December 10, 2020
Security selection and sectoral analysis are growing in importance as renewed business confidence may lead to increased mergers and acquisitions (M&A). Gautam Khanna, portfolio manager of the BNY Mellon Core Plus strategy, explains why companies are issuing less debt than at the start of the pandemic and what this means for his investment universe.
Q: Can you describe why companies are issuing less debt than they were at the onset of the pandemic? Is this a positive sign and how does it affect the universe in which you invest?
A: Issuance swelled to record volumes in the months after the pandemic hit in March and April. This was a result of issuers coming to market to exercise the ‘precautionary principle’. They raised liquidity and termed out debt to ensure they had enough cash to ride out an extended period of uncertainty. The reason issuance has since dropped off is because, quite simply, most of this activity has been completed. The bulk of large investment grade corporates now have the liquidity they need and have little need to return to the primary market.
As such, we expect issuance to continue to slow down in 2021 – with perhaps 25% to 35% less issuance next year. We believe this is good for our investment universe, from both a technical and fundamental perspective. From a technical standpoint, falling supply means that prices will rise (all else being equal). And fundamentally, a company’s liquidity position is one of the most important metrics for their ability to repay debt.
Now that a light is appearing at the end of the pandemic tunnel, it appears the ‘precautionary principle’ has paid off, and many corporates appear overfunded and therefore particularly appealing from a credit repayment perspective. The outlook is much clearer now, so companies may increasingly find themselves in a position to normalize their liquidity positions, taking out debt via tenders and exchanges.
Q: Where are some of the areas you’re seeing this most prominently take place? Is your corporate debt allocation tilted toward these types of companies? Why?
A: Since the pandemic hit in March and April, the first issuers to come to market were typically the largest and most robust investment grade corporates, or credits from ‘stay-at-home’ sectors that were in a position to benefit during the pandemic (such as tech, telecoms and supermarkets). By contrast, the last to arrive were typically smaller names, high yield companies and those with business models that were particularly exposed to a stay-at-home world (such as theme parks, cruise liners or energy companies).
Generally, it’s these names that still need to issue. Within the ‘winning’ sectors – there may be opportunities to move down the capital structure of individual issuers or perhaps into more niche players. The ‘losing’ sectors also offer potential opportunity – although we favor sticking to the largest, most competitive names in those sectors – as long as they have sufficient liquidity, staying power and best-inclass credentials. Many have a potentially compelling path to recovery as vaccines get rolled out and life normalizes. Those names may also benefit from reduced competition, as their weaker peers fade away, as well as the ability to consolidate their market share or consolidate through acquisitions.
Q: Do you anticipate smaller deals and fewer new higher-rated debt deals in aggregate and would that increase the level of opportunity?
A: As mentioned, some smaller companies and lower-rated names still need to come to market. However, the exception may be M&A-related issuance. As corporate boardrooms at the largest and stronger companies gain more confidence about the future, we’ve noticed they are starting to raise debt to acquire smaller competitors, in an effort to consolidate their position and structurally engineer shareholder growth. For example, in the energy sector, some smaller players have merged to generate better economies of scale and reduce production costs.
Although M&A activity is considered friendly to shareholders it is often unfriendly to bondholders, as they are associated with rising leverage. As such, owning higher quality companies can actually increase exposure to event risk, as those companies are more likely to have the capacity and appetite to engage in debt-funded acquisitions.
However, by the same token, M&A activity can be a credit positive event for lower-rated acquisition targets. For example, if a high yield issuer is acquired by a large investment grade company, the high yield bondholders would be expected to benefit. This provides an opportunity to investors: To avoid companies with appetite for leveraged acquisitions but consider adding those likely to be the targets. As such, a strong bottom-up security selection process will be extremely important in 2021.
Q: What are some unique components to your analysis that help you select which company’s debt to invest in?
A: We take a bottom-up approach to company and sectoral analysis, as well as continually assessing the potential for event risk such as M&A activity.
For example, the energy sector was severely impacted at the start of the pandemic as global oil prices sold off sharply. It became clear to us that industry consolidation would be an important step toward bringing down per-barrel production costs across the sector. Our credit analysts looked at the E&P energy credits they covered and considered the acreage of land owned. Then they assessed how attractive that would make them as M&A targets to industry leaders, resulting in their bonds getting upgraded and generating strong price performance.
Q: Can we expect companies to issue debt at the same pace going into 2021?
A: We expect issuance in 2021 to be 25-35% less than 2020. We’ll be moving from a situation where companies are raising debt to one where they are paying it down.
In 2020 new issuance was a source of alpha, and in 2021 investors will need to focus on extracting value from the secondary market, given lower-new issue volumes. As a result, we believe security selection within the secondary market will be a more important source of active value.
Q: Why do you believe security selection will be even more important moving forward?
A: We believe security selection will continue to be crucial because—while the path of the pandemic may now be clearer—it sharply sped up a number of secular trends.
In our view, the pandemic may have permanently accelerated changes to how people work and may be a game-changer for productivity growth. It also likely accelerated the process of creative destruction; thus, the ability of policy makers to manage the transition from the old regime to the new one will be crucial. Unfortunately, it feels likely there will be some bumps in the road along the way.
There is a need to be particularly careful during periods of regime change. This is because the disruption could be painful for certain areas that are now well into secular as well as cyclical decline, such as retail and potentially some areas of commercial real estate.
This disruption will likely be positive for a number of industries, but as credit investors we are asymmetrically exposed to downside. As such, we believe bottom-up security selection is the most certain line of defence for navigating the environment. We will want to ensure we are positioned in the disrupters and not the disrupted.
Q: What are some benefits of accessing this market through an active fixed income strategy?
A: Since the start of the pandemic, the market has been heavily bifurcated into winners and losers. An active strategy has the ability to employ security and sector selection to avoid areas in secular and cyclical decline. Active strategies can also take greater risk within winning sectors and employ selective exposure to the best-in-class members of challenged sectors.
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Recent market risks include pandemic risks related to COVID-19. The effects of COVID-19 have contributed to increased volatility in global markets and will likely affect certain countries, companies, industries and market sectors more dramatically than others.
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