Credit Opportunities Still Abound

RA: The turnaround in sentiment from the March lows has been impressive, with credit markets staging a tremendous comeback. Do you see room for further spread compression across risk assets?

MB: Yes. While the first two quarters of the year appear to be mirror images of each other, the rebound in Q2 hasn’t fully offset the magnitude of the market damage caused by the Q1 selloff. Performance across sectors has been uneven with US and UK investment-grade (IG) credit, higher quality residential MBS (RMBS) and select subsectors of US and European high-yield (HY) posting strong gains, while lower-rated commercial MBS (CMBS) and EM local markets have lagged the rally. Essentially, those areas of the credit markets that received direct support from central bank and government stimulus measures have benefited from a stronger performance tailwind.

Over the near term, we think the overall market direction is bullish given the steady progress we’ve seen on the medical front. We’re encouraged by the fact that the brightest minds in the world—currently representing more than two dozen pharmaceutical companies globally—are coordinated in developing therapeutic medicines, improved treatment techniques and a vaccine to prevent COVID-19 infection. We think it’s not a matter of if, but when, a successful vaccine or advanced treatment becomes available. We’re also encouraged by the transparent roadmap that policymakers across the major economies have laid out; their rhetoric continues to reinforce a commitment to providing monetary and fiscal stimulus to support economic activity and market functioning as needed.

RA: With the US economy continuing to face a number of headwinds, how do you expect corporate credit fundamentals to hold up?

MB: The best place to begin assessing the health of the corporate credit market is among the big US banks which make up nearly 50% of the global banking system. These banks came into 2020 with strong balance sheets and earnings power. In looking at their Q2 earnings, what’s most striking is how much they embraced the valuable lessons from the global financial crisis (GFC) by quickly diverting cash flows away from stock buybacks and being very conservative with regard to increasing their loan loss reserves. In our view, the banking system is much more resilient today when compared to how it entered the GFC period.

We’re also seeing companies across a variety of sectors adopt this very conservative management style. They’re increasing cash reserves and controlling expenses; we’re even seeing some companies such as Boeing and Occidental Petroleum eliminating their near-term debt to reduce their exposure to the capital markets and focus on balance sheet management. With all of these actions, combined with explicit support from the Federal Reserve’s (Fed) corporate sector purchase programs, it’s no surprise that IG spreads have compressed significantly from their wides in mid-March.

Back then, our expectation was that IG would be a “first responder” market, given its ability to continue accessing the capital markets and as the immediate beneficiary of any potential Fed support, which cannot be underestimated. That expectation became a reality and we think the IG market will continue to grind tighter as investors, in particular those overseas (where there’s a dearth of yield), look to buy high quality paper for their portfolios. It’s also important to mention that the cost of hedging for Japanese investors buying US credit has improved materially over the last nine months. After hedging, the yield advantage for these investors—whether they are insurance companies, banks or individuals—is over 100 basis points (bps). Historically, low hedging costs have acted as a strong demand-side technical for IG credit. I think it’s also important to highlight that the record supply of new issues year-to-date (YTD) has been easily absorbed by the market and the expectation is that supply will quickly decelerate in the second half of the year.

RA: Despite a solid Q2, HY returns are still negative on the year. What explains this and do you see value in this space?

MB: HY returns YTD reflect the tug of war between stressed sectors such as energy, gaming and airlines which were hardest hit by the pandemic and sectors such as cable, wireless and healthcare which have benefited from the increased demand for these types of services. The HY market also had to absorb $149 billion of new issuance in Q2 which shattered the previous record for quarterly new issuance. The silver lining is that higher quality names rated BB represented over 60% of this new paper. And similar to what we see in the IG space, HY issuers are using the proceeds for what we call “general corporate purposes,” but mainly for building up cash reserves. As lenders, it’s absolutely vital that companies move to control their balance sheets in uncertain times.

One important technical factor we need to discuss is the Fed, because it is now in the market buying both IG and HY corporate bonds. We saw hints that this was a possibility back in March, but it’s been more impressive to see how malleable the policy response has been to changes in market conditions. The Fed has purchased $12 billion so far in the secondary market credit purchase program, well shy of the $750 billion in announced buying power. While the Fed’s pace of corporate bond purchases has slowed recently, this by no means suggests it is running out of buying power. If we were to see another dislocation or wider spreads from here, the Fed would easily ramp up the pace and size of its purchases. For all of these reasons, and given where spreads are today, we see HY as a market offering strong return potential going forward.

RA: Bank loans and CLOs are close relatives to HY. What are your thoughts on these sectors?

MB: Bank loans are underperforming HY this year, which you wouldn’t expect given their more senior status. One data point that may concern investors is that the market-implied default rate spiked to 15% in March and still sits at 9% today. But, we don’t expect defaults to eclipse 6% for 2020. And with the average loan price currently at 91 cents on the dollar, we view bank loans as one of the cheaper asset classes out there.

As for the CLO market, we’re still seeing a lot of alarmist headline noise on the asset class, but with those perceived risks comes a lot of potential opportunity. AAA CLO tranches at L+175 to L+190 represent one of the cheapest asset classes in the fixed-income universe, especially when compared to similarly rated IG credit spreads in the low 100s and CMBS at 125 bps. BB and BBB tranches haven’t enjoyed the same bounce as other tranches and are still at or near their wides. But this is another segment of the CLO market we’re closely monitoring.

RA: What explains the slow recovery in structured credit valuations?

MB: Mortgage credit, both residential and commercial, has certainly lagged corporate credit mainly because the bulk of the asset class didn’t benefit from any direct or explicit Fed stimulus. If anything, we’ve only seen support toward AAA rated conduit CMBS and new-issue ABS, which explains the recent compression in spreads in those subsectors. So, the relative underperformance is a function of both the lack of broad market support and uncertainties impacting collateral performance.

When looking specifically at the residential space, it’s important to highlight that the US housing market is in far better shape than it was during the GFC. Coming into the COVID-19 crisis, aggregate US consumer fundamentals were in a strong position with debt as a percentage of income at the lowest level in over a decade. And while some may be expecting to see a wave of homes coming onto the market, the policy response has reduced the risk of homeowners being forced to sell. We’re actually seeing evidence that many homeowners who were planning to sell their homes have now taken their homes off the market. The spike in forbearance applications that materialized as the crisis unfolded has also declined, and temporary suspension of foreclosures and evictions along with generous forbearance plans has reduced distressed housing sales pressures. By many metrics, housing has already experienced a V-shaped recovery, but spreads have lagged due to continued uncertainty. At current valuations, residential non-agency MBS can withstand severe home price declines, but this isn’t our base case.

The commercial real estate (CRE) market is much more complicated as properties have been forced to shut down, rents are down as some tenants are not paying and owners are facing liquidity challenges in servicing debt. CMBS delinquencies increased significantly following the shutdown, with single-asset-single-borrower collateral performing better than conduit MBS. As the economy has been slowly reopening over the past few months, we’ve begun to see some improvement in property cash flows and collateral performance. But the hardest-hit sectors have undoubtedly been retail and hotels. Retail malls were already under pressure for a number of years; the shutdown just forced certain retailers to file for bankruptcy or close stores. Within hospitality, there have been some green shoots in occupancy and revenue that have bounced off their historical lows as the economy reopens. All that stated, valuations today are still pricing in extraordinary price declines and permanent impairment, which isn’t our view. Rather, we expect CRE debt to continue lagging other parts of the market as investors assess the path and implications of the virus.

RA: Given the significant stimulus programs announced in the US and the continued buildup in debt, are you concerned that we’ll soon see a spike in interest rates?

MB: We’d answer this question by asking “what is the Fed telling us?” Clearly, the Fed is intensely focused on inflation. Its bias for easing is much stronger than its bias for tightening. If anything, the Fed has explicitly stated that it has a tolerance for letting inflation run “hot.” Yes, there’s been a lot of debt issued to pay for all of the latest stimulus which raises concern over slower growth prospects over the long term. But in the near term, we expect the Fed to keep short-term rates pinned at or near zero, which is highly supportive for spread sector performance.

RA: With all of the uncertainties around the pandemic and the economic outlook, how should investors position their portfolios?

MB: There’s no question that markets are hostage to the path of the virus. While we’re optimistic we can make it to the other side, we recognize the path will not be linear. At a minimum, this means investor portfolios need to have a high resiliency against further bouts of volatility. At Western Asset, we’ve long advocated a diversified-strategies approach to mitigate the risk of any one strategy dominating portfolio returns. Heavily barbelled approaches in credit portfolios may seem intuitive (i.e., having an equally high concentration to low and high beta asset classes), but for portfolios with higher risk tolerances (i.e., high return objectives) they’re vulnerable in scenarios where both spread sectors and government bonds sell off in tandem. We saw this during the taper tantrum episode in 2013. Investing in only one or two areas of the market for an extended period of time can also be a losing proposition if those segments fall out of favor and there’s no opportunity to pivot elsewhere in a timely way.

In our view, a fully diversified portfolio that can take high conviction views and dynamically rotate across credit sectors makes the most sense. Credit sectors don’t necessarily move in tandem; they have different cycles and they do well in different markets. In an environment of prolonged uncertainty and expectations of continued volatility, embracing diversification and flexibility is going to be vital for long-term investment success.

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