The US high yield market could have been forgiven for taking a breather in 2021 after the wild swings of 2020, a year which managed to feature both a month of zero supply in March and full-year volume of $418bn, an all-time record. Instead, US HY has ridden its considerable momentum into the new year with issuers placing a further $51.9bn in the hands of investors last month, the busiest January on record and the third busiest month ever.
While very much in contrast to the relatively more subdued supply we have seen in Europe so far this year, this latest surge of higher beta supply is hardly a surprise, driven as it is by the now familiar trends of low borrowing costs and strong market support from the Federal Reserve. However, the composition of the supply does appear to be evolving and this should be of interest to investors looking for opportunities in a market that has rallied at relentless pace in recent months. CCC rated debt accounted for $12.88bn or 25% of the January total, its strongest showing in months.
Again we can’t really say we are surprised by this interest in lower quality names, since it is being driven mainly by growing confidence among the investor community in pro-cyclicality. The support mechanisms in the marketplace are strong, ranging from central bank policy to anticipated fiscal stimulus and early success in the rollout of vaccines, all of which should lead to better economic fundamentals going forward. Importantly the Fed chair, Jerome Powell, has recently reinforced the central bank’s policy targets as full employment and 2% inflation, emphasising that transient inflation would not move the needle and highlighting the need to improve job creation.
With this supportive market backdrop, what can we expect over the next few quarters? Looking at how the use of high yield bond proceeds evolves this year could again be instructive; 2020 saw 64% of deals used for refinancing, with 24% for general corporate purposes and about 8% for mergers and acquisitions (M&A). Balance sheet repair and bolstering cash balances was evidently crucial for firms in the early stages of the pandemic, but as the speed of recovery has escalated we have seen refinancing and lowering cost of capital become more prevalent. This year once again should see a high percentage of refinancing, but we would not be surprised to see a relatively material pick-up in M&A financing as companies seek to take advantage of opportunities created by the economic turmoil coupled with lower financing costs.
Furthermore, those companies that found it hard to access markets over the course of the last year would now appear able to tap the markets, which gives investors a decision to make – do they go fishing in CCCs? With credit spreads having moved such a long way in such a short period (IG spreads, for example, haven’t just gone through pre-COVID levels but are now threatening the tights of the previous cycle), it would be easy to see the appeal of doing so. While capital gains were hard to come by in January as the risk rally took a definite pause, US CCCs returned an impressive 2.5% for the month.
Earlier in this most rapidly evolving cycle we had warned of the dangers of shopping in the very lowest ratings bands at the early phase of the recovery, since in our view there have been more prudent ways of adding more pro-cyclicality to bond portfolios, such as higher rated subordinated financials, corporate hybrids and European CLOs. But whether we like it or not, we now expect CCCs to be one of the best performing credit sectors in 2021 as spreads generally grind tighter along with compression between ratings bands, and some of the market’s best trade ideas this year are likely to come with a CCC label.
We think it is indeed time to begin the search for recovery stories and deleveraging credits in sectors where the execution strategy is likely to succeed. This point we think is very important. Not only do companies’ management have to want to improve their financial profile, they also need the economic backdrop to facilitate it and sufficient cash to get them there. If there are companies that fulfil these criteria at the bottom of the ratings spectrum then they could indeed be worthy of closer scrutiny, and would likely produce some of the strongest returns. However, we would still urge a material amount of caution when considering investing in the lowest ratings cohorts, as defaults are still likely to come through and it is in these ratings bands where volatility is typically highest.
In our view, then, this robust new issue pipeline of lower quality credit is worth poring over as there are likely to be some good stories in here for investors with sufficient liquidity to get involved.