Journey to the end of the night

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July 13, 2020

Indiscriminate market sell-offs and bouts of volatility have hit credit investors across many fixed-income sectors in 2020. But as markets settle, just what lies ahead for bond markets? Here, Newton head of fixed income Paul Brain takes stock of the evolving credit outlook.

In the midst of a global pandemic crisis, financial markets have been no place for faint-hearted investors. As markets fell violently in March and the stampede to exit an unusually wide range of assets classes gathered pace, the outlook was bleak.

In fixed income, an exodus from high-yield bonds was just one feature of a more widespread market sell-off that put even Treasury bonds under sustained pressure.

While fixed-income markets have now settled – thanks in no small part to the introduction of emergency support packages from central banks such as the Federal Reserve (Fed), the European Central Bank and the Bank of England – the macroeconomic picture remains worryingly uncertain.

So little is known about the Covid-19 coronavirus that its future spread and longer-term impact remain hard to predict. With several developed markets now loosening lockdown measures, markets remain optimistic yet also apprehensive at what might come next and the potential for a second wave of infections as restrictions ease.

Credit downgrades

Most credit-rating agencies have downgraded their expectations for GDP growth to negative this year. For example, S&P Global Ratings forecasts that global GDP growth will shrink by 2.3% this year with contractions of 5.2% in the US and 7.5% in the Eurozone. Amid this gloom, however, it does predict modest GDP growth of 0.3% in the Asia-Pacific region.1

Commenting on the current market picture, Newton’s Paul Brain says: “This year has so far generally been a negative environment for fixed-income markets, in particular riskier assets such as high yield and emerging-market debt.

“At a macro level, economic growth has collapsed under the lockdown implemented by many countries, and this has impacted both developed- and emerging-market economies. From an economic standpoint, it looks more like a wartime scenario than the global financial crisis.”

Brain adds that, after a difficult March, April and May saw a significant bounce-back in fixed-income investments – particularly in an investment-grade sector that produced some record amounts of new issuance – and a general easing of liquidity.

“The investment-grade market is seeing a rally, led by the prospect of recovery and recent central-bank market interventions. This has led to a record amount of issuance from companies looking to prop up their balance sheets,” he says.

Despite this, Brain sees no immediate end to current economic pressures.

“We are in a deflationary shock where there is a lack of demand and, in some cases, supply. I think it will be a long time before we work through to a surplus of demand and shortage of supply.

“While some are predicting a fairly rapid ‘V-shaped’ recovery, we expect to see a more prolonged ‘U-shaped’ recovery in which some business sectors will perform better than others and where there will be winners and losers. We also anticipate that unemployment rates will stay quite high for some time and are definitely not expecting to see any pick-up in wages.” Against this backdrop, opinions on the level of default rates likely in 2020 vary considerably, tending to range from 10% to 13% for the US and from 7% to 11% for Europe.

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Brain predicts a default rate range of about 9–10% for the US and 8–9% for Europe and adds that at least some sovereign-debt issuers in emerging markets may not be able to service their debt and will likely have to restructure. In more developed corporate markets, he believes that the high-yield energy space will remain vulnerable to default and could also see some significant restructuring.

“It is becoming clear a number of companies will struggle to maintain their coupon payments and will also struggle with liquidity as the current economic environment looks set to continue through to at least the third or fourth quarter of 2020. There is further potential for ‘fallen angels’2 to drop into the high-yield index and ripple through the high-yield market itself.”

What is different this time, says Brain, is that, as the Fed has reiterated, companies are not to blame and it is likely more measures will be put in place to help buy time for struggling businesses. Ultimately, however, as with Covid-19 itself, this is more likely to have the effect of ‘flattening the curve’ – spreading any new measures out over a longer period so that banks are not overwhelmed – rather than avoiding a very high level of defaults.

“To give some context, the US lost around 14 million jobs in just six weeks at the height of the pandemic compared to about 3.5 million over a year between June 2008 and June 2009 during the global financial crisis,” he says.

“These jobs don’t simply reappear within a few months – after the last financial crisis, it took about four years to reduce the number of unemployed back to the levels of early 2008. In our view, this must have an impact on consumer confidence and consumption levels.”

Despite all this gloom, Brain continues to see select opportunities in the market in areas such as high-quality supranational AAA-rated bonds (AAA bonds) and parts of the investment-grade market. Brain also believes an increasing lack of dividend income in equity markets could drive renewed interest in corporate bonds given the prevailing macroeconomic conditions.

“The economic challenge currently faced by companies is immense. Many firms have switched from maximizing shareholder value through share buybacks and dividends to focusing on keeping their businesses alive as they react to significant drops in cash flow. In our view, not all companies will be successful in doing so.

“For investors, the collapse in dividend payouts could refocus their attention on bond income, which is contractual and therefore more stable. The economic uncertainty has raised the potential for bond downgrades and defaults, but has raised the yield available on a broad universe of corporate bonds, thereby improving the income stream in the future,” he concludes.

1 S&P Global. Global Credit Conditions April 2020.

2 Fallen Angels are bonds that were initially given investment-grade ratings but have since been downgraded to high yield.


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