Macro Perspective

Western Asset’s base case outlook is for an elongated, U-shaped global economic recovery. While coronavirus-related setbacks have meaningfully reduced global growth, an incipient recovery appears to be gaining traction. We expect the battle against COVID-19 will take time; however, we are encouraged by signs of progress in the global race for a vaccine and the decline in global mortality rates, which suggest that renewed lockdowns are unlikely. Forceful policy action to date has buoyed global economic activity and restored market functioning. We expect central banks to remain extraordinarily accommodative, especially in light of subdued global inflation pressures, and to remain so until the recovery clearly begins. Given that the timing and slope of an eventual recovery are the greatest uncertainties, our portfolios are positioned to withstand further market volatility, yet remain flexible enough to capture exceptional 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.

Fallen Angels Update

Rating actions have come fast and furious over the past few months. Moody’s has announced over 600 downgrades in the past three months alone, versus a quarterly average of 123 over the past two years. In addition, there are currently $973 billion of investment-grade corporate bonds that are rated low BBB (BAA3 or BBB-). Of that amount, $466 billion is on a negative watch list by at least one major rating agency. Already this year, the high-yield market has had to absorb $154 billion in fallen angels. Not surprisingly, the industry with the largest amount of fallen angels is energy, with $63 billion of par value issues joining the asset class.

2020 has already had the greatest number of downgrades to below-investment-grade on record, surpassing the annual amounts of the recession in 2002, the global financial crisis (GFC) in 2009 and the commodity price crash in 2015. With $466 billion of BBB- issuers on negative watch lists, fallen angel volume will continue to increase throughout the balance of 2020. Estimates vary from Wall Street strategists for 2020 full-year fallen angel volume, ranging from $200 billion to $500 billion.

Those issuers that have recently fallen into the high-yield market have had a tremendous impact on performance. The fallen angel wave began in earnest during March when some large issuers such as Ford, Occidental Petroleum and Western Gas entered high-yield indices. While the investment-grade indices absorbed a lot of fallen angel pain, those fallen angels have had quite the opposite impact since joining high-yield indices. These names had an immediate positive impact, boosting average high-yield returns for April by 105 basis points (bps) and over 150 bps since the wave began. Looking ahead, we expect fallen angel activity to have a meaningful impact on HY index performance.

Municipal Market: Expect Additional Federal Support and Increased Issuance

The municipal market will remain in the headlines in the coming months as issuers will undoubtedly grapple with acute budget stress associated with the economic implications of COVID-19. Budget challenges are likely to lead to austerity measures that could impact regional and national economic growth. The degree of austerity and budgetary pain on downstream entities will be seen on a case-by-case basis, and will ultimately be informed by the length of regional economic shutdowns and the amount of federal support received.

While municipal valuations have been supported by positive market sentiment associated with expectations of robust Congressional and Federal Reserve (Fed) support, actual US federal government support has been limited versus other markets. We anticipate another substantive Congressional aid package to confirm market expectations and support the vast majority of the municipal market over the near term. In addition, we expect the Fed to extend its Municipal Liquidity Facility (MLF) as needed to support state and local governments in managing cash flow challenges.

Supply and demand technicals, supportive of municipal valuations throughout the summer, could soften and offer an opportunity for municipal investors to lock in a relatively high degree of tax-exempt income. Seasonally high coupon and principal reinvestment is on pace to decline, and we anticipate municipalities will issue more debt to take advantage of low borrowing rates to help them address budget needs.

Western Asset Coronavirus Task Force Update

Given the recent reacceleration of viral cases in some US states, there remains ongoing concern about renewed COVID-19 infections and the potential impact on the pace of the economic recovery. There has been limited data suggesting that SARS-Cov-2 is more likely to spread in the fall due to cold temperatures. As a result, our base case is not for a “seasonal” second wave of COVID-19 in the fall, but instead for an ongoing risk of additional breakouts in geographies with relaxed containment and a lack of testing/tracking in place. The accompanying map shows divergent progress on containment of the virus across the US, with states such as Florida, Arizona and Texas showing significant “first wave” COVID-19 growth as social distancing has abated. Meanwhile, Louisiana is the only state thought to be in a “second wave” under our definition of a state with a 5% acceleration in viral growth since Memorial Day (May 25) and a greater than 5% estimated infection rate. Europe has also experienced smaller regional flare-ups in meatpacking plants and tourist destinations, but has been moving to relax intra-EU travel restrictions as summer vacations begin.

Despite the huge downward impact of COVID-19 on global growth and the aforementioned concerns about ongoing viral spread, financial markets as a whole have recovered significantly since March’s volatility. The Task Force continues to evaluate prospects of the many SARS-Cov-2 vaccine candidates being rapidly advanced in the clinic, with critical Phase 3 data anticipated by the end of 2020. One or more successful vaccines would potentially enable a sharp 2021 economic recovery, although we would note the challenges of any given therapeutic treatment making it through the drug development process. Western Asset also attributes some of the equity and credit markets’ resilience to the enormous impact of global central bank support, which has included purchases of government bonds, investment-grade credit, fallen angels and even high-yield ETFs. We expect support from the Fed and the European Central Bank (ECB) to continue for the duration of the COVID-19 downturn, with additional backstops such as the buying of individual cash bonds should the virus or the economy take a turn for the worse.

In the Global Corporate Credit Sector Views section, we provide our Investment Team’s latest views including an assessment of industry vulnerability to COVID-19 related risks.

Global Credit Markets: Relative Value Round-Up
Investment-Grade (IG) Credit

Sector valuations continue to remain attractive. The technical backdrop is supportive with reduced new-issue supply expected in the second half of the year and the Fed engaged as a backstop through its asset purchase programs. Fund flows are solidly positive as overseas investors continue to seek yield but with much more favorable FX hedging costs now. Our bias in the near term is to remain overweight, especially through the higher-quality issuers added throughout Q2 as these are companies with robust franchises, solid balance sheets and have the wherewithal to survive in challenging environments. In Europe, spread levels look less compelling. Names with little or no exposure to the pandemic are trading near their pre-COVID levels. That stated, ECB and Bank of England bond purchase programs continue to be supportive of Euro IG credit markets. Credit fundamentals for REITS and financials remain robust and valuations still offer some opportunity. Sterling credit has benefited from a quieter new-issue calendar.

High-Yield (HY) Credit

The resurgence of COVID-19 cases, the ability of the economy to stabilize and the upcoming election season are the main drivers of future market direction. Technicals remain supportive on modest new-issue supply, pent-up investor demand and the Fed’s commitment to buy HY securities. In Q2, we took advantage of deeply discounted securities in cruise lines, airlines and retail. We remain overweight financials, consumer services and secured airlines. New issuance should continue to provide investment opportunities as terms will be favorable.

In Europe, spreads have narrowed during Q2 back to levels consistent with early-2016 and late-2018. Default rates will likely be lower than initially feared and companies are proactively improving corporate liquidity. This, plus the increase in economic activity should help risk premiums decline further over time. We prefer corporate hybrids over BB rated issues; in B rated issues and below, we have a preference for defensive industries (healthcare, telecom/cable) and companies with ample liquidity in more cyclical industries.

Bank Loans

The loan market will be driven in the near term by the pervasive demand technicals from CLO issuance, further exacerbated by limited new-issue loan supply and loan repayments, causing investors to recycle cash into the secondary market. We expect the market to grind higher given this strong technical and greater bifurcation between high quality defensive credits trading range-bound in the mid-to-high 90s, single B names in the mid-to-high 80s and consumer cyclical/high COVID-risk names in the 80 range. While defensive industries have continued to recover, we believe industries such as consumer staple, healthcare and communication offer a better risk/return profile given the uncertainty regarding the length of the economic shutdown.

CLOs

As expected, the IG-rated portion of CLOs snapped back in Q2, boosted by a supportive macro backdrop and Fed policy measures. With bank loans recovering almost 70% of its March widening, CLO tranches followed suit. Should the recovery timeline extend due to a continuation of this second wave and/or a renewal of broad economic shutdowns, we could see bouts of volatility in lower-rated CLO tranches. AAA CLOs are still more than 60% wide of 2020 tights and offer spread premia over other comparably rated products. AAAs will also perform well in either a bearish or bullish scenario. BB and BBB CLOs offer compelling total return at current valuations.

Emerging Markets

The ramifications on emerging markets (EM) from coronavirus-related growth challenges and volatile oil prices are still not over. Given EM’s limitations to implement significant monetary and fiscal programs versus developed markets (DM), the crisis may linger longer. We have already seen an increase in USD-denominated sovereign supply to fund necessary fiscal programs to mitigate further economic damage. Select IG-rated EM USD-denominated sovereigns remain attractive from both a carry and total return standpoint, but we continue to be vigilant about the potential for fallen angels. We maintain a bias toward local rates while being generally cautious on EM currencies that remain susceptible to virus-induced volatility. With real rates still high relative to DM, we view local rates as a carry rather than total return play. We are taking advantage of primary issuance from IG and crossover-rated corporates, whose spreads have widened considerably relative to US credit. We are cautious about single B rated EM corporates with cyclical/commodity exposure or domiciles with vulnerability to COVID risks.

Structured Credit

While uncertainty surrounding the COVID crisis remains, housing was in a strong position going into the crisis. The response from regulators and the Fed has been swift and effective at preventing a spike in foreclosures and keeping capital flowing into the housing market. We are positive on legacy NARMBS/new-issue re-performing loan deals as many of these borrowers have already withstood similar disruptions, (i.e., the GFC and hurricanes) and are proven performers. Turning to CMBS, we remain cautious in the near term as it is uncertain how long it will take for commercial real estate markets to fully recover from the negative impacts of the pandemic. We expect the fundamental outlook to be uneven across property types and markets as the impact varies by property type and geography. We remain positive on short-duration, well-structured single-borrower securitizations and loans. We prefer bonds that can better withstand a period of reduced operating income.

Fallen Angels Update
Feather Icon

Rating actions have come fast and furious over the past few months. Moody’s has announced over 600 downgrades in the past three months alone, versus a quarterly average of 123 over the past two years. In addition, there are currently $973 billion of investment-grade corporate bonds that are rated low BBB (BAA3 or BBB-). Of that amount, $466 billion is on a negative watch list by at least one major rating agency. Already this year, the high-yield market has had to absorb $154 billion in fallen angels. Not surprisingly, the industry with the largest amount of fallen angels is energy, with $63 billion of par value issues joining the asset class.

2020 has already had the greatest number of downgrades to below-investment-grade on record, surpassing the annual amounts of the recession in 2002, the global financial crisis (GFC) in 2009 and the commodity price crash in 2015. With $466 billion of BBB- issuers on negative watch lists, fallen angel volume will continue to increase throughout the balance of 2020. Estimates vary from Wall Street strategists for 2020 full-year fallen angel volume, ranging from $200 billion to $500 billion.

Those issuers that have recently fallen into the high-yield market have had a tremendous impact on performance. The fallen angel wave began in earnest during March when some large issuers such as Ford, Occidental Petroleum and Western Gas entered high-yield indices. While the investment-grade indices absorbed a lot of fallen angel pain, those fallen angels have had quite the opposite impact since joining high-yield indices. These names had an immediate positive impact, boosting average high-yield returns for April by 105 basis points (bps) and over 150 bps since the wave began. Looking ahead, we expect fallen angel activity to have a meaningful impact on HY index performance.

Municipal Market: Expect Additional Federal Support and Increased Issuance
Pie Dislcation

The municipal market will remain in the headlines in the coming months as issuers will undoubtedly grapple with acute budget stress associated with the economic implications of COVID-19. Budget challenges are likely to lead to austerity measures that could impact regional and national economic growth. The degree of austerity and budgetary pain on downstream entities will be seen on a case-by-case basis, and will ultimately be informed by the length of regional economic shutdowns and the amount of federal support received.

While municipal valuations have been supported by positive market sentiment associated with expectations of robust Congressional and Federal Reserve (Fed) support, actual US federal government support has been limited versus other markets. We anticipate another substantive Congressional aid package to confirm market expectations and support the vast majority of the municipal market over the near term. In addition, we expect the Fed to extend its Municipal Liquidity Facility (MLF) as needed to support state and local governments in managing cash flow challenges.

Supply and demand technicals, supportive of municipal valuations throughout the summer, could soften and offer an opportunity for municipal investors to lock in a relatively high degree of tax-exempt income. Seasonally high coupon and principal reinvestment is on pace to decline, and we anticipate municipalities will issue more debt to take advantage of low borrowing rates to help them address budget needs.

Western Asset Coronavirus Task Force Update
Coronavirus Icon

Given the recent reacceleration of viral cases in some US states, there remains ongoing concern about renewed COVID-19 infections and the potential impact on the pace of the economic recovery. There has been limited data suggesting that SARS-Cov-2 is more likely to spread in the fall due to cold temperatures. As a result, our base case is not for a “seasonal” second wave of COVID-19 in the fall, but instead for an ongoing risk of additional breakouts in geographies with relaxed containment and a lack of testing/tracking in place. The accompanying map shows divergent progress on containment of the virus across the US, with states such as Florida, Arizona and Texas showing significant “first wave” COVID-19 growth as social distancing has abated. Meanwhile, Louisiana is the only state thought to be in a “second wave” under our definition of a state with a 5% acceleration in viral growth since Memorial Day (May 25) and a greater than 5% estimated infection rate. Europe has also experienced smaller regional flare-ups in meatpacking plants and tourist destinations, but has been moving to relax intra-EU travel restrictions as summer vacations begin.

Spread of COVID-19 in the US Since Memorial Day (May 25, 2020)
USA Map

Despite the huge downward impact of COVID-19 on global growth and the aforementioned concerns about ongoing viral spread, financial markets as a whole have recovered significantly since March’s volatility. The Task Force continues to evaluate prospects of the many SARS-Cov-2 vaccine candidates being rapidly advanced in the clinic, with critical Phase 3 data anticipated by the end of 2020. One or more successful vaccines would potentially enable a sharp 2021 economic recovery, although we would note the challenges of any given therapeutic treatment making it through the drug development process. Western Asset also attributes some of the equity and credit markets’ resilience to the enormous impact of global central bank support, which has included purchases of government bonds, investment-grade credit, fallen angels and even high-yield ETFs. We expect support from the Fed and the European Central Bank (ECB) to continue for the duration of the COVID-19 downturn, with additional backstops such as the buying of individual cash bonds should the virus or the economy take a turn for the worse.

In the Global Corporate Credit Sector Views section, we provide our Investment Team’s latest views including an assessment of industry vulnerability to COVID-19 related risks.

Global Credit Markets: Relative Value Round-Up
Sectors Icon

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.

Investment-Grade (IG) Credit

Sector valuations continue to remain attractive. The technical backdrop is supportive with reduced new-issue supply expected in the second half of the year and the Fed engaged as a backstop through its asset purchase programs. Fund flows are solidly positive as overseas investors continue to seek yield but with much more favorable FX hedging costs now. Our bias in the near term is to remain overweight, especially through the higher-quality issuers added throughout Q2 as these are companies with robust franchises, solid balance sheets and have the wherewithal to survive in challenging environments. In Europe, spread levels look less compelling. Names with little or no exposure to the pandemic are trading near their pre-COVID levels. That stated, ECB and Bank of England bond purchase programs continue to be supportive of Euro IG credit markets. Credit fundamentals for REITS and financials remain robust and valuations still offer some opportunity. Sterling credit has benefited from a quieter new-issue calendar.

High-Yield (HY) Credit

The resurgence of COVID-19 cases, the ability of the economy to stabilize and the upcoming election season are the main drivers of future market direction. Technicals remain supportive on modest new-issue supply, pent-up investor demand and the Fed’s commitment to buy HY securities. In Q2, we took advantage of deeply discounted securities in cruise lines, airlines and retail. We remain overweight financials, consumer services and secured airlines. New issuance should continue to provide investment opportunities as terms will be favorable. In Europe, spreads have narrowed during Q2 back to levels consistent with early-2016 and late-2018. Default rates will likely be lower than initially feared and companies are proactively improving corporate liquidity. This, plus the increase in economic activity should help risk premiums decline further over time. We prefer corporate hybrids over BB rated issues; in B rated issues and below, we have a preference for defensive industries (healthcare, telecom/cable) and companies with ample liquidity in more cyclical industries.

Bank Loans

The loan market will be driven in the near term by the pervasive demand technicals from CLO issuance, further exacerbated by limited new-issue loan supply and loan repayments, causing investors to recycle cash into the secondary market. We expect the market to grind higher given this strong technical and greater bifurcation between high quality defensive credits trading range-bound in the mid-to-high 90s, single B names in the mid-to-high 80s and consumer cyclical/high COVID-risk names in the 80 range. While defensive industries have continued to recover, we believe industries such as consumer staple, healthcare and communication offer a better risk/return profile given the uncertainty regarding the length of the economic shutdown.

CLOs

As expected, the IG-rated portion of CLOs snapped back in Q2, boosted by a supportive macro backdrop and Fed policy measures. With bank loans recovering almost 70% of its March widening, CLO tranches followed suit. Should the recovery timeline extend due to a continuation of this second wave and/or a renewal of broad economic shutdowns, we could see bouts of volatility in lower-rated CLO tranches. AAA CLOs are still more than 60% wide of 2020 tights and offer spread premia over other comparably rated products. AAAs will also perform well in either a bearish or bullish scenario. BB and BBB CLOs offer compelling total return at current valuations.

Emerging Markets

The ramifications on emerging markets (EM) from coronavirus-related growth challenges and volatile oil prices are still not over. Given EM’s limitations to implement significant monetary and fiscal programs versus developed markets (DM), the crisis may linger longer. We have already seen an increase in USD-denominated sovereign supply to fund necessary fiscal programs to mitigate further economic damage. Select IG-rated EM USD-denominated sovereigns remain attractive from both a carry and total return standpoint, but we continue to be vigilant about the potential for fallen angels. We maintain a bias toward local rates while being generally cautious on EM currencies that remain susceptible to virus-induced volatility. With real rates still high relative to DM, we view local rates as a carry rather than total return play. We are taking advantage of primary issuance from IG and crossover-rated corporates, whose spreads have widened considerably relative to US credit. We are cautious about single B rated EM corporates with cyclical/commodity exposure or domiciles with vulnerability to COVID risks.

Structured Credit

While uncertainty surrounding the COVID crisis remains, housing was in a strong position going into the crisis. The response from regulators and the Fed has been swift and effective at preventing a spike in foreclosures and keeping capital flowing into the housing market. We are positive on legacy NARMBS/new-issue re-performing loan deals as many of these borrowers have already withstood similar disruptions, (i.e., the GFC and hurricanes) and are proven performers. Turning to CMBS, we remain cautious in the near term as it is uncertain how long it will take for commercial real estate markets to fully recover from the negative impacts of the pandemic. We expect the fundamental outlook to be uneven across property types and markets as the impact varies by property type and geography. We remain positive on short-duration, well-structured single-borrower securitizations and loans. We prefer bonds that can better withstand a period of reduced operating income.

Global Corporate Credit Sector Views

Auto & Related
COVID-19 Impact
Baraomter Levels High
Key Observations The global automotive sector is caught squarely in the eye of the COVID-19 storm, as the highly consumer-discretionary nature of light vehicle purchases depends on many factors, including consumer confidence, healthy household balance sheets, modest unemployment levels, attractive financing terms and stable used car residual values. All of the aforementioned items have been negatively impacted, which has led to dealerships being closed, production lines shut down and substantial cash burn rates at both the OEM and supplier levels due to the high fixed cost nature of their operations. While most automotive names entered this year with healthy balance sheets and sizable liquidity buffers, no company’s business model is equipped to survive extended periods of zero production/revenues. As such, we maintain a cautious stance.
Energy
COVID-19 Impact
Baraomter Levels High
Key Observations The impacts of the “stay at home” policies from COVID continue to bite with material demand destruction. However, the trough has been worked through with economies reopening and demand ticking up, although it is still some 13% below pre-COVID levels. The physical oil market remains in an oversupplied position and balance restoration not only requires a more durable demand recovery but continued rational OPEC+ behavior. With recent higher prices some previously curtailed US production is returning but OPEC+ has also begun tapering its production cuts which should serve to provide a cap and floor in prices (and hopefully more stability).
Gaming
COVID-19 Impact
Baraomter Levels High
Key Observations The gaming industry is highly reliant upon consumer confidence, access to discretionary income/capital, as well as a willingness and capability to travel. Given the severity and uncertainty surrounding the duration of the COVID-19 impact on the timing of the reopening of integrated resorts, many gaming companies have sought to draw down on their respective revolving credit facilities and/or tap the HY debt market to shore up additional liquidity. At this time, we are taking a cautious approach and prefer to invest in the top of the capital structure of companies we believe have sufficient cash buffers and solid management teams. As we have seen to date, the industry has reopened in a phased manner and the US regional markets, primarily outside of Las Vegas, have witnessed early signs of consumer foot traffic over the course of the last six to eight weeks. While the Las Vegas Strip has reopened, we expect this segment to rebound last, given the “fly-in” nature required for visitation. Outside of the US, we believe Macau and Singapore will experience a slow ramp-up period, as the local governments have maintained a very cautious approach to opening these markets due to heightened concerns about a second wave of COVID-19.
Retailing
COVID-19 Impact
Baraomter Levels High
Key Observations We believe that COVID-19 lockdowns and store closures are accelerating the pre-existing secular transition to online shopping across the world, thus putting pressure on general retail including department stores, shopping malls and other legacy formats. As a result, we are seeing a dramatic impact on sector credit quality with large IG issuers experiencing pressure from rating agencies and many weaker names facing bankruptcy/debt restructuring. Food retail, on the other hand, remains a safe haven. Beyond the initial surge in stockpiling, many consumers remain unable (in the case of lockdowns) or uninterested in dining out, which helps explain continued strong like-for-like revenue growth among food retailers. Looking ahead, we expect the hit to consumer pocketbooks to once again pressurize margins and drive rising discounter market shares.
Transportation
COVID-19 Impact
Baraomter Levels High
Key Observations Travel demand has increased sharply from the low level of demand experienced in April, but the recent rise in COVID-19 cases in certain parts of the US is creating more unwanted headwinds for the airlines. The pandemic continues to pressure travel demand, so the US airlines are focused on minimizing cash burn in 2020 by slashing capacity and costs. During Q2, the airlines were able to raise billions through secondary equity offerings, as well as multiple bank and bond deals, that will add cash to their balance sheets. The CARES Act is providing the US airlines with billions of financial assistance that further enhances their liquidity runway well into 2021. However, travel restrictions and quarantine requirements in Europe and various parts of the world are preventing US visitors from traveling abroad. In addition, the economic slowdown will delay a recovery in business travel, which is the most profitable segment for the US airlines. Large international events and conferences will not resume until the virus is contained or a viable vaccine is available, which appears to be most likely in 2021 at best.
Metals & Mining
COVID-19 Impact
Baraomter Levels Medium High
Key Observations Metals demand has been adversely impacted by the lower economic activity and subsequent weaker end-use markets observed with the COVID-19 pandemic. However, the supply side of the equation has not been immune with COVID-related mine/plant closures taking production offline which serves to mitigate inventory builds and provide a better starting point for when economies reignite; the inventory position was arguably better than at the beginning of the prior down cycle. Nonetheless, there is surplus metals overhang in many products but it can be drawn down quickly with an uptick in economic activity. We have seen the largest commodity consumer, China, begin ramping activity and as such tightened the market for copper (for example), providing ballast while developed markets look to reopen and recover. We continue to watch the impacts of the unprecedented size and scale of fiscal and monetary stimulus in the system, which have the potential to quickly balance the market.
Banks
COVID-19 Impact
Baraomter Levels Medium
Key Observations We maintain a large overweight to the highest-quality banks given resilient/low-risk business models, benign technicals, conservative credit ratings and attractive valuations. We expect a meaningful recession in 2020, but we believe banks will fare much better than expected given that they have the strongest balance sheets in decades. The duration and severity of the economic shutdown will determine both the degree of earnings decline and balance sheet damage, but meaningful fiscal and monetary stimulus combined with limited shareholder payouts should be supportive. Global regulatory best practices and conservative stress tests over the last decade provide strong pillars to our thesis that banks have grown into a stronger, safer and simpler industry.
Consumer
Products &
Apparel
COVID-19 Impact
Baraomter Levels Medium
Key Observations Most consumer products and apparel companies are less levered than retailers and do not carry the burden of monthly cash outflow for rent on a leased store base. Many have already outsourced production to other geographies to lessen exposure to tariff concerns. Currently, we have seen improved demand across consumer discretionary categories which bottomed-out in late-March/early-April. In branded apparel, the companies with strong brands and sophisticated omni-channel capabilities are best suited to benefit from the accelerating shift to online and gradual reopening of brick and mortar establishments. Looking ahead, companies are focusing on addressing supply-chain disruptions and changes in consumer buying habits post emergence from quarantine.
Health Care
COVID-19 Impact
Baraomter Levels Medium
Key Observations We favor managed care over providers in the current environment, as we see higher acuity, elective surgeries delayed to 2H20. This dynamic benefits managed care via lower medical loss ratios during 1H20, while many providers will see volumes delayed to later this year. Some elective procedures will not occur at all due to rising unemployment rates. Liquidity profiles for health care providers were recently bolstered via various provisions under the CARES Act. The Act provides a host of benefits available to health care providers in our coverage universe, $100 billion in direct grants for incremental costs and lost revenues related to COVID-19, changes to interest expense deduction and ~$450 billion of emergency loans, loan guarantees and other investments for businesses.
Food &
Beverage
COVID-19 Impact
Baraomter Levels Low
Key Observations The COVID-19 pandemic has provided short-term organic sales growth for packaged-food companies, but there are mounting cost pressures, including a lack of farm workers, which may affect the availability and cost of ingredients. Also, supply chains are being strained due to a flux in demand—with the larger, well capitalized packaged-food companies able to endure prolonged supply chain disruptions caused by the virus, but the smaller operators lacking the financial and operational flexibility. A rise in the infection rate may cause some production lines to shut down, while seasonal labor and transportation costs are rising.
Pharmaceuticals
COVID-19 Impact
Baraomter Levels Low
Key Observations In the IG sector, there have not been any product delivery delays. The focus continues to be on finding a vaccine and/or therapeutics to survive COVID-19. Within the HY segment, key market players have not cited any major disruptions to their supply chains but we would expect any negative impacts to come from a lower demand for drugs tied to elective surgeries, which have been reduced or delayed due to the pandemic.
Technology
COVID-19 Impact
Baraomter Levels Low
Key Observations At the outset of the COVID-19 crisis one of our chief concerns in technology had been potential Asia/China supply-chain disruptions. But Asian manufacturing is now experiencing only very limited disruptions and management commentary indicates no material issues, while the shift to a more work-from-home (WFH) economy has actually accelerated investments in both hardware and software. Looking forward and into next year, we believe that many subsectors including, for example, cloud computing, tech-related infrastructure and cybersecurity, will emerge from the crisis as winners.
Telecommunications & Media
COVID-19 Impact
Baraomter Levels Low
Key Observations Temporary retail store closures and reduced roaming charges given travel restrictions as well as broader macro weakness are putting pressure on telecom issuers’ revenues. On this note, we expect 2Q20 and 3Q20 consumer weakness, but that the weakness will be short-lived given rising demand for mobile and fixed connectivity and eventual (albeit delayed) 5G rollout post COVID-19. Furthermore, operator efforts around infrastructure asset sharing and cost optimization are powerful near- and medium-term mitigants. In media, substantial cuts in advertising budgets are inflicting damage on ad-driven business models such as legacy broadcasters and ad agencies, for example, thereby exacerbating existing structural pressures.
Utilities
COVID-19 Impact
Baraomter Levels Low
Key Observations Utilities have been adversely impacted by the stay-at-home orders as commercial and industrial load declined while residential load saw a mild uptick, but not enough to offset the decline despite higher margins for that part of the business. The potential for bad debts has risen with higher unemployment rates and we continue to watch upcoming rate case filings given the pressures from the consumer side and potential for regulatory pushback on authorized rates of returns.
Industry COVID-19 Impact Key Observations
Auto & Related Baraomter Levels High The global automotive sector is caught squarely in the eye of the COVID-19 storm, as the highly consumer-discretionary nature of light vehicle purchases depends on many factors, including consumer confidence, healthy household balance sheets, modest unemployment levels, attractive financing terms and stable used car residual values. All of the aforementioned items have been negatively impacted, which has led to dealerships being closed, production lines shut down and substantial cash burn rates at both the OEM and supplier levels due to the high fixed cost nature of their operations. While most automotive names entered this year with healthy balance sheets and sizable liquidity buffers, no company’s business model is equipped to survive extended periods of zero production/revenues. As such, we maintain a cautious stance.
Energy Baraomter Levels High The impacts of the “stay at home” policies from COVID continue to bite with material demand destruction. However, the trough has been worked through with economies reopening and demand ticking up, although it is still some 13% below pre-COVID levels. The physical oil market remains in an oversupplied position and balance restoration not only requires a more durable demand recovery but continued rational OPEC+ behavior. With recent higher prices some previously curtailed US production is returning but OPEC+ has also begun tapering its production cuts which should serve to provide a cap and floor in prices (and hopefully more stability).
Gaming Baraomter Levels High The gaming industry is highly reliant upon consumer confidence, access to discretionary income/capital, as well as a willingness and capability to travel. Given the severity and uncertainty surrounding the duration of the COVID-19 impact on the timing of the reopening of integrated resorts, many gaming companies have sought to draw down on their respective revolving credit facilities and/or tap the HY debt market to shore up additional liquidity. At this time, we are taking a cautious approach and prefer to invest in the top of the capital structure of companies we believe have sufficient cash buffers and solid management teams. As we have seen to date, the industry has reopened in a phased manner and the US regional markets, primarily outside of Las Vegas, have witnessed early signs of consumer foot traffic over the course of the last six to eight weeks. While the Las Vegas Strip has reopened, we expect this segment to rebound last, given the “fly-in” nature required for visitation. Outside of the US, we believe Macau and Singapore will experience a slow ramp-up period, as the local governments have maintained a very cautious approach to opening these markets due to heightened concerns about a second wave of COVID-19.
Retailing Baraomter Levels High We believe that COVID-19 lockdowns and store closures are accelerating the pre-existing secular transition to online shopping across the world, thus putting pressure on general retail including department stores, shopping malls and other legacy formats. As a result, we are seeing a dramatic impact on sector credit quality with large IG issuers experiencing pressure from rating agencies and many weaker names facing bankruptcy/debt restructuring. Food retail, on the other hand, remains a safe haven. Beyond the initial surge in stockpiling, many consumers remain unable (in the case of lockdowns) or uninterested in dining out, which helps explain continued strong like-for-like revenue growth among food retailers. Looking ahead, we expect the hit to consumer pocketbooks to once again pressurize margins and drive rising discounter market shares.
Transportation Baraomter Levels High Travel demand has increased sharply from the low level of demand experienced in April, but the recent rise in COVID-19 cases in certain parts of the US is creating more unwanted headwinds for the airlines. The pandemic continues to pressure travel demand, so the US airlines are focused on minimizing cash burn in 2020 by slashing capacity and costs. During Q2, the airlines were able to raise billions through secondary equity offerings, as well as multiple bank and bond deals, that will add cash to their balance sheets. The CARES Act is providing the US airlines with billions of financial assistance that further enhances their liquidity runway well into 2021. However, travel restrictions and quarantine requirements in Europe and various parts of the world are preventing US visitors from traveling abroad. In addition, the economic slowdown will delay a recovery in business travel, which is the most profitable segment for the US airlines. Large international events and conferences will not resume until the virus is contained or a viable vaccine is available, which appears to be most likely in 2021 at best.
Metals & Mining Baraomter Levels Medium High Metals demand has been adversely impacted by the lower economic activity and subsequent weaker end-use markets observed with the COVID-19 pandemic. However, the supply side of the equation has not been immune with COVID-related mine/plant closures taking production offline which serves to mitigate inventory builds and provide a better starting point for when economies reignite; the inventory position was arguably better than at the beginning of the prior down cycle. Nonetheless, there is surplus metals overhang in many products but it can be drawn down quickly with an uptick in economic activity. We have seen the largest commodity consumer, China, begin ramping activity and as such tightened the market for copper (for example), providing ballast while developed markets look to reopen and recover. We continue to watch the impacts of the unprecedented size and scale of fiscal and monetary stimulus in the system, which have the potential to quickly balance the market.
Banks Baraomter Levels Medium We maintain a large overweight to the highest-quality banks given resilient/low-risk business models, benign technicals, conservative credit ratings and attractive valuations. We expect a meaningful recession in 2020, but we believe banks will fare much better than expected given that they have the strongest balance sheets in decades. The duration and severity of the economic shutdown will determine both the degree of earnings decline and balance sheet damage, but meaningful fiscal and monetary stimulus combined with limited shareholder payouts should be supportive. Global regulatory best practices and conservative stress tests over the last decade provide strong pillars to our thesis that banks have grown into a stronger, safer and simpler industry.
Consumer
Products &
Apparel
Baraomter Levels Medium Most consumer products and apparel companies are less levered than retailers and do not carry the burden of monthly cash outflow for rent on a leased store base. Many have already outsourced production to other geographies to lessen exposure to tariff concerns. Currently, we have seen improved demand across consumer discretionary categories which bottomed-out in late-March/early-April. In branded apparel, the companies with strong brands and sophisticated omni-channel capabilities are best suited to benefit from the accelerating shift to online and gradual reopening of brick and mortar establishments. Looking ahead, companies are focusing on addressing supply-chain disruptions and changes in consumer buying habits post emergence from quarantine.
Health Care Baraomter Levels Medium We favor managed care over providers in the current environment, as we see higher acuity, elective surgeries delayed to 2H20. This dynamic benefits managed care via lower medical loss ratios during 1H20, while many providers will see volumes delayed to later this year. Some elective procedures will not occur at all due to rising unemployment rates. Liquidity profiles for health care providers were recently bolstered via various provisions under the CARES Act. The Act provides a host of benefits available to health care providers in our coverage universe, $100 billion in direct grants for incremental costs and lost revenues related to COVID-19, changes to interest expense deduction and ~$450 billion of emergency loans, loan guarantees and other investments for businesses.
Food &
Beverage
Baraomter Levels Low The COVID-19 pandemic has provided short-term organic sales growth for packaged-food companies, but there are mounting cost pressures, including a lack of farm workers, which may affect the availability and cost of ingredients. Also, supply chains are being strained due to a flux in demand—with the larger, well capitalized packaged-food companies able to endure prolonged supply chain disruptions caused by the virus, but the smaller operators lacking the financial and operational flexibility. A rise in the infection rate may cause some production lines to shut down, while seasonal labor and transportation costs are rising.
Pharmaceuticals Baraomter Levels Low In the IG sector, there have not been any product delivery delays. The focus continues to be on finding a vaccine and/or therapeutics to survive COVID-19. Within the HY segment, key market players have not cited any major disruptions to their supply chains but we would expect any negative impacts to come from a lower demand for drugs tied to elective surgeries, which have been reduced or delayed due to the pandemic.
Technology Baraomter Levels Low At the outset of the COVID-19 crisis one of our chief concerns in technology had been potential Asia/China supply-chain disruptions. But Asian manufacturing is now experiencing only very limited disruptions and management commentary indicates no material issues, while the shift to a more work-from-home (WFH) economy has actually accelerated investments in both hardware and software. Looking forward and into next year, we believe that many subsectors including, for example, cloud computing, tech-related infrastructure and cybersecurity, will emerge from the crisis as winners.
Telecommunications & Media Baraomter Levels Low Temporary retail store closures and reduced roaming charges given travel restrictions as well as broader macro weakness are putting pressure on telecom issuers’ revenues. On this note, we expect 2Q20 and 3Q20 consumer weakness, but that the weakness will be short-lived given rising demand for mobile and fixed connectivity and eventual (albeit delayed) 5G rollout post COVID-19. Furthermore, operator efforts around infrastructure asset sharing and cost optimization are powerful near- and medium-term mitigants. In media, substantial cuts in advertising budgets are inflicting damage on ad-driven business models such as legacy broadcasters and ad agencies, for example, thereby exacerbating existing structural pressures.
Utilities Baraomter Levels Low Utilities have been adversely impacted by the stay-at-home orders as commercial and industrial load declined while residential load saw a mild uptick, but not enough to offset the decline despite higher margins for that part of the business. The potential for bad debts has risen with higher unemployment rates and we continue to watch upcoming rate case filings given the pressures from the consumer side and potential for regulatory pushback on authorized rates of returns.