Macro Perspective

Following the sharpest monthly decline in risk assets on record in March, which occurred due to the unexpected coronavirus/COVID-19 pandemic and oil price shock, Western Asset’s base case outlook is for a longer, U-shaped global economic recovery. This is premised on the view that near-term growth will be severely impacted, but that this shortfall will prove to be largely transitory as policymakers push to resuscitate economic activity. On this front, significant central bank policy easing, extensive liquidity provisions and enhanced fiscal stimulus are already underway. Together, they should help temper the negative impact of restrictive social distancing policies on global economies and enable markets to function more smoothly. As the actual timing of any eventual recovery will be tied to the length and severity of the pandemic—a key uncertainty at this point—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 outlook and describe where we see value across global fixed-income markets.

Default Risk: Are We at a Tipping Point?
Investment-Grade (IG) Credit

Despite significant headline noise around “fallen angels,” we do not expect a significant number of IG-rated companies to default. With IG companies able to access the primary markets again (after reopening) they have been able to begin terming out near-term maturities and some have begun paying down any revolvers they have drawn. The Fed has stepped in to address the liquidity risk concerns before they morphed into a more widespread solvency issue. In addition, airlines—one of the most impacted industries, and one that had been deemed in a critical state—was also given a direct lifeline via the CARES Act. However, some industries remain very susceptible to a prolonged lockdown; these include cruise operators, gaming and select retail names.

High-Yield (HY) Credit

Option-adjusted spread (OAS) levels on the Bloomberg Barclays US High Yield Index as of late-April imply a 10% default rate for each of the next five years assuming a recovery rate of 30%. That equates to four out of every 10 issuers in the asset class defaulting. We expect the default rate to move up throughout 2020 (mainly driven by the energy sector) and do not disagree with Wall Street estimates of 8% to 10% for 2020. But we would also expect defaults to plateau at that level and as the economy begins returning to its long-term growth pattern to then correct back to the historical average range of 3% to 4% going forward.

Bank Loans

Wall Street estimates range from 8% to 9% with some analysts forecasting that if the US economic stoppage lasts through the summer, default rates could rise to 10% or higher. However, we expect a modest re-opening of the economy, which should contain the default rate in the range of 7% to 8% in 2020. We have already seen instances of lenders offering issuers concessions to terms of their agreements. There have been many headlines of lenders agreeing to forbearance as companies navigate the unprecedented economic environment. These actions could very well keep defaults below the forecasts mentioned.

CLOs

In a scenario of higher-than-expected loan defaults, we would expect market sentiment around the CLO market to be impacted. However, the risk of impairment for AAA CLOs, the senior most part of a CLO capital structure, is remote, as these have significant subordination support from the lower tranches. Overall, the long-term average annual default rate for CLOs is 0.70%, according to Wells Fargo, which has maintained the median default rate for the CLO universe on a monthly basis going back to January 2001. The Fed stepped in and expanded the Term Asset-Backed Securities Loan Facility (TALF) as well as the Primary and Secondary Corporate Credit Facility to include CLOs. Though the direct impact for CLOs is extremely limited under the new guidelines, they do somewhat provide a floor.

Structured Credit

Market expectations of default risk, mainly in the lower-rated segments of the non-agency mortgage space, have risen over the past few weeks. The pricing of these securities is discounting severe scenarios last seen during the GFC. For example, we are cautious on hotels and retail properties in the CMBS space. That stated, we believe that there are many reasons to be optimistic. The GFC was the direct result of an inflated housing market fueled by a credit bubble in mortgage lending, with subprime lending defining its pinnacle. We do not see these conditions present today; housing is in a much more stable place with record low levels of construction and extremely tight credit standards. Aggregate US consumer fundamentals entered the COVID-19 pandemic in a much stronger position, with debt as a percentage of income at the lowest level in over a decade.

Municipals Market: Recent Market Dislocation Presents Opportunities

Following the 10.9% decline of the Bloomberg Barclay’s Municipal Bond Index observed from the recent peak-to-trough ending March 23, the muni market has since returned 8.2% through mid-April. The average yield of the Bloomberg Barclays Municipal Bond Index declined 1.6% through mid-April, retracing approximately 70% of the 2.4% yield increase observed in mid-March. While market liquidity has improved and the new-issue calendar has slowly normalized, interest has been bifurcated and firmer in higher-quality names while more challenged for lower-grade structures. We anticipate near-term technicals to remain challenged as negative headlines highlighting budget stresses and credit challenges associated with COVID-19 will likely persist over the medium term, despite robust federal stimulus.

We remain constructive on the municipal asset class, as the retail flight out of market and into higher-quality credits has offered opportunities for investors to be better compensated for marginal credit risk. However, we anticipate negative sentiment and headlines to persist as long as municipalities remain on the front lines combating social and economic challenges from COVID-19.

Despite a perceived flight to quality toward general obligation securities, we believe long-term investors will be better served by remaining diversified across sound IG revenue bonds with healthy liquidity profiles that will be supportive through a temporary demand shock. We seek to avoid below-IG security structures, particularly recent-vintage project finance transactions that rely on capitalized interest or aggressive economic assumptions to meet debt service requirements, and will not likely benefit from federal economic support during the downturn.

Western Asset Coronavirus Task Force Update

Over the past several weeks, in response to containment measures implemented in March, global COVID-19 cases/deaths have started to peak, while forecasts of future stress on health systems have become less worrisome. Important data surrounding the total number of infected patients, and thus mortality rates, is still elusive in the absence of more widespread testing. However, positive trends in the infection data have encouraged policymakers and politicians to start discussing the gradual release of containment measures and the resumption of economic activity. We expect that in order to relax the engineered lockdown that has temporarily strangled the global economy, the following factors will need to be in place:

  • A sustained reduction in new COVID-19 cases,
  • Adequate testing and contact tracing regimes,
  • Sufficient health care capacity for handling new cases,
  • Plans to protect vulnerable populations until a long-term solution is found, and
  • Development progress on therapeutics and/or vaccines.

Given continual progress on this checklist, we have seen some European countries and US states start to gradually release containment measures, with much of the developed market likely to follow during the month of May. As the lockdown has crushed economic activity in April, it’s clear that 2Q20 global GDP will be very weak, but with economic activity expected to start rebounding in May/June, we believe 3Q20 will show sequential progress. Assuming that the return-to-work measures outlined earlier are effective and infections remain low, we anticipate that utilization will increase across large parts of the economy in 4Q20, with 2021 showing a more broad-based recovery that will include more consumer sectors. We do remain cautious on sectors that may be vulnerable over the longer term to social distancing and changed consumer behavior, such as travel, entertainment and sports. Key risks that we are monitoring include: a) the threat of second waves of infection that would prolong containment measures and economic recovery and b) changes in behavior of the virus; mutation could increase severity, but more asymptomatic cases could improve herd immunity.

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 Markets

The Fed is now directly engaged in supporting the corporate bond market and liquidity imbalances; this should help to support continued spread compression against a backdrop of massive new-issue supply. Our bias in the near term is on high-quality issuers with robust franchises and longer-dated new issues of infrequent borrowers offering generous spread concessions. In Europe, ECB purchases will likely support spreads and the liquidity of IG markets moving forward. We expect a number of sectors to demonstrate resilience while others face downgrade pressure. Companies are reaching for liquidity, bringing elevated supply despite a quiet M&A picture. We prefer financials and REITs over credits in sectors more directly impacted by the COVID-19 outbreak.

High-Yield Markets

Fed support may not be enough to limit default risk in subsectors most impacted by COVID-19. Regardless of the timing and slope of the eventual recovery, remaining defensive with regard to issue, industry and credit quality is the prudent path for now. We remain overweight consumers, health care and communications. New issuance may provide buy opportunities as terms will be favorable. In Europe, the economic outlook is challenging in the near term; we expect default rates will increase and that credit ratings will remain under downward pressure. Spreads have adjusted accordingly, with levels not seen since the eurozone crisis. Industries to watch include retail, autos and transportation.

Bank Loan Markets

Higher risk credits have already accessed capital markets for liquidity. If this trend continues, we should see significant additional demand for risk (as default risk declines) against a backdrop of limited new issuance. Ongoing market volatility will provide highly attractive entry points into defensive names within the loan market. While defensive industries have recovered more than cyclical sectors, we believe industries like consumer staples, health care and communication offer a better risk/return profile given the uncertainty of the economic shutdown.

CLO Markets

Recent Fed initiatives have helped to stabilize the CLO market, especially AAA tranches. While selling pressure has subsided, the first round of relevant earnings from loan issuers will provide a preview of potential ratings downgrades and defaults. Until we see clarity on this front as well as regarding the length and extent of the COVID-related shutdown, lower-rated CLOs may continue to trade at levels that reflect a somewhat draconian set of outcomes on the broader loan market. At present, AAAs to higher quality BBB tranches are attractive relative to other segments of the HY and Loan market. However, BB rated CLOs are likely to remain range-bound at more depressed levels.

Emerging Markets

Compared to the developed market (DM) world, EM constraints limit the degree to which authorities can use monetary and fiscal levers to respond to crises and oil price shocks. We anticipate an eventual meaningful uptick in sovereign supply as balance sheets are used to absorb fallout from fiscal stimulus and to bail out the private sector. We consider select IG-rated EM USD-denominated sovereigns attractive from both a carry and total return standpoint, but we remain vigilant about the potential for fallen angels. EM corporates have outperformed many other asset classes year to date, given their lower spread duration. We find value in front-end EM corporate bonds and high-quality longer-dated paper.

Structured Credit Markets

We prefer legacy RMBS/new-issue re-performing loan deals as many of these borrowers have already withstood similar disruptions. In the CMBS space, valuations are favorable relative to fundamentals. Here, we prefer short-duration, well-structured single-asset single-borrower securitizations; in conduit deals we see better value in AAA rated bonds. Turning to the ABS market, reduced travel is expected to have a negative impact on restaurants and auto sales. We prefer senior ABS classes from sectors of TALF-eligible collateral such as auto, cards, equipment and student loans.

Default Risk: Are We at a Tipping Point?
Barometer Levels

Fear over rising liquidity stress, credit impairments and default risk across credit markets remains elevated as we move into 2Q20. In the following, we provide our Investment Team’s views on these risks for investment-grade, high-yield and structured credit—the key sectors under investor scrutiny.

Investment-Grade (IG) Credit

Despite significant headline noise around “fallen angels,” we do not expect a significant number of IG-rated companies to default. With IG companies able to access the primary markets again (after reopening) they have been able to begin terming out near-term maturities and some have begun paying down any revolvers they have drawn. The Fed has stepped in to address the liquidity risk concerns before they morphed into a more widespread solvency issue. In addition, airlines—one of the most impacted industries, and one that had been deemed in a critical state—was also given a direct lifeline via the CARES Act. However, some industries remain very susceptible to a prolonged lockdown; these include cruise operators, gaming and select retail names.

High-Yield (HY) Credit

Option-adjusted spread (OAS) levels on the Bloomberg Barclays US High Yield Index as of late-April imply a 10% default rate for each of the next five years assuming a recovery rate of 30%. That equates to four out of every 10 issuers in the asset class defaulting. We expect the default rate to move up throughout 2020 (mainly driven by the energy sector) and do not disagree with Wall Street estimates of 8% to 10% for 2020. But we would also expect defaults to plateau at that level and as the economy begins returning to its long-term growth pattern to then correct back to the historical average range of 3% to 4% going forward.

Bank Loans

Wall Street estimates range from 8% to 9% with some analysts forecasting that if the US economic stoppage lasts through the summer, default rates could rise to 10% or higher. However, we expect a modest re-opening of the economy, which should contain the default rate in the range of 7% to 8% in 2020. We have already seen instances of lenders offering issuers concessions to terms of their agreements. There have been many headlines of lenders agreeing to forbearance as companies navigate the unprecedented economic environment. These actions could very well keep defaults below the forecasts mentioned.

CLOs

In a scenario of higher-than-expected loan defaults, we would expect market sentiment around the CLO market to be impacted. However, the risk of impairment for AAA CLOs, the senior most part of a CLO capital structure, is remote, as these have significant subordination support from the lower tranches. Overall, the long-term average annual default rate for CLOs is 0.70%, according to Wells Fargo, which has maintained the median default rate for the CLO universe on a monthly basis going back to January 2001. The Fed stepped in and expanded the Term Asset-Backed Securities Loan Facility (TALF) as well as the Primary and Secondary Corporate Credit Facility to include CLOs. Though the direct impact for CLOs is extremely limited under the new guidelines, they do somewhat provide a floor.

Structured Credit

Market expectations of default risk, mainly in the lower-rated segments of the non-agency mortgage space, have risen over the past few weeks. The pricing of these securities is discounting severe scenarios last seen during the GFC. For example, we are cautious on hotels and retail properties in the CMBS space. That stated, we believe that there are many reasons to be optimistic. The GFC was the direct result of an inflated housing market fueled by a credit bubble in mortgage lending, with subprime lending defining its pinnacle. We do not see these conditions present today; housing is in a much more stable place with record low levels of construction and extremely tight credit standards. Aggregate US consumer fundamentals entered the COVID-19 pandemic in a much stronger position, with debt as a percentage of income at the lowest level in over a decade.

Municipals Market: Recent Market Dislocation Presents Opportunities
Pie Dislcation

Following the 10.9% decline of the Bloomberg Barclay’s Municipal Bond Index observed from the recent peak-to-trough ending March 23, the muni market has since returned 8.2% through mid-April. The average yield of the Bloomberg Barclays Municipal Bond Index declined 1.6% through mid-April, retracing approximately 70% of the 2.4% yield increase observed in mid-March. While market liquidity has improved and the new-issue calendar has slowly normalized, interest has been bifurcated and firmer in higher-quality names while more challenged for lower-grade structures. We anticipate near-term technicals to remain challenged as negative headlines highlighting budget stresses and credit challenges associated with COVID-19 will likely persist over the medium term, despite robust federal stimulus.

We remain constructive on the municipal asset class, as the retail flight out of market and into higher-quality credits has offered opportunities for investors to be better compensated for marginal credit risk. However, we anticipate negative sentiment and headlines to persist as long as municipalities remain on the front lines combating social and economic challenges from COVID-19.

Despite a perceived flight to quality toward general obligation securities, we believe long-term investors will be better served by remaining diversified across sound IG revenue bonds with healthy liquidity profiles that will be supportive through a temporary demand shock. We seek to avoid below-IG security structures, particularly recent-vintage project finance transactions that rely on capitalized interest or aggressive economic assumptions to meet debt service requirements, and will not likely benefit from federal economic support during the downturn.

Western Asset Coronavirus Task Force Update
Coronavirus Icon

Over the past several weeks, in response to containment measures implemented in March, global COVID-19 cases/deaths have started to peak, while forecasts of future stress on health systems have become less worrisome. Important data surrounding the total number of infected patients, and thus mortality rates, is still elusive in the absence of more widespread testing. However, positive trends in the infection data have encouraged policymakers and politicians to start discussing the gradual release of containment measures and the resumption of economic activity. We expect that in order to relax the engineered lockdown that has temporarily strangled the global economy, the following factors will need to be in place:

  • A sustained reduction in new COVID-19 cases,
  • Adequate testing and contact tracing regimes,
  • Sufficient health care capacity for handling new cases,
  • Plans to protect vulnerable populations until a long-term solution is found, and
  • Development progress on therapeutics and/or vaccines.

Given continual progress on this checklist, we have seen some European countries and US states start to gradually release containment measures, with much of the developed market likely to follow during the month of May. As the lockdown has crushed economic activity in April, it’s clear that 2Q20 global GDP will be very weak, but with economic activity expected to start rebounding in May/June, we believe 3Q20 will show sequential progress. Assuming that the return-to-work measures outlined earlier are effective and infections remain low, we anticipate that utilization will increase across large parts of the economy in 4Q20, with 2021 showing a more broad-based recovery that will include more consumer sectors. We do remain cautious on sectors that may be vulnerable over the longer term to social distancing and changed consumer behavior, such as travel, entertainment and sports. Key risks that we are monitoring include: a) the threat of second waves of infection that would prolong containment measures and economic recovery and b) changes in behavior of the virus; mutation could increase severity, but more asymptomatic cases could improve herd immunity.

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 Markets

The Fed is now directly engaged in supporting the corporate bond market and liquidity imbalances; this should help to support continued spread compression against a backdrop of massive new-issue supply. Our bias in the near term is on high-quality issuers with robust franchises and longer-dated new issues of infrequent borrowers offering generous spread concessions. In Europe, ECB purchases will likely support spreads and the liquidity of IG markets moving forward. We expect a number of sectors to demonstrate resilience while others face downgrade pressure. Companies are reaching for liquidity, bringing elevated supply despite a quiet M&A picture. We prefer financials and REITs over credits in sectors more directly impacted by the COVID-19 outbreak.

High-Yield Markets

Fed support may not be enough to limit default risk in subsectors most impacted by COVID-19. Regardless of the timing and slope of the eventual recovery, remaining defensive with regard to issue, industry and credit quality is the prudent path for now. We remain overweight consumers, health care and communications. New issuance may provide buy opportunities as terms will be favorable. In Europe, the economic outlook is challenging in the near term; we expect default rates will increase and that credit ratings will remain under downward pressure. Spreads have adjusted accordingly, with levels not seen since the eurozone crisis. Industries to watch include retail, autos and transportation.

Bank Loan Markets

Higher risk credits have already accessed capital markets for liquidity. If this trend continues, we should see significant additional demand for risk (as default risk declines) against a backdrop of limited new issuance. Ongoing market volatility will provide highly attractive entry points into defensive names within the loan market. While defensive industries have recovered more than cyclical sectors, we believe industries like consumer staples, health care and communication offer a better risk/return profile given the uncertainty of the economic shutdown.

CLO Markets

Recent Fed initiatives have helped to stabilize the CLO market, especially AAA tranches. While selling pressure has subsided, the first round of relevant earnings from loan issuers will provide a preview of potential ratings downgrades and defaults. Until we see clarity on this front as well as regarding the length and extent of the COVID-related shutdown, lower-rated CLOs may continue to trade at levels that reflect a somewhat draconian set of outcomes on the broader loan market. At present, AAAs to higher quality BBB tranches are attractive relative to other segments of the HY and Loan market. However, BB rated CLOs are likely to remain range-bound at more depressed levels.

Emerging Markets

Compared to the developed market (DM) world, EM constraints limit the degree to which authorities can use monetary and fiscal levers to respond to crises and oil price shocks. We anticipate an eventual meaningful uptick in sovereign supply as balance sheets are used to absorb fallout from fiscal stimulus and to bail out the private sector. We consider select IG-rated EM USD-denominated sovereigns attractive from both a carry and total return standpoint, but we remain vigilant about the potential for fallen angels. EM corporates have outperformed many other asset classes year to date, given their lower spread duration. We find value in front-end EM corporate bonds and high-quality longer-dated paper.

Structured Credit Markets

We prefer legacy RMBS/new-issue re-performing loan deals as many of these borrowers have already withstood similar disruptions. In the CMBS space, valuations are favorable relative to fundamentals. Here, we prefer short-duration, well-structured single-asset single-borrower securitizations; in conduit deals we see better value in AAA rated bonds. Turning to the ABS market, reduced travel is expected to have a negative impact on restaurants and auto sales. We prefer senior ABS classes from sectors of TALF-eligible collateral such as auto, cards, equipment and student loans.

Global Corporate Credit Sector Views

Auto & Related
Trade War Risk
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 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
Trade War Risk
Baraomter Levels High
Key Observations The impacts of the “stay at home” policies from COVID are biting with material demand destruction. The lack of transportation and subsequent lower refinery utilization, hence reduced demand for crude oil, has resulted in an oversupplied physical market with a lack of storage availability, almost reaching capacity. The supply side has attempted to “fix” its side of the problem with the OPEC+ agreement taking barrels off the market, beginning in May and running through April 2022. This only came after a short-lived price war that hurt all producers to varying degrees. The continued lower realized prices and the “market mechanics” leading producers to shut in uneconomic production. However, these current production curtailments do not offset the observed demand destruction, but could set the stage for better future pricing. The return of demand post COVID—the pace and trajectory of course is still unknown—would be greeted with continued supply restraint. Inventories would be worked off as supply is managed and we see a return to market supply/demand balance over time. Net/net, what is needed is a return of demand by reigniting economies and continued production shut-ins.
Gaming
Trade War Risk
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 re-opening 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. We believe that the industry will likely reopen in a phased manner and that foreign markets, primarily Singapore and Macau, should see the first green shoots of consumer foot traffic beginning in June. In the US, we expect regional gaming operators to rebound first—most likely in late-May/early-June—albeit at significantly lower levels than those seen in the last five years. The Las Vegas Strip is likely to rebound last, in our view, given the “fly-in” nature required for stays.
Retailing
Trade War Risk
Baraomter Levels High
Key Observations We believe that COVID-19 lockdowns and non-food retail store closures are accelerating the pre-existing secular transition to online shopping across the world, thus putting pressure on department stores, shopping malls and other legacy formats. As a result, we are seeing a dramatic impact on credit quality with well-known operators losing their IG ratings while in HY we expect a fresh wave of debt restructurings, particularly in Europe. Food retail, on the other hand, remains a relative safe haven, with issuer disclosures indicating the surge in consumer stockpiling positively impacting revenue, though we view this as something of a “one-off” which may in some cases be offset by COVID-19 related additional operating expenditures. Looking ahead, we expect the hit to consumer pocketbooks to once again pressurize margins and possibly drive rising discounter market shares.
Transportation
Trade War Risk
Baraomter Levels High
Key Observations The passenger airline sector is one of the sectors most significantly affected by COVID-19 given its exposure to travel restrictions and sensitivity to consumer demand and sentiment. Lower fuel prices serve as a modest tailwind, but demand for air travel is not expected to recover until 2021. Since mid-March 2020, the global airlines have parked thousands of planes, deferred new aircraft deliveries and slashed costs. In April 2020, the US airlines received $25 billion in grants and loans to pay flight attendants, pilots and other employees for the next six months. However, over the next several months, certain weaker airlines, which are not national flag carriers and don’t qualify for government assistance, may need to restructure or liquidate. By the end of 2020, the global airline industry is expected to contract by at least 20% and may not fully recover to 2019 levels of flying until 2023 or later.
Metals & Mining
Trade War Risk
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, producers have been reacting with safety as their top priority, focused upon liquidity preservation and rationalizing operations while continuing to serve customers. This has resulted in a production slowdown (i.e., idling of mines), which has provided a partial offset. Consequently, inventories are not building as fast, but the industry came into 2020 with a better inventory position than in prior down cycles. In the interim, surplus metal expectations remain. As we look forward, balance may be restored more quickly given the sheer size and scale of fiscal and monetary stimulus. China has already begun to increase activity after the peak of its COVID-19 crisis. As China is a consumer of 50% of most commodities, this may provide some ballast while Western economies find a footing.
Banks
Trade War Risk
Baraomter Levels Medium
Key Observations We recommend a large overweight to the highest-quality banks given resilient/low-risk business models, benign technicals, conservative credit ratings and attractive valuation. 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
Trade War Risk
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. Demand for household and personal care products has remained stable and, if anything, has increased given higher usage of sanitization products and pantry loading of staples. In branded apparel, the companies with strong brands and sophisticated omni-channel capabilities are best suited to benefit from the accelerating shift to online. In their efforts to preserve liquidity and improve cash balances, companies have drawn on their revolvers, suspended dividends and/or share buybacks and raised debt to bolster liquidity.
Health Care
Trade War Risk
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. 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
Trade War Risk
Baraomter Levels Low
Key Observations Food companies, which have historically operated with modest leverage, have been deemed essential businesses, so they have not been adversely impacted by the COVID-19 pandemic. Nervous consumers have been pantry stocking and preparing more meals at home, which has disproportionately benefited food retailers and their suppliers. However, consumer demand for perishables like produce and butter is not sufficient to absorb the sudden glut created by the widespread closures of restaurants and food services operations as a result of the pandemic.
Pharmaceuticals
Trade War Risk
Baraomter Levels Low
Key Observations The focus over the past month has been on potential threats to the sector supply chain. With many Application Program Interface (API) tools sourced from China and India, and with lockdown orders in place, there may be disruption to the global supply chain. For example, roughly 40% to 50% of US generic industry product is sourced from India while India imports nearly 70% of its APIs from China. 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/delayed due to the pandemic.
Technology
Trade War Risk
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 limited disruptions and management commentary indicates no material issues. On the contrary, we believe that many subsectors including, for example, cloud computing, tech-related infrastructure and cybersecurity, will emerge from the crisis as winners.
Telecommunications & Media
Trade War Risk
Baraomter Levels Low
Key Observations We believe that retail store closures as well as broader COVID-19 induced macro weakness will put pressure on telecom issuers’ revenues. On this note, we expect 2Q20 and 3Q20 consumer weakness in tablets, PCs and phones, but that the weakness will be short-lived given rising demand and eventual (albeit delayed) 5G rollout post COVID. Moreover, we expect the effect to be limited as mobile and fixed connectivity are becoming more essential than ever. Furthermore, operator efforts around infrastructure asset sharing and cost optimization are powerful near- and medium-term mitigants. In media, we expect substantial cuts in advertising budgets to inflict damage on ad-driven business models, including legacy broadcasters and ad agencies to name but a few subsectors.
Utilities
Trade War Risk
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. Given the essential nature of operations, utilities should fare better than other sectors. For now, the potential for increased bad debts has risen with higher unemployment rates and the timing of rate case filings in focus given the pressures from the consumer side and potential for regulatory pushback on authorized rates of returns. Management teams have been proactive in preserving access to liquidity with revolver draws. Many have arranged short-dated term loans in order to continue executing on their investment plans despite still having access to capital markets.
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 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 are biting with material demand destruction. The lack of transportation and subsequent lower refinery utilization, hence reduced demand for crude oil, has resulted in an oversupplied physical market with a lack of storage availability, almost reaching capacity. The supply side has attempted to “fix” its side of the problem with the OPEC+ agreement taking barrels off the market, beginning in May and running through April 2022. This only came after a short-lived price war that hurt all producers to varying degrees. The continued lower realized prices and the “market mechanics” leading producers to shut in uneconomic production. However, these current production curtailments do not offset the observed demand destruction, but could set the stage for better future pricing. The return of demand post COVID—the pace and trajectory of course is still unknown—would be greeted with continued supply restraint. Inventories would be worked off as supply is managed and we see a return to market supply/demand balance over time. Net/net, what is needed is a return of demand by reigniting economies and continued production shut-ins.
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 re-opening 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. We believe that the industry will likely reopen in a phased manner and that foreign markets, primarily Singapore and Macau, should see the first green shoots of consumer foot traffic beginning in June. In the US, we expect regional gaming operators to rebound first—most likely in late-May/early-June—albeit at significantly lower levels than those seen in the last five years. The Las Vegas Strip is likely to rebound last, in our view, given the “fly-in” nature required for stays.
Retailing Baraomter Levels High We believe that COVID-19 lockdowns and non-food retail store closures are accelerating the pre-existing secular transition to online shopping across the world, thus putting pressure on department stores, shopping malls and other legacy formats. As a result, we are seeing a dramatic impact on credit quality with well-known operators losing their IG ratings while in HY we expect a fresh wave of debt restructurings, particularly in Europe. Food retail, on the other hand, remains a relative safe haven, with issuer disclosures indicating the surge in consumer stockpiling positively impacting revenue, though we view this as something of a “one-off” which may in some cases be offset by COVID-19 related additional operating expenditures. Looking ahead, we expect the hit to consumer pocketbooks to once again pressurize margins and possibly drive rising discounter market shares.
Transportation Baraomter Levels High The passenger airline sector is one of the sectors most significantly affected by COVID-19 given its exposure to travel restrictions and sensitivity to consumer demand and sentiment. Lower fuel prices serve as a modest tailwind, but demand for air travel is not expected to recover until 2021. Since mid-March 2020, the global airlines have parked thousands of planes, deferred new aircraft deliveries and slashed costs. In April 2020, the US airlines received $25 billion in grants and loans to pay flight attendants, pilots and other employees for the next six months. However, over the next several months, certain weaker airlines, which are not national flag carriers and don’t qualify for government assistance, may need to restructure or liquidate. By the end of 2020, the global airline industry is expected to contract by at least 20% and may not fully recover to 2019 levels of flying until 2023 or later.
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, producers have been reacting with safety as their top priority, focused upon liquidity preservation and rationalizing operations while continuing to serve customers. This has resulted in a production slowdown (i.e., idling of mines), which has provided a partial offset. Consequently, inventories are not building as fast, but the industry came into 2020 with a better inventory position than in prior down cycles. In the interim, surplus metal expectations remain. As we look forward, balance may be restored more quickly given the sheer size and scale of fiscal and monetary stimulus. China has already begun to increase activity after the peak of its COVID-19 crisis. As China is a consumer of 50% of most commodities, this may provide some ballast while Western economies find a footing.
Banks Baraomter Levels Medium We recommend a large overweight to the highest-quality banks given resilient/low-risk business models, benign technicals, conservative credit ratings and attractive valuation. 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. Demand for household and personal care products has remained stable and, if anything, has increased given higher usage of sanitization products and pantry loading of staples. In branded apparel, the companies with strong brands and sophisticated omni-channel capabilities are best suited to benefit from the accelerating shift to online. In their efforts to preserve liquidity and improve cash balances, companies have drawn on their revolvers, suspended dividends and/or share buybacks and raised debt to bolster liquidity.
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. 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 Food companies, which have historically operated with modest leverage, have been deemed essential businesses, so they have not been adversely impacted by the COVID-19 pandemic. Nervous consumers have been pantry stocking and preparing more meals at home, which has disproportionately benefited food retailers and their suppliers. However, consumer demand for perishables like produce and butter is not sufficient to absorb the sudden glut created by the widespread closures of restaurants and food services operations as a result of the pandemic.
Pharmaceuticals Baraomter Levels Low The focus over the past month has been on potential threats to the sector supply chain. With many Application Program Interface (API) tools sourced from China and India, and with lockdown orders in place, there may be disruption to the global supply chain. For example, roughly 40% to 50% of US generic industry product is sourced from India while India imports nearly 70% of its APIs from China. 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/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 limited disruptions and management commentary indicates no material issues. On the contrary, 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 We believe that retail store closures as well as broader COVID-19 induced macro weakness will put pressure on telecom issuers’ revenues. On this note, we expect 2Q20 and 3Q20 consumer weakness in tablets, PCs and phones, but that the weakness will be short-lived given rising demand and eventual (albeit delayed) 5G rollout post COVID. Moreover, we expect the effect to be limited as mobile and fixed connectivity are becoming more essential than ever. Furthermore, operator efforts around infrastructure asset sharing and cost optimization are powerful near- and medium-term mitigants. In media, we expect substantial cuts in advertising budgets to inflict damage on ad-driven business models, including legacy broadcasters and ad agencies to name but a few subsectors.
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. Given the essential nature of operations, utilities should fare better than other sectors. For now, the potential for increased bad debts has risen with higher unemployment rates and the timing of rate case filings in focus given the pressures from the consumer side and potential for regulatory pushback on authorized rates of returns. Management teams have been proactive in preserving access to liquidity with revolver draws. Many have arranged short-dated term loans in order to continue executing on their investment plans despite still having access to capital markets.