Supply points to Selectivity?
Over the past 12 months, we have seen many companies whose credit fundamentals had deteriorated significantly and whose bonds were trading at very suppressed levels rebound aggressively once restrictions eased and the liquidity tap opened. The dramatic rebounds have driven the default rate to extraordinarily compressed levels for this stage in the cycle. For example, the 12-month rolling rate in European High Yield, currently at 2.9%, is expected to drop to 1% by the end of this year as the COVID related restructurings of last year bear less influence upon the 12-month numbers.
This very benign backdrop has been met with record levels of supply across most of our bond markets. For example, in European High Yield, the first six months of 2021 saw roughly €93bn of gross issuance. This activity compares to €103bn issued during the entirety of 2020, which surpassed the previous high of €101bn in 2017. On a net basis, the numbers look even more extraordinary, with 2021 supply only €1.4bn behind the €58bn seen in the whole of 2020.
And the market is not ready to slow down just yet, with July, typically a quiet month as the market winds down to the summer, expected to provide a steady stream of high yield issuance.
Part of this will come from M&A, which has picked up sharply this year; another portion will derive from leveraged buyouts, with the news surrounding supermarket chain Morrisons serving as the latest example. Refinancing’s however, will continue to be the primary driver of issuance as companies look to lock in attractive spreads before central banks look to start tapering and raising rates later in the cycle.
One note of caution however is the trend of issuers who drew down on their revolving lines subsequently terming these facilities out to the bond market. Approximately 200 issuers in European High drew the maximum amount from their liquidity lines in the first and second quarter of 2020, an amount that totalled €55bn (source: Debtwire). While over sixty of these issuers have fully repaid loans and forty partially, ninety-seven companies have not repaid their revolver at all.
Many of these are likely to be “COVID-exposed” names. While the vast majority of repayments so far have come from operating cash (74% of repayments to 1Q21), we believe the remaining fully drawn liquidity lines will possess a greater weighting to refinancings in the bond market than previously, as banks look to de-risk their exposure to these names and companies with high operating leverage take longer to generate the necessary cash flows after economies fully reopen. So a potentially more risky cohort of supply is on its way.
While a 1% default rate looks benign and credit fundamentals are nearly perfect, conditions are unlikely to remain quite this good. Therefore, we believe the bond market should see a pick up in the default rate as we go into 2022 and beyond, given this COVID related leveraging.
Therefore, doing the necessary work to understand the difference between companies merely exposed to COVID restrictions and those structurally damaged by them continues to be extremely important, particularly given the higher level of gross debt that is building in some cases.