or indirectly from the $900 billion bill passed through Congress at the end of 2020. As we have received additional clarity surrounding the US elections, we believe the increased prospects for higher tax rates and additional stimulus measures will lend support to the asset class in the first quarter. We continue to favor revenue-backed securities versus general obligation-backed liens. From a quality perspective, we are maintaining an overweight to lower investment-grade segments of the market that remain attractive relative to pre-pandemic tights and comparable corporate valuations.

Emerging Markets

We continue to favor high-quality hard currency bonds from both a carry and total return standpoint, while being observant of ongoing fundamental growth challenges in EM. We also favor local rates, as they offer more favorable risk/reward potential. We are trading EM currencies opportunistically and seeking to avoid currencies that are susceptible to oil-related or virus-induced growth setbacks, given EM currencies’ higher volatility and role as a pressure relief valve. Our convictions during this crisis continue to center on select EM countries with ample foreign exchange reserves, low external economic dependency, lower political uncertainty and effective policy executions. A focus on credit differentiation is paramount, investing in countries that we believe are better positioned to weather the growth slowdown. Finally, we continue to exercise caution and remain selective on debt issued by lower-rated frontier market countries that face an uphill road ahead.

Structured Credit

The reopening of economies supported by the release of multiple effective Covid vaccines should be a positive catalyst for sectors such as mortgage and consumer credit, which have lagged other credit sectors in the rebound since March. The combination of solid fundamentals with attractive valuations suggests significant potential for the asset class to generate strong performance. The largest dislocated opportunities are in residential and commercial mortgage credit, which are sectors that have not received the benefit of a Fed backstop.

Global Corporate Credit Sector Views

Auto & Related
COVID-19 Impact
Baraomter Levels High
Key Observations The sector has now moved past the worst of the Covid-related production challenges. The US light vehicle market has experienced stronger-than-expected consumer demand despite the more challenging unemployment backdrop, while the European market remains burdened by extended lockdown measures; the Chinese market is the best performer, having recovered as soon as 2Q20. Looking ahead, we continue to focus on each OEM/supplier’s liquidity position, ability to flex their respective cost structures and capacity to evolve their business models to a more rapid adoption of EV/hybrid vehicle platforms.
Energy
COVID-19 Impact
Baraomter Levels High
Key Observations While volatility is expected to prevail, albeit at lower levels, prices continue to be range-bound. The source of the volatility is likely more supply-side driven than demand-side given the COVID-19 vaccine; OPEC+ cooperation and resolve are still required at this juncture. We recognize we are in the midst of a cyclical upswing but also understand there is a longer-term energy transition underway; still, we believe fossil fuel demand will continue to grow but at a slower pace. We continue to believe there is a distinction between companies and strategies employed to weather the down-cycle. We have seen a wave of consolidation in a short period of time which we view as necessary, and we do not believe it is over yet (only slowed). Rating agencies have begun to stabilize the ratings and outlooks at current higher oil prices.
Gaming
COVID-19 Impact
Baraomter Levels High
Key Observations Regional markets are expected to perform best given the “drive-in” nature of their operations, ability to quickly right-size their cost structures, and appeal to consumers given limited entertainment options. Las Vegas will take time to recover, as this is a destination market that requires “air lift” into town. Given consumers’ reluctance to travel on domestic airlines as a result of Covid concerns, visitation trends have been down substantially on a year-over-year basis, and the mid-week convention business has essentially been eliminated, resulting in occupancy rates of 20% to 30% during the week and approximately 50% on the weekends. Macau and Singapore face hurdles similar to those of Las Vegas given their destination status and more onerous quarantine/travel restrictions.
Retailing
COVID-19 Impact
Baraomter Levels High
Key Observations During 2020, COVID-19 lockdowns globally accelerated the pre-existing secular transition to online shopping, thus putting immense pressure on legacy retailers such as department store and shopping mall operators. The resulting sharp deterioration in sector credit quality manifested itself in waves of rating agency downgrades and bankruptcies. Looking ahead, we do expect some “bounce-back“ but typically will prefer to get involved only in those names that have either successfully made the transition to online or are, for whatever name-specific reason, shielded from it. The grocery/supermarket space was a pocket of strength/stability in 2020 and we expect that to remain the case. DIY/builders merchant names also did well in 2020 but in the year ahead we expect some revenue normalization as vaccination and lockdown relaxation prompts consumers to reallocate discretionary spending toward other categories such as travel/leisure.
Transportation
COVID-19 Impact
Baraomter Levels High
Key Observations Air travel demand weakness in late 2020 has carried over into 2021, so the first quarter of 2021 will be characterized by uneven demand and a booking curve that remains compressed. In the US, the Covid-relief bill passed in December 2020 will provide the US legacy carriers with an additional $15 billion of additional payroll support that will preserve jobs through March 31, 2021. As vaccines become more widely distributed and travel restrictions ease, the airline industry expects an inflection point in demand by the middle of 2021 that should result in a sustained improvement in demand and yields by 2H21, especially as offices reopen. We remain very cautious on the European airline sector given over-leveraged balance sheets and where bond market issuance is all in unsecured format.
Metals & Mining
COVID-19 Impact
Baraomter Levels Medium High
Key Observations Macro factors continue to support future demand: fiscal and monetary stimulus in the system with more to come, a focus on infrastructure spending, a recovering China that supports demand while Western economies find a firmer footing, and USD depreciation. The COVID-19 vaccine provides some momentum. Consequently, inventory levels, in general, continue to be in a position to support price levels and demand should continue on an upward trend, particularly for those tied to the global decarbonization efforts. Supply side constraints also play well into the thesis of continued higher pricing levels as the industry recovers from Covid-related stoppages.
Banks
COVID-19 Impact
Baraomter Levels Medium
Key Observations We recommend a large overweight to the highest-quality banks based on the resilient performance of their derisked business models in 2020, continued benign technicals and conservative credit ratings. We believe that there remain attractive investment opportunities in the space but also acknowledge that valuations are the weakest part of our investment thesis for banks. For 2021, we expect a meaningful economic expansion, which should support a recovery in earnings, while continuing fiscal and monetary stimulus combined with limited shareholder payouts should continue to limit downside risks to balance sheets in case a less favorable economic path materializes.
Consumer
Products &
Apparel
COVID-19 Impact
Baraomter Levels Medium
Key Observations We continue to see improved demand across consumer discretionary categories. The share of wallet shift has been most visible in autos, home improvement and sporting goods. In branded apparel, the companies with strong brands and sophisticated omni-channel capabilities are best suited to benefit from the accelerating shift to online sales and the reopening of brick & mortar stores. Looking ahead, companies are focusing on addressing supply chain disruptions and changes in consumer buying habits post emergence from quarantine. Consumer products & apparel companies with an omni-channel presence and strong brand names should be able to weather the change in shopping channel preferences of today’s consumers, post COVID-19.
Health Care
COVID-19 Impact
Baraomter Levels Medium
Key Observations While health insurers faced significant increases in claims costs associated with testing and treatment for COVID-19 in 2020, these costs have been more than offset by a significant level of deferral of non-emergency care, such as elective surgeries, diagnostic testing and routine care. Within the managed care space, negative event risk is on the rise. Looking ahead, we expect the health care landscape to feature substantive federal and state policy-driven debates steered by the pandemic and the Democratic national health care policy. Biden’s proposed stimulus package includes a health care response package of ~$400 billion in total and would allocate dollars to several key programs. At first glance, this agenda is positive for high-yield managed care, hospitals, health care facilities and other providers.
Food &
Beverage
COVID-19 Impact
Baraomter Levels Low
Key Observations The pandemic continues to be a revenue tailwind for food & beverage companies due to the prolonged period of at-home eating that has helped offset weakness in the foodservice channel. However, costs are being pressured by strained supply chains and protein producers continue to suffer from plant closings after localized viral outbreaks. Looking ahead, food & beverage companies are focused on growing and maintaining the additional market share by increasing loyalty and brand engagement. The investments in innovation and brand marketing may further pressure margins, but should result in long-term market share gains.
Pharmaceuticals
COVID-19 Impact
Baraomter Levels Low
Key Observations Pharmaceutical companies face the following headwinds in 2021: 1) uncertainty regarding US drug pricing and the reimbursement policy, 2) lower volume from high unemployment, and 3) lockdowns that continue to hinder new drug launches, as well as rates of diagnoses and certain disease segments requiring regular physician visits. However, these headwinds should be partially offset by increased volume from the expansion of health care insurance from the Biden administration. In high-yield, key market players have not seen major disruptions from COVID-19 and 4Q20 preliminary earnings are trending above expectations so far. While some saw lower demand for drugs tied to elective surgeries earlier in the year, we are seeing some companies cite 2H20/1Q21 tailwinds from this pent-up demand.
Technology
COVID-19 Impact
Baraomter Levels Low
Key Observations As the Covid crisis has evolved, we are seeing clear signs of stability and improvement in the technology sector. Capital investments in hardware and software to support the evolving work-from-home (WFH) business model are bolstered by greater demand for technology products that enable new end uses such as artificial intelligence, EV and autonomous vehicles, 5G telecommunications, virtualized networking and cloud computing. Looking forward and into next year, we believe that many subsectors including, for example, 5G connectivity, electronic payments, tech-related infrastructure, cloud computing and cybersecurity, will emerge post-crisis as winners.
Telecommunications & Media
COVID-19 Impact
Baraomter Levels Low
Key Observations During 2020, telecom operators suffered only relatively minor operational business disruptions from the pandemic. In the US, the decision by telecom operators to collectively spend over $80 billion on spectrum in the January auction should drive substantial fresh primary debt issuance and, in some cases, pressurize rating agency metrics. In Europe, we highlight the recent wave of go-private transactions in the sector. We expect legacy/incumbent operators to be largely unaffected by this trend but note management teams’ efforts to focus infrastructure sharing and towers sale/separation transactions. In media, we expect advertising spending to strongly bounce back, potentially with a double-digit percentage growth rate in 2021.
Utilities
COVID-19 Impact
Baraomter Levels Low
Key Observations Within the US, management teams continue to focus on regulated operations and we observe more companies jettisoning the non-regulated/merchant/traditional non-utility businesses from their consolidated structure. This development is good/positive for greater stability in earnings and cash flows and reduces the complexity of the business models, while improving regulatory support as the theme of grid modernization and the associated capital spend required to execute remains intact. The more stable and consistent regulatory environment promotes better credit quality overall. In Europe, utility investment programs are generally back on track and an accelerated push into renewables is on the horizon—this will likely suppress pricing and result in ongoing retirement of carbon-intensive generation (with subsidy measures increasingly directed to ensure ongoing availability of backup generation from natural gas where historically they were used to incentivize renewables roll out).
Industry COVID-19 Impact Key Observations
Auto & Related Baraomter Levels High The sector has now moved past the worst of the Covid-related production challenges. The US light vehicle market has experienced stronger-than-expected consumer demand despite the more challenging unemployment backdrop, while the European market remains burdened by extended lockdown measures; the Chinese market is the best performer, having recovered as soon as 2Q20. Looking ahead, we continue to focus on each OEM/supplier’s liquidity position, ability to flex their respective cost structures and capacity to evolve their business models to a more rapid adoption of EV/hybrid vehicle platforms.
Energy Baraomter Levels High While volatility is expected to prevail, albeit at lower levels, prices continue to be range-bound. The source of the volatility is likely more supply-side driven than demand-side given the COVID-19 vaccine; OPEC+ cooperation and resolve are still required at this juncture. We recognize we are in the midst of a cyclical upswing but also understand there is a longer-term energy transition underway; still, we believe fossil fuel demand will continue to grow but at a slower pace. We continue to believe there is a distinction between companies and strategies employed to weather the down-cycle. We have seen a wave of consolidation in a short period of time which we view as necessary, and we do not believe it is over yet (only slowed). Rating agencies have begun to stabilize the ratings and outlooks at current higher oil prices.
Gaming Baraomter Levels High Regional markets are expected to perform best given the “drive-in” nature of their operations, ability to quickly right-size their cost structures, and appeal to consumers given limited entertainment options. Las Vegas will take time to recover, as this is a destination market that requires “air lift” into town. Given consumers’ reluctance to travel on domestic airlines as a result of Covid concerns, visitation trends have been down substantially on a year-over-year basis, and the mid-week convention business has essentially been eliminated, resulting in occupancy rates of 20% to 30% during the week and approximately 50% on the weekends. Macau and Singapore face hurdles similar to those of Las Vegas given their destination status and more onerous quarantine/travel restrictions.
Retailing Baraomter Levels High During 2020, COVID-19 lockdowns globally accelerated the pre-existing secular transition to online shopping, thus putting immense pressure on legacy retailers such as department store and shopping mall operators. The resulting sharp deterioration in sector credit quality manifested itself in waves of rating agency downgrades and bankruptcies. Looking ahead, we do expect some “bounce-back“ but typically will prefer to get involved only in those names that have either successfully made the transition to online or are, for whatever name-specific reason, shielded from it. The grocery/supermarket space was a pocket of strength/stability in 2020 and we expect that to remain the case. DIY/builders merchant names also did well in 2020 but in the year ahead we expect some revenue normalization as vaccination and lockdown relaxation prompts consumers to reallocate discretionary spending toward other categories such as travel/leisure.
Transportation Baraomter Levels High Air travel demand weakness in late 2020 has carried over into 2021, so the first quarter of 2021 will be characterized by uneven demand and a booking curve that remains compressed. In the US, the Covid-relief bill passed in December 2020 will provide the US legacy carriers with an additional $15 billion of additional payroll support that will preserve jobs through March 31, 2021. As vaccines become more widely distributed and travel restrictions ease, the airline industry expects an inflection point in demand by the middle of 2021 that should result in a sustained improvement in demand and yields by 2H21, especially as offices reopen. We remain very cautious on the European airline sector given over-leveraged balance sheets and where bond market issuance is all in unsecured format.
Metals & Mining Baraomter Levels Medium High Macro factors continue to support future demand: fiscal and monetary stimulus in the system with more to come, a focus on infrastructure spending, a recovering China that supports demand while Western economies find a firmer footing, and USD depreciation. The COVID-19 vaccine provides some momentum. Consequently, inventory levels, in general, continue to be in a position to support price levels and demand should continue on an upward trend, particularly for those tied to the global decarbonization efforts. Supply side constraints also play well into the thesis of continued higher pricing levels as the industry recovers from Covid-related stoppages.
Banks Baraomter Levels Medium We recommend a large overweight to the highest-quality banks based on the resilient performance of their derisked business models in 2020, continued benign technicals and conservative credit ratings. We believe that there remain attractive investment opportunities in the space but also acknowledge that valuations are the weakest part of our investment thesis for banks. For 2021, we expect a meaningful economic expansion, which should support a recovery in earnings, while continuing fiscal and monetary stimulus combined with limited shareholder payouts should continue to limit downside risks to balance sheets in case a less favorable economic path materializes.
Consumer
Products &
Apparel
Baraomter Levels Medium We continue to see improved demand across consumer discretionary categories. The share of wallet shift has been most visible in autos, home improvement and sporting goods. In branded apparel, the companies with strong brands and sophisticated omni-channel capabilities are best suited to benefit from the accelerating shift to online sales and the reopening of brick & mortar stores. Looking ahead, companies are focusing on addressing supply chain disruptions and changes in consumer buying habits post emergence from quarantine. Consumer products & apparel companies with an omni-channel presence and strong brand names should be able to weather the change in shopping channel preferences of today’s consumers, post COVID-19.
Health Care Baraomter Levels Medium While health insurers faced significant increases in claims costs associated with testing and treatment for COVID-19 in 2020, these costs have been more than offset by a significant level of deferral of non-emergency care, such as elective surgeries, diagnostic testing and routine care. Within the managed care space, negative event risk is on the rise. Looking ahead, we expect the health care landscape to feature substantive federal and state policy-driven debates steered by the pandemic and the Democratic national health care policy. Biden’s proposed stimulus package includes a health care response package of ~$400 billion in total and would allocate dollars to several key programs. At first glance, this agenda is positive for high-yield managed care, hospitals, health care facilities and other providers.
Food &
Beverage
Baraomter Levels Low The pandemic continues to be a revenue tailwind for food & beverage companies due to the prolonged period of at-home eating that has helped offset weakness in the foodservice channel. However, costs are being pressured by strained supply chains and protein producers continue to suffer from plant closings after localized viral outbreaks. Looking ahead, food & beverage companies are focused on growing and maintaining the additional market share by increasing loyalty and brand engagement. The investments in innovation and brand marketing may further pressure margins, but should result in long-term market share gains.
Pharmaceuticals Baraomter Levels Low Pharmaceutical companies face the following headwinds in 2021: 1) uncertainty regarding US drug pricing and the reimbursement policy, 2) lower volume from high unemployment, and 3) lockdowns that continue to hinder new drug launches, as well as rates of diagnoses and certain disease segments requiring regular physician visits. However, these headwinds should be partially offset by increased volume from the expansion of health care insurance from the Biden administration. In high-yield, key market players have not seen major disruptions from COVID-19 and 4Q20 preliminary earnings are trending above expectations so far. While some saw lower demand for drugs tied to elective surgeries earlier in the year, we are seeing some companies cite 2H20/1Q21 tailwinds from this pent-up demand.
Technology Baraomter Levels Low As the Covid crisis has evolved, we are seeing clear signs of stability and improvement in the technology sector. Capital investments in hardware and software to support the evolving work-from-home (WFH) business model are bolstered by greater demand for technology products that enable new end uses such as artificial intelligence, EV and autonomous vehicles, 5G telecommunications, virtualized networking and cloud computing. Looking forward and into next year, we believe that many subsectors including, for example, 5G connectivity, electronic payments, tech-related infrastructure, cloud computing and cybersecurity, will emerge post-crisis as winners.
Telecommunications & Media Baraomter Levels Low During 2020, telecom operators suffered only relatively minor operational business disruptions from the pandemic. In the US, the decision by telecom operators to collectively spend over $80 billion on spectrum in the January auction should drive substantial fresh primary debt issuance and, in some cases, pressurize rating agency metrics. In Europe, we highlight the recent wave of go-private transactions in the sector. We expect legacy/incumbent operators to be largely unaffected by this trend but note management teams’ efforts to focus infrastructure sharing and towers sale/separation transactions. In media, we expect advertising spending to strongly bounce back, potentially with a double-digit percentage growth rate in 2021.
Utilities Baraomter Levels Low Within the US, management teams continue to focus on regulated operations and we observe more companies jettisoning the non-regulated/merchant/traditional non-utility businesses from their consolidated structure. This development is good/positive for greater stability in earnings and cash flows and reduces the complexity of the business models, while improving regulatory support as the theme of grid modernization and the associated capital spend required to execute remains intact. The more stable and consistent regulatory environment promotes better credit quality overall. In Europe, utility investment programs are generally back on track and an accelerated push into renewables is on the horizon—this will likely suppress pricing and result in ongoing retirement of carbon-intensive generation (with subsidy measures increasingly directed to ensure ongoing availability of backup generation from natural gas where historically they were used to incentivize renewables roll out).