High yield debt, the new investment grade... or not
Frédéric Salomon, a bond manager, is already calling 2020 his most challenging year ever, even more so than 2009, the year after the financial crisis. The head of credit investments at Schelcher Prince Gestion spoke at Agefi‘s European Investors Day on Monday during a round table on high yield debt. This segment of the bond market had a “surprising” year in two stages, according to Benjamin Sabahi, head of credit research at Spread Research and another speaker at the event. “We had a significant market decline until March before a robust recovery that began in April and May, thanks to the ECB’s intervention, governments’ quick-fix plans, and European companies’ ability to manage their cash flow well on the whole.” Several institutional investors took part in the high yield market’s recovery, although in France, their opinions were split on the asset class.
“Investors are adjusting their portfolios to their liabilities and their needs. In September, the French Association of Institutional Investors (AF2I) reported on trends in French institutional investors’ allocations; two of them replied that they had taken contrary positions on high yield debt. One of them bought more, and the other sold his positions,” said Jean-François Boulier, honorary chairman of AF2I during the event. High yield bond investments in French institutional portfolios amounted to 2.3% of their allocation, keeping in mind that bonds account for 70%, or about €3,200bn in assets under management. “This is a significant, but relatively modest percentage. In terms of risk management, high yield is in competition with other asset classes, such as convertibles, hybrid bank securities and others,” Boulier added. To Olivier Colsoul, senior strategist at AG Insurance of Belgium, “institutionals still have a low tendency to go into high yield, especially as there are alternatives such as private debt, mortgage loans or even equities, risk on which remains less expensive in terms of Solvency II requirements.”
Some categories are close to investment grade
There is still a border between high yield and investment grade, but it is becoming more blurred, according to Colsoul. “In high yield bonds there is no convergence in spreads towards pre-pandemic levels, unlike in investment grade. Moreover, for an institutional, high yield debt in a worsening environment can become a junk bond,” he said, point out that it still has downsides, such as downgrades and loss of value.
Sabahi sees some value in premiums on BB/BB+ bonds, as their default rates are low. “But there is the official rating and then there is what the market thinks. In July, the cruise line operator Carnival came to market with a BB+/Baa rating and traded for a few days with a coupon of more than 10% on a five-year maturity. Clearly, this wasn’t a BB+/Baa. The market didn’t need agencies to have an idea of the risk entailed,” he said. Sabahi noted that the agencies have been far more responsive recently on issuers such as the CMA CGM, the shipping company. However, he cautioned on the risk in newcomers from the loan market and recommended analysing such issuers’ risks closely.
Salomon believes that issuers with one foot in high yield and the other in investment grade are attractive, given their spreads and possible ECB support, if they are eligible for it. According to Salomon, there has never been so much money on the high yield market. Liquidity is abundant even when selling a CCC rated bond. This is as much a sign of maturity as of the effects of ECB policy.
Default rate: a peak in late 2020 or early 2021
To Sabahi, if the various lockdowns are as severe as in last spring, the scenario could play out as follows: a widening in spreads, a decline in risky assets, and cash exits. “This is uncertain in the short term. The matter then arises of being properly remunerated for risk amidst this uncertainty. If lockdowns are more flexible than last spring, this uncertainty will be more manageable. As long as you are careful to avoid those sectors most heavily exposed to this uncertainty, you can be comfortable on defaults,” he said, predicting a peak in default rates at 7-8% late this year, if the “lockdown light” scenario continues.
Colsoul expects defaults to peak at some point in the first quarter of 2021, with default rates 2% higher than they are now. Salomon also expects a peak in early 2021 but remains pragmatic and is already thinking about what the credit market will be like in the early phase of normalisation.