Macro Perspective

Western Asset expects US and global growth to decelerate from their cyclically driven highs as we move into 2022. Contributing factors include a sharp reduction in global fiscal stimulus, a reduction in monetary accommodation by key central banks such as the US Federal Reserve (Fed) and the European Central Bank (ECB) and the persistence of secular-related headwinds that include rising global debt burdens, aging demographics and technology displacement. Inflation remains challenging for policymakers, but we expect the impact of supply-chain disruptions to ease meaningfully through the course of next year. While Covid continues to bedevil global populations, we are optimistic that the worst is behind us, which bodes well for the continued recovery of reopening sectors and spread product performance. Here, we provide a summary of the key drivers behind our global credit outlook and details about where we see value across credit markets.

Recent Credit Binge Creates Opportunities for Asset Managers

The culmination of strong nominal growth, low default rates, rising equities and relatively easy access to credit markets has resulted in a surge of newly issued credit securities. While issuance has grown much faster in some parts of the world, and some sectors have seen more confidence to borrow more than others, it brings an abundance of opportunities and difficult choices for global investment managers. The dilemma investors face of course is between searching for income in a very low global interest rate environment and the risk.

For background, one of a few distortions unique to fixed-income markets is debt capitalization weighted indices. The index design can create undesirable risks as well as opportunity for active managers who can identify the differences in price and long-term fundamental value. Most fixed-income investment managers and passive funds are measured relative to these benchmarks, which bias lending to the biggest borrowers. In addition, investors are incentivized to increase allocations to sectors of the market that are borrowing more rather than investing in companies that are more likely to see their balance sheets improve. Historically this has led to undesirable outcomes when the liquidity recedes. There is a litany of examples from telecom and technology sectors in the late 1990s, to the mortgage crisis ending in 2008, and perhaps more recently with overconfident borrowers in Chinese property markets. There are many anecdotes that suggest sectors that borrow the most are typically the ones that see more agency downgrades, coerced selling and defaults as the cycle turns.

That being said, we still find more value in spread markets than developed market (DM) government bonds given the growth outlook and strong technicals. We expect relatively range-bound markets in fixed-income in the near term, but it’s important to understand some of the nuances in credit markets that will again be exposed when liquidity recedes. We see the benefits of taking an active approach to finding fundamental value and are currently finding it in reopening trades, select floating-rate securities in both corporate and structured credit markets, and securities that rating agencies are likely to upgrade toward our independent research ratings (i.e., rising stars).

Municipals: Market Impact of “Building Back Better”

In September, the House Ways and Means Committee advanced legislation containing key tax and municipal bond provisions as part of the Build Back Better Act. The legislation, if enacted, could unlock hundreds of billions of dollars of new issuance across tax-exempt and taxable municipal markets. The legislation also includes significant tax increases for individuals and corporations that could bolster demand for municipal securities.

The legislation reverses the repeal on tax-exempt advanced refundings, which we believe could be the most impactful for municipal market supply. Annual tax-exempt issuance declined nearly 20%, or $74 billion, since the 2017 Tax Cuts and Jobs Act revoked tax-exempt advanced refundings. We estimate that such a reversal could bring up to $100 billion in additional tax-exempt issuance in 2022 (+30% of calendar year 2020 levels). In addition to the reinstatement of tax-exempt advanced refundings, the legislation also includes an expansion of the small issuer exception and expansion of Private Activity Bonds (PABs), both of which would be positive for new issuance.

The legislation also includes a new taxable muni direct pay program that will offer a federal subsidy payment of 35% of the interest costs from 2022 to 2024, which will decrease to 28% by 2027 and thereafter. Under the similar Build America Bonds (BABs) program which is part of the American Recovery and Investment Act of 2009 (and also includes a 35% subsidy), issuers sold $187 billion of BABs in 2009 and 2010, and we would anticipate a similar adoption rate from municipal issuers.

We believe that higher tax-exempt issuance should be well received, especially considering the pay-fors within the legislation that increase the top marginal federal tax rate to the Obama-era 39.6% level, as well as institute a 3.0% surtax on individuals earning above $5 million. For top earners in New York, top marginal tax rates could rise to 61.2%, increasing the value of the tax exemption from municipal debt. Meanwhile, low global interest rates paired with attractive hedging costs continue to support global demand for taxable municipal assets. A BABs-like taxable bond incentive program would certainly be welcomed by global market participants, particularly if tax-exempt advanced refunding returns and a large portion of taxable supply shifts to tax-exempt markets.

All told, these initiatives would be constructive for both municipal supply and demand; however, we expect these tax reform and spending initiatives could prove challenging, considering the ongoing national pandemic recovery and the razor thin margins in the Senate.

Thoughts on China’s Real Estate Industry

Concerns over the viability of a large Chinese property developer, Evergrande, have escalated since the beginning of September. Recently, speculation on tighter regulations in the gaming industry following a series of regulatory crackdowns barely three months ago weighed on sentiment. These developments are occurring amid a soft patch in China’s growth cycle in the current quarter (see our Global Outlook for macro views on China).

Western Asset has maintained a longstanding zero exposure to Evergrande, given our fundamental concerns on the credit. Should the firm be forced to restructure its debt, we expect the authorities stand ready to step in and stabilize markets as needed. We would note that the potential systemic fallout from Evergrande has been well-flagged. Since 2018, Chinese regulators have instructed financial institutions to stress-test their exposures to a specified list of large privately owned firms that included Evergrande.

A few additional points are worth highlighting. First, China’s real estate industry is highly fragmented and geographically dispersed, in stark contrast to the dominance of a handful of players in the case of Hong Kong SAR. The top-10 property companies in China account for about 30% of market share, compared with around half in DM countries. Second, the loan-to-value ratio of mortgage loans made by Chinese households is manageable, with the vast majority of first-time mortgage applicants needing a downpayment of 30% or more (and at least 40% for second property purchases). Last, letting Evergrande fail would allow the authorities to exercise more control over the housing market by facilitating the consolidation of its better-capitalized competitors through taking up its market share.

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 constructive on the near-term path for credit fundamentals as Covid appears to be waning, while corporate managements continue to operate conservatively with their balance sheets. We remain vigilant of potential shareholder-friendly activity (e.g., LBOs and M&A) but against that, favorable technicals endure. Valuations, however, have already recovered to pre-Covid and even pre-financial crisis levels for many sectors. We are maintaining overweights to banking, select reopening industries and rising-star candidates where allowed. In European investment-grade credit, balance sheet discipline remains evident for both banks and corporates. Supply chain and input cost issues are a theme in certain sectors and bring uncertainty. Valuations have held very steady but continue to look rich on a historic basis. Low government bond yields and ECB corporate purchases continue to drive demand for investment-grade bonds. We find some opportunities in subordinated financials and REITs.

High-Yield (HY) Credit

High-yield spreads remain relatively attractive given the economic growth and low default outlook. We continue to position for a reopening trade and rising stars. We remain overweight certain cyclical sectors including airlines, cruise lines and select retail segments complemented by a higher quality bias in less cyclical subsectors. Issue selection and asset class allocation remain the key drivers for portfolios. We will look to add selectively (away from LBO issuance and credits that aren’t rising stars) for total return/spread compression given valuations. In European high-yield, supply has increased, surpassing annual 2019/2020 levels, with a higher proportion of B rated issues and more M&A/LBO related issuance. Some sectors facing headwinds from higher input costs and supply chain disruption. Spreads have been range-bound over the last quarter with some weakness recently. Further volatility in Q4 could provide more opportunities. We remain cautious on retail and auto suppliers given current headwinds.

Bank Loans

Fundamentals remain healthy and minimal defaults are expected given the strong economic outlook. Issuance has been very robust, driven by LBO/M&A activity. That said, demand for higher-yielding floating-rate securities from retail, institutional clients and CLOs is expected to be robust. We believe outperformance will come from carry and avoiding problem credits. We are focused on select names where fundamentals remain intact and prices are at discounts to their call price. In Europe, with €66 billion of institutional issuance (source: S&P LCD), H1 2021 was the busiest first half of any year for loan primary since the global financial crisis (GFC). As more M&A-related deals are expected, we may see loan spreads widen in the short term due to an element of oversupply. However, we expect CLO and broader demand for floating-rate securities to remain supportive, offering investors stable carry-driven returns through year-end. With recovery in European economies expected to gather pace, single B rated loans provide attractive returns. We focus on credits in that category with potential to convert the post-pandemic rebound into strong free cash flows that will alleviate the pressure of highly levered capital structures.

Emerging Markets (EM)

The unevenness of the post-pandemic recovery across regions and countries has led to a greater emphasis on idiosyncratic risks. This contrasts with a uniformly dominant theme in favor of high-grade duration last year, reflecting synchronized and severe economic contractions in 2020. Historically, EM assets have thrived amid a rebound in global growth. As we gradually exit the pandemic-induced shock, our convictions continue to center on select EM countries with ample foreign exchange reserves, low external economic dependency, lower political uncertainty and effective policy executions. In the hard currency space, we continue to take advantage of primary issuance from short- and intermediate-dated investment-grade and high-yield EM corporates. In local rates, we cannot overlook the risk that DM countries may sharply accelerate policy tightening which will weigh heavily on EM. We remain biased toward, but highly selective on local rates for their relatively attractive real yield.

Municipals

Municipal credit will continue to be supported by improved fundamentals following strong revenue collections and robust direct federal aid measures that have led issuer cash balances to near pre-pandemic high levels. However, as valuations (spreads) have approached near all-time tight levels, we remain cautious on credits that have not materially addressed structural budget challenges, particularly as any impact of federal aid subsides. We maintain an overweight to key higher-beta revenue sectors that would continue to benefit from an ongoing economic recovery, focusing on the transportation sector, health care sector and select high-yield issuers. However, we remain mindful of current valuations following a record municipal mutual fund inflow cycle and we believe the market is providing an opportunity to improve portfolio liquidity, which should deliver flexibility in the event of unforeseen market volatility. The outlook for municipal debt will also be shaped by the spending and infrastructure legislation being debated in Congress, which includes both municipal supply incentives and increased tax rates.

Mortgage and Consumer Credit

The combination of better than expected fundamentals with depressed valuations suggests significant potential for the asset class to generate strong performance. The largest dislocated opportunities are in residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS), which are sectors that have not received the benefit of a Fed backstop and have lagged other credit sectors in the rebound since March 2020. In RMBS, we are positive on GSE credit risk transfers as well as legacy non-agency and new-issue loan deals. In CMBS, we are neutral up the capital stack and positive on select mezzanine and below-investment-grade credits. Overall, the team believes mortgage credit offers value backed by real assets that benefit from a rising inflation environment and can generate attractive risk-adjusted returns.

Recent Credit Binge Creates Opportunities for Asset Managers
Bank Icon

There has been a surge of newly issued credit securities.

The culmination of strong nominal growth, low default rates, rising equities and relatively easy access to credit markets has resulted in a surge of newly issued credit securities. While issuance has grown much faster in some parts of the world, and some sectors have seen more confidence to borrow more than others, it brings an abundance of opportunities and difficult choices for global investment managers. The dilemma investors face of course is between searching for income in a very low global interest rate environment and the risk.

For background, one of a few distortions unique to fixed-income markets is debt capitalization weighted indices. The index design can create undesirable risks as well as opportunity for active managers who can identify the differences in price and long-term fundamental value. Most fixed-income investment managers and passive funds are measured relative to these benchmarks, which bias lending to the biggest borrowers. In addition, investors are incentivized to increase allocations to sectors of the market that are borrowing more rather than investing in companies that are more likely to see their balance sheets improve. Historically this has led to undesirable outcomes when the liquidity recedes. There is a litany of examples from telecom and technology sectors in the late 1990s, to the mortgage crisis ending in 2008, and perhaps more recently with overconfident borrowers in Chinese property markets. There are many anecdotes that suggest sectors that borrow the most are typically the ones that see more agency downgrades, coerced selling and defaults as the cycle turns.

That being said, we still find more value in spread markets than developed market (DM) government bonds given the growth outlook and strong technicals. We expect relatively range-bound markets in fixed-income in the near term, but it’s important to understand some of the nuances in credit markets that will again be exposed when liquidity recedes. We see the benefits of taking an active approach to finding fundamental value and are currently finding it in reopening trades, select floating-rate securities in both corporate and structured credit markets, and securities that rating agencies are likely to upgrade toward our independent research ratings (i.e., rising stars).

Municipals: Market Impact of “Building Back Better”
Municipals Icon

Tax reform and spending initiatives could prove challenging.

In September, the House Ways and Means Committee advanced legislation containing key tax and municipal bond provisions as part of the Build Back Better Act. The legislation, if enacted, could unlock hundreds of billions of dollars of new issuance across tax-exempt and taxable municipal markets. The legislation also includes significant tax increases for individuals and corporations that could bolster demand for municipal securities.

The legislation reverses the repeal on tax-exempt advanced refundings, which we believe could be the most impactful for municipal market supply. Annual tax-exempt issuance declined nearly 20%, or $74 billion, since the 2017 Tax Cuts and Jobs Act revoked tax-exempt advanced refundings. We estimate that such a reversal could bring up to $100 billion in additional tax-exempt issuance in 2022 (+30% of calendar year 2020 levels). In addition to the reinstatement of tax-exempt advanced refundings, the legislation also includes an expansion of the small issuer exception and expansion of Private Activity Bonds (PABs), both of which would be positive for new issuance.

The legislation also includes a new taxable muni direct pay program that will offer a federal subsidy payment of 35% of the interest costs from 2022 to 2024, which will decrease to 28% by 2027 and thereafter. Under the similar Build America Bonds (BABs) program which is part of the American Recovery and Investment Act of 2009 (and also includes a 35% subsidy), issuers sold $187 billion of BABs in 2009 and 2010, and we would anticipate a similar adoption rate from municipal issuers.

We believe that higher tax-exempt issuance should be well received, especially considering the pay-fors within the legislation that increase the top marginal federal tax rate to the Obama-era 39.6% level, as well as institute a 3.0% surtax on individuals earning above $5 million. For top earners in New York, top marginal tax rates could rise to 61.2%, increasing the value of the tax exemption from municipal debt. Meanwhile, low global interest rates paired with attractive hedging costs continue to support global demand for taxable municipal assets. A BABs-like taxable bond incentive program would certainly be welcomed by global market participants, particularly if tax-exempt advanced refunding returns and a large portion of taxable supply shifts to tax-exempt markets.

All told, these initiatives would be constructive for both municipal supply and demand; however, we expect these tax reform and spending initiatives could prove challenging, considering the ongoing national pandemic recovery and the razor thin margins in the Senate.

Thoughts on China’s Real Estate Industry
Real Estate Icons

Concerns over the viability of Evergrande have escalated.

Concerns over the viability of a large Chinese property developer, Evergrande, have escalated since the beginning of September. Recently, speculation on tighter regulations in the gaming industry following a series of regulatory crackdowns barely three months ago weighed on sentiment. These developments are occurring amid a soft patch in China’s growth cycle in the current quarter (see our Global Outlook for macro views on China).

Western Asset has maintained a longstanding zero exposure to Evergrande, given our fundamental concerns on the credit. Should the firm be forced to restructure its debt, we expect the authorities stand ready to step in and stabilize markets as needed. We would note that the potential systemic fallout from Evergrande has been well-flagged. Since 2018, Chinese regulators have instructed financial institutions to stress-test their exposures to a specified list of large privately owned firms that included Evergrande.

A few additional points are worth highlighting. First, China’s real estate industry is highly fragmented and geographically dispersed, in stark contrast to the dominance of a handful of players in the case of Hong Kong SAR. The top-10 property companies in China account for about 30% of market share, compared with around half in DM countries. Second, the loan-to-value ratio of mortgage loans made by Chinese households is manageable, with the vast majority of first-time mortgage applicants needing a downpayment of 30% or more (and at least 40% for second property purchases). Last, letting Evergrande fail would allow the authorities to exercise more control over the housing market by facilitating the consolidation of its better-capitalized competitors through taking up its market share.

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

Further volatility in high-yield credit during Q4 could provide more opportunities.

As we gradually exit the pandemic-induced shock, our convictions continue to center on select EM countries.

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 constructive on the near-term path for credit fundamentals as Covid appears to be waning, while corporate managements continue to operate conservatively with their balance sheets. We remain vigilant of potential shareholder-friendly activity (e.g., LBOs and M&A) but against that, favorable technicals endure. Valuations, however, have already recovered to pre-Covid and even pre-financial crisis levels for many sectors. We are maintaining overweights to banking, select reopening industries and rising-star candidates where allowed. In European investment-grade credit, balance sheet discipline remains evident for both banks and corporates. Supply chain and input cost issues are a theme in certain sectors and bring uncertainty. Valuations have held very steady but continue to look rich on a historic basis. Low government bond yields and ECB corporate purchases continue to drive demand for investment-grade bonds. We find some opportunities in subordinated financials and REITs.

High-Yield (HY) Credit

High-yield spreads remain relatively attractive given the economic growth and low default outlook. We continue to position for a reopening trade and rising stars. We remain overweight certain cyclical sectors including airlines, cruise lines and select retail segments complemented by a higher quality bias in less cyclical subsectors. Issue selection and asset class allocation remain the key drivers for portfolios. We will look to add selectively (away from LBO issuance and credits that aren’t rising stars) for total return/spread compression given valuations. In European high-yield, supply has increased, surpassing annual 2019/2020 levels, with a higher proportion of B rated issues and more M&A/LBO related issuance. Some sectors facing headwinds from higher input costs and supply chain disruption. Spreads have been range-bound over the last quarter with some weakness recently. Further volatility in Q4 could provide more opportunities. We remain cautious on retail and auto suppliers given current headwinds.

Bank Loans

Fundamentals remain healthy and minimal defaults are expected given the strong economic outlook. Issuance has been very robust, driven by LBO/M&A activity. That said, demand for higher-yielding floating-rate securities from retail, institutional clients and CLOs is expected to be robust. We believe outperformance will come from carry and avoiding problem credits. We are focused on select names where fundamentals remain intact and prices are at discounts to their call price. In Europe, with €66 billion of institutional issuance (source: S&P LCD), H1 2021 was the busiest first half of any year for loan primary since the global financial crisis (GFC). As more M&A-related deals are expected, we may see loan spreads widen in the short term due to an element of oversupply. However, we expect CLO and broader demand for floating-rate securities to remain supportive, offering investors stable carry-driven returns through year-end. With recovery in European economies expected to gather pace, single B rated loans provide attractive returns. We focus on credits in that category with potential to convert the post-pandemic rebound into strong free cash flows that will alleviate the pressure of highly levered capital structures.

Emerging Markets (EM)

The unevenness of the post-pandemic recovery across regions and countries has led to a greater emphasis on idiosyncratic risks. This contrasts with a uniformly dominant theme in favor of high-grade duration last year, reflecting synchronized and severe economic contractions in 2020. Historically, EM assets have thrived amid a rebound in global growth. As we gradually exit the pandemic-induced shock, our convictions continue to center on select EM countries with ample foreign exchange reserves, low external economic dependency, lower political uncertainty and effective policy executions. In the hard currency space, we continue to take advantage of primary issuance from short- and intermediate-dated investment-grade and high-yield EM corporates. In local rates, we cannot overlook the risk that DM countries may sharply accelerate policy tightening which will weigh heavily on EM. We remain biased toward, but highly selective on local rates for their relatively attractive real yield.

Municipals

Municipal credit will continue to be supported by improved fundamentals following strong revenue collections and robust direct federal aid measures that have led issuer cash balances to near pre-pandemic high levels. However, as valuations (spreads) have approached near all-time tight levels, we remain cautious on credits that have not materially addressed structural budget challenges, particularly as any impact of federal aid subsides. We maintain an overweight to key higher-beta revenue sectors that would continue to benefit from an ongoing economic recovery, focusing on the transportation sector, health care sector and select high-yield issuers. However, we remain mindful of current valuations following a record municipal mutual fund inflow cycle and we believe the market is providing an opportunity to improve portfolio liquidity, which should deliver flexibility in the event of unforeseen market volatility. The outlook for municipal debt will also be shaped by the spending and infrastructure legislation being debated in Congress, which includes both municipal supply incentives and increased tax rates.

Mortgage and Consumer Credit

The combination of better than expected fundamentals with depressed valuations suggests significant potential for the asset class to generate strong performance. The largest dislocated opportunities are in residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS), which are sectors that have not received the benefit of a Fed backstop and have lagged other credit sectors in the rebound since March 2020. In RMBS, we are positive on GSE credit risk transfers as well as legacy non-agency and new-issue loan deals. In CMBS, we are neutral up the capital stack and positive on select mezzanine and below-investment-grade credits. Overall, the team believes mortgage credit offers value backed by real assets that benefit from a rising inflation environment and can generate attractive risk-adjusted returns.

Global Corporate Credit Sector Views

Auto & Related
COVID-19 Impact
Baraomter Levels High
Key Observations The global automotive market has experienced ongoing challenges associated with the COVID-19 pandemic and the worldwide semiconductor shortage on the industry supply chain. Throughout the summer, production was anticipated to be approximately 85 million units for FYE 2021; however, throughout August and September, further challenges materialized, resulting in significant downward revisions by many third-party industry forecasters. As we look further out to FYE 2022, we believe progress will be made in terms of sourcing chips, although we are closely monitoring rising input costs across the value chain, as these higher costs may offset a portion of the price/mix strength the OEMs and suppliers have clawed back throughout the pandemic given lower inventory levels and strong consumer demand.
Energy
COVID-19 Impact
Baraomter Levels High
Key Observations Oil and gas prices continue to move higher on tighter balances, continued OPEC+ discipline and improved demand. Supply side restraint continues with US domestic producers not responding with higher drilling activity as they have historically done to higher prices and OPEC+ cohesion and resolve ongoing. OPEC+ has marginally increased supply reflecting the continued desire to maintain more balanced markets but has been unable to keep pace with the increase in demand. US producers remain resolute in maintaining capital discipline; focusing instead on improving the credit profile and shareholder returns versus growing production. We have observed upward ratings migration with the ongoing restraint and realization less leverage. We continue to believe longer term that scale and basin diversity is required to weather the cyclical lows, increased price volatility, and the prospect of lower future prices (currently backward-dated futures).
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 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 Retailers’ revenues in many cases remain below 2019 levels. However, issuers generally are benefiting from pent-up demand, elevated consumer savings and higher wages. In our view, this bodes well for the sector’s revenue outlook heading into Q4 as well as Q1 next year. Looking ahead, demand on the apparel side will be driven by occasion wear, accessories to complement travel, entertainment and dining out as consumers adjust to a post-Covid environment. Of concern are port closures in Asia, labor shortages and insufficient warehouse storage which have contributed to the ongoing global supply chain dislocation and resulted in product delivery delays and a significant rise in freight costs. We expect the current situation to persist at least until 1Q22. On that basis, supply chain headwinds are likely to negatively impact margins in Q4 and early 2022.
Transportation
COVID-19 Impact
Baraomter Levels High
Key Observations The recovery in air travel is being fueled by fewer restrictions, although the delta variant recently caused the airlines to lower capacity guidance. The more sluggish reopening and return-to-office trends in the US should further subside in Q4 thanks to robust demand for domestic holiday air travel. International air travel remains the slowest to recover owing to continuing restrictions on the freedom of movement across borders, quarantine measures and traveler uncertainty. Over the past 18 months, the airlines have achieved aggressive cost reductions, but the recent rise in fuel costs will pressure margins in Q4.
Metals & Mining
COVID-19 Impact
Baraomter Levels Medium High
Key Observations We continue to believe that the focus on fiscal and monetary policies by governments to stimulate GDP growth (in particular, policies of large infrastructure spending) underscores the current and future demand for metals. The prospect of a weaker US dollar and higher inflation also bodes well for metals prices, which would be beneficial to the revenue generation of the sector. Supply and supply response are becoming more important to understand. Industry has underinvested in the business for several years post the last price rout as managements concentrated on bolstering liquidity and repairing the balance sheet; this conservatism continues today. Consequently, supply cannot be turned on quickly and is exacerbated by the capital-intensive, depletive nature of the industry. Any new supply requires greater cooperation with host countries, higher royalties and taxes, and increased social and environmental considerations, which all lead to longer lead times from discovery to development to production. As a result, tighter balances and higher metals prices are expected to remain.
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 In the high-yield space, liquidity positions remain solid as recent government stimulus and grant money has benefited the sector. Heading into 4Q21, we are focused on key health care provisions that are part of the $3.5 trillion “Build Back Better” reconciliation package and ways to fund these measures. The Biden Administration and Democrat-controlled Congress continue to explore ways to expand health care coverage via existing platforms in the ACA and Medicaid, benefiting high-yield providers and managed care. For the high-yield hospital names under coverage, we see margin pressure into 4Q21 due to a rise in COVID-19 volumes and continued wage inflation pressures (some have cited this as one of the most challenging labor environments in history).
Food &
Beverage
COVID-19 Impact
Baraomter Levels Low
Key Observations The pandemic drove a dramatic shift toward conventional food retailers in 2020, but that trend is slowly reversing as offices and schools reopen, although at-home consumption remains fairly sticky. Food retailers face rising input costs for raw materials, as well as rising packaging, transportation and logistics costs in Q4 that may pressure margins. The largest food and beverage companies remain rational with regards to pricing and promotional activity, as they have both size and scale to navigate the pandemic and inflation headwinds.
Pharmaceuticals
COVID-19 Impact
Baraomter Levels Low
Key Observations 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 high-yield pharma will be more idiosyncratic events specific to these credits (i.e., opioid litigation trials, patent challenges, spin-off transactions, etc.). Drug pricing reform will remain topical during 4Q21 as we expect to see more internal clash among Democrats around the specifics.
Telecommunications & Media
COVID-19 Impact
Baraomter Levels Low
Key Observations Compared to other industrial sectors, the global telecoms industry proved highly resilient during Covid. We recommend continued special focus on the remarkable divergence in the sector’s equity valuations across private and public markets. Indeed, the LBO theme continues and the fact that two of the four French operators have initiated take-private transactions in the past year, further illustrates the risk to bondholders. Another notable sector trend is the rise of independently governed wireless towers operators in Europe. Over the long-run we expect industry structure to look more like the US where towers assets are typically held outside of incumbent telecoms operators. In media, the overarching narrative at this time remains the resurging ad spend, including in particular for digital channels.
Utilities
COVID-19 Impact
Baraomter Levels Low
Key Observations The domestic industry continues to focus on returning to a fully regulated electric utility model. Managements have, and continue to, rationalize the non-regulated, merchant, and traditional non-utility businesses in their consolidated structures. The focus on decarbonization and renewables combined with grid modernization to ensure stability in service means elevated capital budgets would remain over a prolonged period and the need for maintaining a constructive regulatory environment is required to facilitate the investment recovery (in customer rates). As such, we continue to watch both political and regulatory developments.
Industry COVID-19 Impact Key Observations
Auto & Related Baraomter Levels High The global automotive market has experienced ongoing challenges associated with the COVID-19 pandemic and the worldwide semiconductor shortage on the industry supply chain. Throughout the summer, production was anticipated to be approximately 85 million units for FYE 2021; however, throughout August and September, further challenges materialized, resulting in significant downward revisions by many third-party industry forecasters. As we look further out to FYE 2022, we believe progress will be made in terms of sourcing chips, although we are closely monitoring rising input costs across the value chain, as these higher costs may offset a portion of the price/mix strength the OEMs and suppliers have clawed back throughout the pandemic given lower inventory levels and strong consumer demand.
Energy Baraomter Levels High Oil and gas prices continue to move higher on tighter balances, continued OPEC+ discipline and improved demand. Supply side restraint continues with US domestic producers not responding with higher drilling activity as they have historically done to higher prices and OPEC+ cohesion and resolve ongoing. OPEC+ has marginally increased supply reflecting the continued desire to maintain more balanced markets but has been unable to keep pace with the increase in demand. US producers remain resolute in maintaining capital discipline; focusing instead on improving the credit profile and shareholder returns versus growing production. We have observed upward ratings migration with the ongoing restraint and realization less leverage. We continue to believe longer term that scale and basin diversity is required to weather the cyclical lows, increased price volatility, and the prospect of lower future prices (currently backward-dated futures).
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 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 Retailers’ revenues in many cases remain below 2019 levels. However, issuers generally are benefiting from pent-up demand, elevated consumer savings and higher wages. In our view, this bodes well for the sector’s revenue outlook heading into Q4 as well as Q1 next year. Looking ahead, demand on the apparel side will be driven by occasion wear, accessories to complement travel, entertainment and dining out as consumers adjust to a post-Covid environment. Of concern are port closures in Asia, labor shortages and insufficient warehouse storage which have contributed to the ongoing global supply chain dislocation and resulted in product delivery delays and a significant rise in freight costs. We expect the current situation to persist at least until 1Q22. On that basis, supply chain headwinds are likely to negatively impact margins in Q4 and early 2022.
Transportation Baraomter Levels High The recovery in air travel is being fueled by fewer restrictions, although the delta variant recently caused the airlines to lower capacity guidance. The more sluggish reopening and return-to-office trends in the US should further subside in Q4 thanks to robust demand for domestic holiday air travel. International air travel remains the slowest to recover owing to continuing restrictions on the freedom of movement across borders, quarantine measures and traveler uncertainty. Over the past 18 months, the airlines have achieved aggressive cost reductions, but the recent rise in fuel costs will pressure margins in Q4.
Metals & Mining Baraomter Levels Medium High We continue to believe that the focus on fiscal and monetary policies by governments to stimulate GDP growth (in particular, policies of large infrastructure spending) underscores the current and future demand for metals. The prospect of a weaker US dollar and higher inflation also bodes well for metals prices, which would be beneficial to the revenue generation of the sector. Supply and supply response are becoming more important to understand. Industry has underinvested in the business for several years post the last price rout as managements concentrated on bolstering liquidity and repairing the balance sheet; this conservatism continues today. Consequently, supply cannot be turned on quickly and is exacerbated by the capital-intensive, depletive nature of the industry. Any new supply requires greater cooperation with host countries, higher royalties and taxes, and increased social and environmental considerations, which all lead to longer lead times from discovery to development to production. As a result, tighter balances and higher metals prices are expected to remain.
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 In the high-yield space, liquidity positions remain solid as recent government stimulus and grant money has benefited the sector. Heading into 4Q21, we are focused on key health care provisions that are part of the $3.5 trillion “Build Back Better” reconciliation package and ways to fund these measures. The Biden Administration and Democrat-controlled Congress continue to explore ways to expand health care coverage via existing platforms in the ACA and Medicaid, benefiting high-yield providers and managed care. For the high-yield hospital names under coverage, we see margin pressure into 4Q21 due to a rise in COVID-19 volumes and continued wage inflation pressures (some have cited this as one of the most challenging labor environments in history).
Food &
Beverage
Baraomter Levels Low The pandemic drove a dramatic shift toward conventional food retailers in 2020, but that trend is slowly reversing as offices and schools reopen, although at-home consumption remains fairly sticky. Food retailers face rising input costs for raw materials, as well as rising packaging, transportation and logistics costs in Q4 that may pressure margins. The largest food and beverage companies remain rational with regards to pricing and promotional activity, as they have both size and scale to navigate the pandemic and inflation headwinds.
Pharmaceuticals Baraomter Levels Low 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 high-yield pharma will be more idiosyncratic events specific to these credits (i.e., opioid litigation trials, patent challenges, spin-off transactions, etc.). Drug pricing reform will remain topical during 4Q21 as we expect to see more internal clash among Democrats around the specifics.
Telecommunications & Media Baraomter Levels Low Compared to other industrial sectors, the global telecoms industry proved highly resilient during Covid. We recommend continued special focus on the remarkable divergence in the sector’s equity valuations across private and public markets. Indeed, the LBO theme continues and the fact that two of the four French operators have initiated take-private transactions in the past year, further illustrates the risk to bondholders. Another notable sector trend is the rise of independently governed wireless towers operators in Europe. Over the long-run we expect industry structure to look more like the US where towers assets are typically held outside of incumbent telecoms operators. In media, the overarching narrative at this time remains the resurging ad spend, including in particular for digital channels.
Utilities Baraomter Levels Low The domestic industry continues to focus on returning to a fully regulated electric utility model. Managements have, and continue to, rationalize the non-regulated, merchant, and traditional non-utility businesses in their consolidated structures. The focus on decarbonization and renewables combined with grid modernization to ensure stability in service means elevated capital budgets would remain over a prolonged period and the need for maintaining a constructive regulatory environment is required to facilitate the investment recovery (in customer rates). As such, we continue to watch both political and regulatory developments.