Macro Perspective

Western Asset expects that the second half of the year should see very strong growth in global GDP as the world economy reopens. That stated, we are cautious about extrapolating short-term cyclical boosts into a presumption of a higher secular trend rate of growth or inflation. The secular challenges that have kept US and global growth to a moderate pace at best over the last several decades persist. These include the stagnation of Western societies’ middle-class wages, aging demographics and rising global debt burdens. Moreover, the small and medium-sized business destruction in many countries not seen since the Great Depression may take years to repair. Given this backdrop, Western Asset expects central banks to remain extraordinarily accommodative for the foreseeable future. We aim to position our portfolios to withstand further market volatility, yet remain flexible enough to capture value opportunities as they appear. Here, we provide a summary of the key drivers behind our global credit outlook and details about where we see value across credit markets.

Growth of the Collateralized Loan Obligation (CLO) Asset Class

The underlying collateral of the CLO market, bank loans, has grown to over $1.2 trillion and remains an important source of capital for US corporations to fund their operations. As of today, CLO vehicles own approximately 60% of the $1.2 trillion bank loan market with the balance being owned by mutual funds and institutional entities. Much of the growth in the CLO market can be attributed to a continuously expanding investor base consisting of large banks, both foreign and domestic, insurance companies and asset managers that are drawn to CLOs due to their diversification benefits, strong historical performance and attractive relative value.

Western Asset believes CLOs provide positive benefits to investors as they offer many attractive features that may not be found in other investments, including but not limited to:

  • No Rate Risk: CLO tranches are floating-rate assets.
  • Diversification: The typical CLO holds an average of 200 issuers across approximately 40 industries. CLOs have historically exhibited low correlations versus equities and US Treasuries.
  • Compelling Value: CLOs offer strong relative value compared with other asset classes and comparably rated investments with extensive sponsorship from large US banks, insurance companies and asset managers.
  • Proven Track Record: CLOs have never experienced an impairment in any tranche rated A and higher, and impairments for BBB and lower-rated tranches have been much lower than that experienced in the broader and similarly rated credit markets.

Emerging Asia IG Credit: Attractive Valuations, Especially Versus Developed Markets

With developed market (DM) credit indices hitting multi-decade tights, we see relative value in Asian investment-grade (IG) bonds. Spread on the JACI IG currently stands at 190 bps, off the most recent tights seen at the beginning of 2018 (Exhibit 1). Furthermore, we highlight that current JACI IG spread premiums over US IG credit indices, such as JULI Ex-EM spreads, are at decade highs, with little in the way of credit fundamentals and credit ratings deterioration being explanatory factors. We do note that, for the global investor, in addition to the benefit of geographical diversification, an increase in allocation to Asian credits is consistent with the favorable post-pandemic outlook for the region’s GDP growth.

From an investment standpoint, the upshot is that Asian IG credits provide a unique blend of value and diversification for the global investor seeking to express a constructive fundamental view on the region. In addition, market technicals have improved over time, with the investor base dominated by long-term, buy-and-hold players.

Exhibit 1: Asian IG Credit Versus US IG Credit Spreads
(Select the image to expand the view.)
Exhibit 1 Source: JP Morgan. As of 30 Jun 21. Select the image to expand the view.

With a market cap of almost $1 trillion, we believe there is significant scope for active managers to cherry-pick high quality credits that should be positioned to withstand the vagaries of financial markets’ boom-and-bust cycles. With Asian IG investments that are appropriately customized, calibrated and actively managed, we believe the credit investor has the opportunity to be rewarded over longer time horizons.

Municipals Update: Receding Fiscal Risk?

In July 2021, President Biden and a bipartisan group of 10 Republican and 10 Democrat senators announced an agreement on a $579 billion infrastructure proposal. The proposal is significantly scaled back from President Biden’s original $2.3 trillion proposal from earlier in the year and has a greater focus on “hard infrastructure,” with less spending on electric vehicles, housing, workforce development and community-based health care initiatives.

While bipartisan efforts to address long-awaited infrastructure challenges have progressed, the ability to advance such legislation could remain difficult. The removal of more progressive measures such as climate initiatives and the child care tax credit could lead to the loss of support from key progressive Democrats, and we would expect any solution that would garner acceptance from a Senate majority to be challenged in passing the House. Whether or not this pared-back measure advances, the Democrat majority could still attempt a second bill under reconciliation, which we expect would include more “social infrastructure” initiatives and could be funded through tax increases. However, this path would take time and the scale could be more modest than many expect, which could result in a more limited impact on the muni market than market participants originally anticipated.

Global Credit Markets: Relative Value Round-Up

Active management in fixed-income is essential to identify and exploit value opportunities and to manage downside risk. Here, we present our Investment Team’s high-level views across global credit markets. In the Global Corporate Credit Sector Views section, we provide our Investment Team’s latest views including an assessment of industry vulnerability to COVID-19 related risks.

Investment-Grade (IG) Credit

We are optimistic on near-term credit fundamentals as earnings outlooks are still aided by the tailwinds of reopening economic activity. We remain vigilant for signs of shareholder-friendly activity (e.g., LBOs and M&A). That stated, conservative balance sheet management is broadly intact, with firms beginning to tender for debt with the war chest of liquidity raised in 2020. While favorable technicals endure, valuations have already returned to pre-Covid (and even pre-financial crisis) levels for many sectors. With overall valuations fully recovered, our bias remains to sell into further strength in those sectors and issues where valuations have returned to pre-Covid levels. We maintain our overweights to banking, select reopening industries and rising-star candidates where allowed.

High-Yield (HY) Credit

High-yield spreads were 42 bps tighter in 2Q21, a continuation from last quarter as the vaccine rollout accelerated along with strong reopening trends in place. We are optimistic about fundamentals, however, valuations already largely reflect that optimism in many industries. Overall high-yield spreads, which had widened to more than 1,100 bps over US Treasuries (USTs) during the depths of Covid, have more than completed the round trip back to where they began 2020 (at +336 bps). Overall valuations are thus less attractive than in the recent past. The technical backdrop, however, remains very positive as demand is expected to remain robust in a world starved for yield. We continue to position for a “reopening trade” and remain overweight certain cyclical sectors including airlines, cruise lines and select retail segments complemented by a higher quality bias in those less cyclical subsectors (along with rising-star candidates) providing ballast in portfolios.

Bank Loans

With close to 90% of the $700 billion CLO market expected to end their respective non-call periods by year-end, supply will continue to remain the central theme for 2021. We are expecting record net issuance in 2021 of $130 billion-$135 billion which, if met, would surpass the level set in 2018. Despite the supply backdrop, demand has been steady out of US banks, asset managers and insurance companies, and deals have been clearing without any material spread widening. We believe outperformance will come primarily from significant interest carry, avoiding problem credits, and owning select names where fundamentals and liquidity remain intact and there is still real price convexity in the credit.

Collateralized Loan Obligations (CLOs)

Given current valuations, a constructive fundamental outlook and where the JPY/USD cross-currency basis resides, the market is anticipating overseas demand to create another strong tailwind for the CLO market. The broader loan market default rate is trending at 2% while the universe of loans held in CLOs is running a default rate of less than 30 bps. Any additional widening in the CLO market should be viewed as an opportunity to add attractive yield. We retain our view that AAAs will continue to perform well in either a bearish or bullish scenario with plenty of opportunities across the entire AAA term structure. We expect supply to remain on the heavy side which will lead to unique and bespoke opportunities to add lower-rated CLOs at attractive levels in the coming months.

Municipals

Within the most recent $1.9 trillion American Rescue Plan Act relief package, state and local municipalities received $350 billion of direct aid to address revenue shortfalls associated with the pandemic. Western Asset believes that while some entities will receive more federal aid than needed, the stimulus package will be particularly supportive of lower-grade municipalities, providing liquidity that will lengthen the runway for these entities to address longer-term structural challenges. As the policy focus shifts to infrastructure, supply technicals will be in focus amid possibilities for a return of a taxable municipal infrastructure program. We continue to favor lower investment-grade revenue sectors that should continue to benefit from an economic recovery. However, we are cognizant of rich relative valuations, thus we are maintaining an above average liquidity position to maintain flexibility to navigate near-term market fluctuations associated with an extended tax season or near-term interest rate volatility.

Emerging Markets

Our convictions continue to center on select emerging market (EM) countries with ample foreign exchange reserves, low external economic dependency, lower political uncertainty and effective policy executions. We anticipate continued robust USD sovereign issuance by EM countries to fund fiscal programs and mitigate ongoing economic damage induced by the pandemic. In the hard currency space, we favor select IG-rated EM USD-denominated sovereigns from both a carry and total return standpoint, and exercise caution toward debt issued by lower-rated frontier sovereign countries that face a challenging uphill road ahead. We also continue to take advantage of primary issuance from short- and intermediate-dated IG and HY EM corporates. In local rates, we are mindful that certain EM central banks’ easing cycles are coming to a close. We are being highly selective in this space due to the potential for additional currency market volatility on any Covid-induced growth setbacks.

Structured Credit

Housing has performed strongly over the past year with national home prices increasing 14.6% year-over-year. Home prices have been supported by historically low mortgage rates, a dismal lack of supply on the market, tight lending conditions and a rebirth of household formations, which continue to support further home price appreciation and fundamentals for credit investors. In the non-agency residential MBS (NARMBS) space, we remain constructive on government-sponsored enterprise (GSE) credit risk transfers as well as legacy NARMBS/new-issue re-performing loan deals. Turning to commercial MBS, while the commercial sector remains further behind in terms of recovery, momentum is also building in this sector. In the near term, we remain cautious 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 of COVID-19 on each property type and geography varies. We are positive on short-duration, well-structured single-borrower securitizations and loans. We remain selective and prefer bonds that can better withstand a period of reduced operating income and forbearance and provide good risk/reward.

Growth of the Collateralized Loan Obligation (CLO) Asset Class
Bank Icon

CLOs provide benefits to investors that may not be found in other investments.

The underlying collateral of the CLO market, bank loans, has grown to over $1.2 trillion and remains an important source of capital for US corporations to fund their operations. As of today, CLO vehicles own approximately 60% of the $1.2 trillion bank loan market with the balance being owned by mutual funds and institutional entities. Much of the growth in the CLO market can be attributed to a continuously expanding investor base consisting of large banks, both foreign and domestic, insurance companies and asset managers that are drawn to CLOs due to their diversification benefits, strong historical performance and attractive relative value.

Western Asset believes CLOs provide positive benefits to investors as they offer many attractive features that may not be found in other investments, including but not limited to:

  • No Rate Risk: CLO tranches are floating-rate assets.
  • Diversification: The typical CLO holds an average of 200 issuers across approximately 40 industries. CLOs have historically exhibited low correlations versus equities and US Treasuries.
  • Compelling Value: CLOs offer strong relative value compared with other asset classes and comparably rated investments with extensive sponsorship from large US banks, insurance companies and asset managers.
  • Proven Track Record: CLOs have never experienced an impairment in any tranche rated A and higher, and impairments for BBB and lower-rated tranches have been much lower than that experienced in the broader and similarly rated credit markets.

Emerging Asia IG Credit: Attractive Valuations, Especially Versus Developed Markets
Emerging Markets Icon

Asian IG credits provide a unique blend of value and diversification for the global investor.

With developed market (DM) credit indices hitting multi-decade tights, we see relative value in Asian investment-grade (IG) bonds. Spread on the JACI IG currently stands at 190 bps, off the most recent tights seen at the beginning of 2018 (Exhibit 1). Furthermore, we highlight that current JACI IG spread premiums over US IG credit indices, such as JULI Ex-EM spreads, are at decade highs, with little in the way of credit fundamentals and credit ratings deterioration being explanatory factors. We do note that, for the global investor, in addition to the benefit of geographical diversification, an increase in allocation to Asian credits is consistent with the favorable post-pandemic outlook for the region’s GDP growth.

From an investment standpoint, the upshot is that Asian IG credits provide a unique blend of value and diversification for the global investor seeking to express a constructive fundamental view on the region. In addition, market technicals have improved over time, with the investor base dominated by long-term, buy-and-hold players.

Exhibit 1: Asian IG Credit Versus US IG Credit Spreads

Exhibit 1
Source: JP Morgan. As of 30 Jun 21. Select the image to expand the view.

With a market cap of almost $1 trillion, we believe there is significant scope for active managers to cherry-pick high quality credits that should be positioned to withstand the vagaries of financial markets’ boom-and-bust cycles. With Asian IG investments that are appropriately customized, calibrated and actively managed, we believe the credit investor has the opportunity to be rewarded over longer time horizons.

Municipals Update: Receding Fiscal Risk?
Municipals Icons

Advancing infrastructure legislature remains difficult.

In July 2021, President Biden and a bipartisan group of 10 Republican and 10 Democrat senators announced an agreement on a $579 billion infrastructure proposal. The proposal is significantly scaled back from President Biden’s original $2.3 trillion proposal from earlier in the year and has a greater focus on “hard infrastructure,” with less spending on electric vehicles, housing, workforce development and community-based health care initiatives.

While bipartisan efforts to address long-awaited infrastructure challenges have progressed, the ability to advance such legislation could remain difficult. The removal of more progressive measures such as climate initiatives and the child care tax credit could lead to the loss of support from key progressive Democrats, and we would expect any solution that would garner acceptance from a Senate majority to be challenged in passing the House. Whether or not this pared-back measure advances, the Democrat majority could still attempt a second bill under reconciliation, which we expect would include more “social infrastructure” initiatives and could be funded through tax increases. However, this path would take time and the scale could be more modest than many expect, which could result in a more limited impact on the muni market than market participants originally anticipated.

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

We are optimistic on near-term credit fundamentals as earnings outlooks are still aided by the tailwinds of reopening economic activity.

We anticipate continued robust USD-denominated sovereign issuance by EM countries to fund fiscal programs and mitigate ongoing economic damage induced by the pandemic.

Active management in fixed-income is essential to identify and exploit value opportunities and to manage downside risk. Here, we present our Investment Team’s high-level views across global credit markets. In the Global Corporate Credit Sector Views section, we provide our Investment Team’s latest views including an assessment of industry vulnerability to COVID-19 related risks.

Investment-Grade (IG) Credit

We are optimistic on near-term credit fundamentals as earnings outlooks are still aided by the tailwinds of reopening economic activity. We remain vigilant for signs of shareholder-friendly activity (e.g., LBOs and M&A). That stated, conservative balance sheet management is broadly intact, with firms beginning to tender for debt with the war chest of liquidity raised in 2020. While favorable technicals endure, valuations have already returned to pre-Covid (and even pre-financial crisis) levels for many sectors. With overall valuations fully recovered, our bias remains to sell into further strength in those sectors and issues where valuations have returned to pre-Covid levels. We maintain our overweights to banking, select reopening industries and rising-star candidates where allowed.

High-Yield (HY) Credit

High-yield spreads were 42 bps tighter in 2Q21, a continuation from last quarter as the vaccine rollout accelerated along with strong reopening trends in place. We are optimistic about fundamentals, however, valuations already largely reflect that optimism in many industries. Overall high-yield spreads, which had widened to more than 1,100 bps over US Treasuries (USTs) during the depths of Covid, have more than completed the round trip back to where they began 2020 (at +336 bps). Overall valuations are thus less attractive than in the recent past. The technical backdrop, however, remains very positive as demand is expected to remain robust in a world starved for yield. We continue to position for a “reopening trade” and remain overweight certain cyclical sectors including airlines, cruise lines and select retail segments complemented by a higher quality bias in those less cyclical subsectors (along with rising-star candidates) providing ballast in portfolios.

Bank Loans

With close to 90% of the $700 billion CLO market expected to end their respective non-call periods by year-end, supply will continue to remain the central theme for 2021. We are expecting record net issuance in 2021 of $130 billion-$135 billion which, if met, would surpass the level set in 2018. Despite the supply backdrop, demand has been steady out of US banks, asset managers and insurance companies, and deals have been clearing without any material spread widening. We believe outperformance will come primarily from significant interest carry, avoiding problem credits, and owning select names where fundamentals and liquidity remain intact and there is still real price convexity in the credit.

Collateralized Loan Obligations (CLOs)

Given current valuations, a constructive fundamental outlook and where the JPY/USD cross-currency basis resides, the market is anticipating overseas demand to create another strong tailwind for the CLO market. The broader loan market default rate is trending at 2% while the universe of loans held in CLOs is running a default rate of less than 30 bps. Any additional widening in the CLO market should be viewed as an opportunity to add attractive yield. We retain our view that AAAs will continue to perform well in either a bearish or bullish scenario with plenty of opportunities across the entire AAA term structure. We expect supply to remain on the heavy side which will lead to unique and bespoke opportunities to add lower-rated CLOs at attractive levels in the coming months.

Municipals

Within the most recent $1.9 trillion American Rescue Plan Act relief package, state and local municipalities received $350 billion of direct aid to address revenue shortfalls associated with the pandemic. Western Asset believes that while some entities will receive more federal aid than needed, the stimulus package will be particularly supportive of lower-grade municipalities, providing liquidity that will lengthen the runway for these entities to address longer-term structural challenges. As the policy focus shifts to infrastructure, supply technicals will be in focus amid possibilities for a return of a taxable municipal infrastructure program. We continue to favor lower investment-grade revenue sectors that should continue to benefit from an economic recovery. However, we are cognizant of rich relative valuations, thus we are maintaining an above average liquidity position to maintain flexibility to navigate near-term market fluctuations associated with an extended tax season or near-term interest rate volatility.

Emerging Markets

Our convictions continue to center on select emerging market (EM) countries with ample foreign exchange reserves, low external economic dependency, lower political uncertainty and effective policy executions. We anticipate continued robust USD sovereign issuance by EM countries to fund fiscal programs and mitigate ongoing economic damage induced by the pandemic. In the hard currency space, we favor select IG-rated EM USD-denominated sovereigns from both a carry and total return standpoint, and exercise caution toward debt issued by lower-rated frontier sovereign countries that face a challenging uphill road ahead. We also continue to take advantage of primary issuance from short- and intermediate-dated IG and HY EM corporates. In local rates, we are mindful that certain EM central banks’ easing cycles are coming to a close. We are being highly selective in this space due to the potential for additional currency market volatility on any Covid-induced growth setbacks.

Structured Credit

Housing has performed strongly over the past year with national home prices increasing 14.6% year-over-year. Home prices have been supported by historically low mortgage rates, a dismal lack of supply on the market, tight lending conditions and a rebirth of household formations, which continue to support further home price appreciation and fundamentals for credit investors. In the non-agency residential MBS (NARMBS) space, we remain constructive on government-sponsored enterprise (GSE) credit risk transfers as well as legacy NARMBS/new-issue re-performing loan deals. Turning to commercial MBS, while the commercial sector remains further behind in terms of recovery, momentum is also building in this sector. In the near term, we remain cautious 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 of COVID-19 on each property type and geography varies. We are positive on short-duration, well-structured single-borrower securitizations and loans. We remain selective and prefer bonds that can better withstand a period of reduced operating income and forbearance and provide good risk/reward.

Global Corporate Credit Sector Views

Auto & Related
COVID-19 Impact
Baraomter Levels High
Key Observations The global automotive sector has now moved past the worst of the Covid-related production challenges. The US light vehicle market has experienced stronger than expected consumer demand, particularly for SUVs/trucks, despite the more challenging unemployment backdrop, while the European market remains burdened by extended lockdown measures; the Chinese market is the best performer, having recovered as soon as 2Q20. As we move forward throughout FY2021, we continue to focus on each OEM/supplier’s liquidity position, ability to flex its respective cost structures, and capacity to evolve its business models to a more rapid adoption of EV/hybrid vehicle platforms. Additionally, we are closely monitoring the production challenges related to a global shortage of semiconductor chips and how this may manifest itself throughout the supply chain.
Energy
COVID-19 Impact
Baraomter Levels High
Key Observations Oil and gas prices have moved higher on rebounding demand and restrained supplies. We expect price volatility to remain given supply-side rather than demand-side uncertainty assuming no Covid resurgence; OPEC+ cooperation and resolve are still required at this juncture, with market expectations of additional supplies over the course of the year to meet anticipated demand. We see the recent OPEC+ news of gradually increasing supply over the next quarter to be consistent with the cartels’ desire to maintain balanced markets. We recognize we are in the midst of a cyclical upswing but also understand there is a longer-term energy transition underway. We continue to believe there is a distinction between companies and strategies employed to weather the down-cycle. We have seen a wave of consolidation in a short period of time, which we view as necessary, and we believe the consolidation theme will continue despite more comfortable commodity prices and receptive capital markets. Rating agencies have begun to recognize improved balance sheets and more creditor-friendly spending discipline, with ratings and outlooks beginning to move higher for all rating tiers.
Gaming
COVID-19 Impact
Baraomter Levels High
Key Observations Regional markets are expected to perform best given the “drive-in” nature of their operations, ability to quickly right-size their cost structures, and appeal to consumers given limited entertainment options. Las Vegas has recovered faster than originally anticipated, as a more widespread rollout of the vaccine, consumers’ increasing willingness to travel, and the receipt of government stimulus checks have proven to be strong positive catalysts, providing the pathway for improved occupancy rates (40% to 50% throughout the week; 80% to 90% on the weekend) and gross gaming revenue trends. Macau and Singapore have rebounded much more slowly given their destination status and more onerous quarantine/travel-related restrictions. Longer-term, however, we believe there is significant pent-up demand in these markets.
Retailing
COVID-19 Impact
Baraomter Levels High
Key Observations Lockdowns during Covid put immense pressure on traditional retail and omni-channel business models including department store and mall operators to name some of the hardest hit. Beyond store closures, companies also struggled with demand destruction in categories such as formalwear as well as logistics/inventory management challenges as customer shopped online. Looking ahead, however, most issuers in our coverage universe have since reopened their stores while also raising their digital game. We also acknowledge significant household savings and pent-up demand as helpful sector tailwinds. Indeed, we are seeing anecdotal evidence of June 2021 performance in some cases matching/outpacing that seen in June 2019. The DIY subsector continues to post strong operating results but we still expect revenue normalization in the second half of the year as consumers reallocate discretionary spending to other sectors including services.
Transportation
COVID-19 Impact
Baraomter Levels High
Key Observations Domestic flying in the US has returned to pre-pandemic levels, while cash burn rates are either manageable or negligible, which has led to ratings stabilizing. Business travel is expected to recover post Labor Day thanks to the more widespread expected return to offices. However, international travel remains restricted due to quarantine requirements and a rise in Covid variants. Given the uneven recovery in air travel demand, the global airlines continue to hoard cash on their balance sheets.
Metals & Mining
COVID-19 Impact
Baraomter Levels Medium High
Key Observations To stimulate GDP growth, governments are implementing policies that are targeting large infrastructure spending; the extent has yet to be observed and is still in the preliminary stages. This combined with continued commitment to loose monetary policy provides support for future commodity demand and the potential for a weaker US dollar. In addition, many metals continue to benefit (demand-wise) from the global focus on energy transition. The supply side continues to be supported from chronic underinvestment. This is likely going to result in long lead times for projects—from permitting to development to production—and likely restrain the future ability to satiate demand. Companies and managements continue to participate in more credit-friendly endeavors; focused on the balance sheet and liquidity with a more conservative capital allocation. With the higher prices, positive free cash flows negate the need for debt issuance providing more supportive technical considerations.
Banks
COVID-19 Impact
Baraomter Levels Medium
Key Observations We currently favor a large overweight to the highest-quality banks based on the resilient performance of their de-risked business models in 2020/2021, an improved near-term outlook for the economy/earnings/credit ratings, benign technicals and reasonable valuations. For 2021, we expect a meaningful economic expansion, which should support a recovery in earnings while continuing fiscal and monetary stimulus combined with limited shareholder payouts in the first half of 2021 should continue to limit downside risks to balance sheets should a less favorable economic path materialize. 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.
Health Care
COVID-19 Impact
Baraomter Levels Medium
Key Observations We saw the following trends from 2Q21 managed care earnings: 1) utilization levels remained below baseline levels, with Covid medical costs dropping significantly in February and March; 2) reserve positions appear conservative going into and out of the quarter; and 3) Medicaid enrollment continued to rise during the quarter, while employer health insurance enrollment stabilized and rose modestly. The recent Supreme Court ruling that leaves the Affordable Care Act (ACA) intact is modestly positive for the managed care sector, as it reduces another set of political risks if the ACA were overturned. In the HY space, liquidity positions have been supported by recent government stimulus and we expect additional grant money to benefit the sector, especially hospital names under coverage. We see the Biden Administration and Democrat-controlled Congress exploring ways to expand health care coverage via existing platforms in the ACA and Medicaid, benefiting HY providers and managed care.
Food &
Beverage
COVID-19 Impact
Baraomter Levels Low
Key Observations Despite the decline in Covid infection rates, consumption trends remain robust compared with last year’s pandemic-induced consumption patterns. Growth is also being driven by inventory replenishment and companies’ ability to pass along higher commodity protein input costs. Hence food retailers continue to express optimism regarding demand trends that are fueling their positive outlook for sales growth in Q3. However, sales may decline toward the end of Q3 as stimulus payments diminish and consumers return to their offices and students return to cafeterias.
Pharmaceuticals
COVID-19 Impact
Baraomter Levels Low
Key Observations We remain constructive on IG pharma. We do not foresee any immediate credit-changing events related to drug reform. We expect limited M&A activity, stable operations and good cash flow generation in the pharma sector. Vaccines will continue to boost results in the near term. In high-yield, key market players have not seen major disruptions from COVID-19 and earnings results have generally come in line with expectations. While some saw lower demand for drugs tied to elective surgeries last summer, we are seeing some companies cite tailwinds from this pent-up demand. The near-term focus for HY pharma will be more idiosyncratic events specific to these credits (i.e., opioid litigation trials, patent challenges, spin-off transactions, etc.).
Telecommunications & Media
COVID-19 Impact
Baraomter Levels Low
Key Observations The global telecoms sector emerged relatively unscathed from the pandemic. Beyond Covid, we believe that the sector’s multi-year equity underperformance represents a much greater source of uncertainty. In Europe particularly we have seen a flurry of LBO activity that aims to take advantage of the stark difference in how telecoms assets are currently valued in public versus private markets. The arbitrage opportunity has not gone unnoticed by the telecoms operators themselves. As a result we are also seeing a wave of towers/fiber infrastructure asset level initiatives including carve-outs, IPOs, joint ventures and outright sales. In media, the key story we think is the strong resurgence in advertising, including in particular in digital channels.
Utilities
COVID-19 Impact
Baraomter Levels Low
Key Observations The US utility industry moves at a slower pace, with management teams continuing to focus on regulated electric utility and natural gas operations as we continue to observe the rationalization of the non-regulated/merchant/traditional non-utility businesses from their consolidated structure. We view the development as a positive move as it would underscore greater stability in earnings and cash flows which is required as the industry has sacrificed credit quality relative to historic periods (with managements running a more aggressive financial policy). Capital budgets are to remain elevated (generating continued negative free cash flow) as managements focus on grid modernization and renewable investments. Consequently, the regulatory and political relationships are more important than they were previously as these bodies aim to protect customers from rate increases; we have observed the increase in regulatory and political ire in recent times.
Industry COVID-19 Impact Key Observations
Auto & Related Baraomter Levels High The global automotive sector has now moved past the worst of the Covid-related production challenges. The US light vehicle market has experienced stronger than expected consumer demand, particularly for SUVs/trucks, despite the more challenging unemployment backdrop, while the European market remains burdened by extended lockdown measures; the Chinese market is the best performer, having recovered as soon as 2Q20. As we move forward throughout FY2021, we continue to focus on each OEM/supplier’s liquidity position, ability to flex its respective cost structures, and capacity to evolve its business models to a more rapid adoption of EV/hybrid vehicle platforms. Additionally, we are closely monitoring the production challenges related to a global shortage of semiconductor chips and how this may manifest itself throughout the supply chain.
Energy Baraomter Levels High Oil and gas prices have moved higher on rebounding demand and restrained supplies. We expect price volatility to remain given supply-side rather than demand-side uncertainty assuming no Covid resurgence; OPEC+ cooperation and resolve are still required at this juncture, with market expectations of additional supplies over the course of the year to meet anticipated demand. We see the recent OPEC+ news of gradually increasing supply over the next quarter to be consistent with the cartels’ desire to maintain balanced markets. We recognize we are in the midst of a cyclical upswing but also understand there is a longer-term energy transition underway. We continue to believe there is a distinction between companies and strategies employed to weather the down-cycle. We have seen a wave of consolidation in a short period of time, which we view as necessary, and we believe the consolidation theme will continue despite more comfortable commodity prices and receptive capital markets. Rating agencies have begun to recognize improved balance sheets and more creditor-friendly spending discipline, with ratings and outlooks beginning to move higher for all rating tiers.
Gaming Baraomter Levels High Regional markets are expected to perform best given the “drive-in” nature of their operations, ability to quickly right-size their cost structures, and appeal to consumers given limited entertainment options. Las Vegas has recovered faster than originally anticipated, as a more widespread rollout of the vaccine, consumers’ increasing willingness to travel, and the receipt of government stimulus checks have proven to be strong positive catalysts, providing the pathway for improved occupancy rates (40% to 50% throughout the week; 80% to 90% on the weekend) and gross gaming revenue trends. Macau and Singapore have rebounded much more slowly given their destination status and more onerous quarantine/travel-related restrictions. Longer-term, however, we believe there is significant pent-up demand in these markets.
Retailing Baraomter Levels High Lockdowns during Covid put immense pressure on traditional retail and omni-channel business models including department store and mall operators to name some of the hardest hit. Beyond store closures, companies also struggled with demand destruction in categories such as formalwear as well as logistics/inventory management challenges as customer shopped online. Looking ahead, however, most issuers in our coverage universe have since reopened their stores while also raising their digital game. We also acknowledge significant household savings and pent-up demand as helpful sector tailwinds. Indeed, we are seeing anecdotal evidence of June 2021 performance in some cases matching/outpacing that seen in June 2019. The DIY subsector continues to post strong operating results but we still expect revenue normalization in the second half of the year as consumers reallocate discretionary spending to other sectors including services.
Transportation Baraomter Levels High Domestic flying in the US has returned to pre-pandemic levels, while cash burn rates are either manageable or negligible, which has led to ratings stabilizing. Business travel is expected to recover post Labor Day thanks to the more widespread expected return to offices. However, international travel remains restricted due to quarantine requirements and a rise in Covid variants. Given the uneven recovery in air travel demand, the global airlines continue to hoard cash on their balance sheets.
Metals & Mining Baraomter Levels Medium High To stimulate GDP growth, governments are implementing policies that are targeting large infrastructure spending; the extent has yet to be observed and is still in the preliminary stages. This combined with continued commitment to loose monetary policy provides support for future commodity demand and the potential for a weaker US dollar. In addition, many metals continue to benefit (demand-wise) from the global focus on energy transition. The supply side continues to be supported from chronic underinvestment. This is likely going to result in long lead times for projects—from permitting to development to production—and likely restrain the future ability to satiate demand. Companies and managements continue to participate in more credit-friendly endeavors; focused on the balance sheet and liquidity with a more conservative capital allocation. With the higher prices, positive free cash flows negate the need for debt issuance providing more supportive technical considerations.
Banks Baraomter Levels Medium We currently favor a large overweight to the highest-quality banks based on the resilient performance of their de-risked business models in 2020/2021, an improved near-term outlook for the economy/earnings/credit ratings, benign technicals and reasonable valuations. For 2021, we expect a meaningful economic expansion, which should support a recovery in earnings while continuing fiscal and monetary stimulus combined with limited shareholder payouts in the first half of 2021 should continue to limit downside risks to balance sheets should a less favorable economic path materialize. 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.
Health Care Baraomter Levels Medium We saw the following trends from 2Q21 managed care earnings: 1) utilization levels remained below baseline levels, with Covid medical costs dropping significantly in February and March; 2) reserve positions appear conservative going into and out of the quarter; and 3) Medicaid enrollment continued to rise during the quarter, while employer health insurance enrollment stabilized and rose modestly. The recent Supreme Court ruling that leaves the Affordable Care Act (ACA) intact is modestly positive for the managed care sector, as it reduces another set of political risks if the ACA were overturned. In the HY space, liquidity positions have been supported by recent government stimulus and we expect additional grant money to benefit the sector, especially hospital names under coverage. We see the Biden Administration and Democrat-controlled Congress exploring ways to expand health care coverage via existing platforms in the ACA and Medicaid, benefiting HY providers and managed care.
Food &
Beverage
Baraomter Levels Low Despite the decline in Covid infection rates, consumption trends remain robust compared with last year’s pandemic-induced consumption patterns. Growth is also being driven by inventory replenishment and companies’ ability to pass along higher commodity protein input costs. Hence food retailers continue to express optimism regarding demand trends that are fueling their positive outlook for sales growth in Q3. However, sales may decline toward the end of Q3 as stimulus payments diminish and consumers return to their offices and students return to cafeterias.
Pharmaceuticals Baraomter Levels Low We remain constructive on IG pharma. We do not foresee any immediate credit-changing events related to drug reform. We expect limited M&A activity, stable operations and good cash flow generation in the pharma sector. Vaccines will continue to boost results in the near term. In high-yield, key market players have not seen major disruptions from COVID-19 and earnings results have generally come in line with expectations. While some saw lower demand for drugs tied to elective surgeries last summer, we are seeing some companies cite tailwinds from this pent-up demand. The near-term focus for HY pharma will be more idiosyncratic events specific to these credits (i.e., opioid litigation trials, patent challenges, spin-off transactions, etc.).
Telecommunications & Media Baraomter Levels Low The global telecoms sector emerged relatively unscathed from the pandemic. Beyond Covid, we believe that the sector’s multi-year equity underperformance represents a much greater source of uncertainty. In Europe particularly we have seen a flurry of LBO activity that aims to take advantage of the stark difference in how telecoms assets are currently valued in public versus private markets. The arbitrage opportunity has not gone unnoticed by the telecoms operators themselves. As a result we are also seeing a wave of towers/fiber infrastructure asset level initiatives including carve-outs, IPOs, joint ventures and outright sales. In media, the key story we think is the strong resurgence in advertising, including in particular in digital channels.
Utilities Baraomter Levels Low The US utility industry moves at a slower pace, with management teams continuing to focus on regulated electric utility and natural gas operations as we continue to observe the rationalization of the non-regulated/merchant/traditional non-utility businesses from their consolidated structure. We view the development as a positive move as it would underscore greater stability in earnings and cash flows which is required as the industry has sacrificed credit quality relative to historic periods (with managements running a more aggressive financial policy). Capital budgets are to remain elevated (generating continued negative free cash flow) as managements focus on grid modernization and renewable investments. Consequently, the regulatory and political relationships are more important than they were previously as these bodies aim to protect customers from rate increases; we have observed the increase in regulatory and political ire in recent times.