The European high yield sector has seen a sharp correction from its highs earlier this year, with the Crossover index moving from a tight of 203bp in January to an intraday wide of 730p on March 18 (by this morning it had also seen a retracement of around 50% to 470bp).
As regular readers of this blog will know, we had been cautious on the sector for a while primarily for two reasons; stretched valuations and the inability of lower rated companies to weather a shock. Given the correction seen in high yield valuations since the escalation of COVID-19, we wanted to share our thoughts on the sector and whether our view had ultimately changed.
Firstly, when we wrote the blog linked above we were not envisaging a shock of the magnitude we are currently experiencing. The speed and aggressiveness of the upcoming recession is likely to be like nothing we have seen before, with a widespread lockdown leading to an almost 100% reduction in revenues for some companies. Management teams have had to very quickly look at rationalising their cost base and, most importantly, manage liquidity for a sustained period of severely depressed revenues.
This can be easier said than done for many single B and CCC rated companies, so we have not been surprised at the speed at which the ratings agencies have moved to downgrade those companies that they see as being most exposed to the virus. In previous cycles the agencies have proved to be less aggressive, instead meeting with management teams and potentially giving the benefit of the doubt to their estimates (which tend to be overly optimistic) before taking action. The nature of this recession is different (as they all tend to be), and ultimately we think it will only be a matter of time before default for many highly cyclical companies facing a lack of both revenues and liquidity. Between Thursday’s close and Tuesday’s open, in Europe, we counted seven separate corporate downgrades with another five placed on negative watch.
The default rate for European HY in 2019 was an extremely low 1.2%. We would not be surprised to see this jump to 8-9% in 2020, in line with the rate of downgrades we have seen in recent weeks, though this is contingent on governmental restrictions being fully lifted over the coming months, which cannot be guaranteed. We expect these defaults to be highly concentrated in low rated cyclical names, an expectation we already see reflected in the level of dispersion in the index; higher rated non-cyclicals have been strongly outperforming the rest.
This leads us to remain relatively cautious on the sector as a whole – for now. While the economic shock of the virus has been very aggressive, we expect the speed at which the economy recovers to be slower and default headlines to dominate corporate news flow in the coming months.
Instead, we currently see far better risk-reward in other sectors of fixed income, including investment grade corporate bonds, where some A rated companies have been issuing bonds at spreads equal to those achieved by single B rated companies just a few months ago, and financials, both in insurance and in banking, where the banks are better capitalised than they have ever been.
While there may be some single securities in the European high yield corporate universe that appear good value to investors, we will remain patient on the sector while this most tricky part of the cycle plays out and the lower rated portion goes through its life-threatening phase.