After the unprecedented market crash in March, European high yield (EHY) rallied strongly in April with almost +6% performance, as “B” credit outperformed “BB” credit and spreads tightened by more than 200 basis points from the wides seen in March1.
Where this year’s market turbulence started with Phase 1 (a total collapse), then moved to Phase 2 (massive central bank and government intervention resulting in a strong bounce back by the asset class), we are now moving into Phase 3 (a reality check). This is where real economic figures, generally turning out worse than expected, are finally giving indications of the negative effect from the Covid-19 virus. Given that worse news is expected for the second quarter figures and with firms withdrawing guidance (and the ongoing uncertainty of when, and in what manner, the world will exit lockdown), the risk of another downturn is being acknowledged by the market.
Issuers with a stronger credit profile have bounced back most, with lower-quality debt relatively weaker. The industry sectors heavily impacted have been autos, leisure, travel, transport and gaming. Liquidity is a key issue for companies’ survivability. Over-leveraged companies are suffering the most, with weak credit struggling to perform. At the same time, some BB-rated credit is starting to look rich again, having reversed much of the price fall seen in March.
The EHY primary market remained shut until the second half of April when Verisure, the Swedish home security company, issued €200 million of floating rate notes on the back of a reverse inquiry (investor demand for issuance)2.This was followed the week after with issuance by Netflix (euro and dollar issues comprising a total of $1 billion) and Merlin, the entertainment theme park company3.
Fallen angels have picked up, with eight new issuers added to the high yield index for the rebalancing at the end of April (also encompassing the March rebalancing that was postponed). They constitute about €40 billion being added to the index or about 10% of the index4.
Though market liquidity continues to be challenged, it is now better than the darker days but still can be problematic. Bid/offer spreads are now two to three points wide and largely one-sided (either buy or sell). This is still a far cry from the normal market spread of 0.5 to 1.0 point, but better than the wides of as much as five to eight points seen in March – if pricing was even available. ETFs are more stable too, trading close to NAV.
Downgrades and default expectations are rising as fundamentals will remain weak. This will keep pressure on HY as credit rating agencies aggressively reduce ratings and their outlook. As commented by Deutsche Bank, HY spreads are pricing high default rates of 40%+, when assuming a 40% recovery rate5. They note that this is the worst ever observed five-year cumulative default rate.
Even with April’s rally, HY market valuations are still much more attractive than at the start of the year, even as spreads have tightened sharply from their wides of March.
European high yield spreads tightened 138 basis points last month to 670 basis points – still over 270 basis points wider than the five-year average, and 2.7 standard deviations wide of the five-year average6.
We also added to issuers which we see as strategically important, including Adient, the largest car seat system manufacturer in the world), as well as those which we liked but previously found too expensive. We have also started to cover the underweight of issuers we see as survivors. High-quality credit over low-quality bonds was one of our investment themes going into the year, and we maintain that theme.
Threadneedle high yield bond fund