As global economies were adopting shelter-in-place policies to combat the spread of Covid-19 earlier this year, markets reacted violently. In corporate bond markets, credit spreads (or risk premiums), driven by heightened uncertainty and revenue pressure, widened dramatically to reflect the increased risk of downgrade and default. While the magnitude of the sell-off was significant, the direction seemed quite logical given the sudden halt of global commerce.
Since March, financial market performance has been much stronger. Global credit markets have benefitted from significant liquidity support, including low interest rates and direct purchases by central banks of corporate bonds and exchange-traded funds. Sequentially, economic data have also begun to improve. However, many aspects of global economic activity remain far from 2019 levels. At first glance, there may appear to be a disconnect between the tighter levels of corporate bond spreads and the weak-but- improving economic picture. With this in mind, we seek to identify what is currently reflected in current corporate bond prices and compare that with our own views.
Downgrades
There are several things that a corporate bond spread should compensate for, one of those is the risk of a downgrade. The credit rating from major rating agencies can influence the buying appetite of several market participants, including banks, insurance companies and asset managers. In 2009, rating agencies downgraded $108 billion of debt from investment grade into high-yield in the wake of the global financial crisis. Midway through 2020, this previous record of so-called “fallen” angels has been surpassed, with $189 billion of debt downgraded to high yield including $151 billion in the first quarter alone (Source: Karoui, Lotfi, Credit Notes: Fallen angels: Lower, but not low, July 7, 2020, Goldman Sachs).
Since the first quarter, the pace of downgrades has slowed meaningfully. We attribute this to the many credit-enhancing decisions management teams have utilized, including dividend and share—buyback cuts, delayed capital expenditures and cost reductions. In addition, the rebound in economic activity and reopening of capital markets have been helpful as well.
While we do not expect a return to the pace of downgrades seen earlier in the year, it is important to note that the risk remains. Exhibit 1 illustrates the gross leverage (debt/EBITDA [Source: Earnings before interest, taxes, depreciation and amortization]) for investment grade companies in the U.S. and Europe that are covered by our internal research team (approximately 80% of the universe of global investment-grade corporate bonds). It also includes our forecasts for our base case and “Covid downside” scenarios.
The latter includes assumptions on a much slower pace of activity driven by additional waves of infection (a so-called “L- shaped” recovery). It is important to note that in that scenario, leverage rises sharply by the end of the year, a development that would likely coincide with another raft of ratings downgrades.
Defaults
As of June 30, the trailing 12-month default rate for U.S. high-yield bonds stood at 6.19% (Source: Acciavatti, Peter, Default Monitor, July 1, 2020, JP Morgan), the highest in 10 years. Our internal default forecast for the next 12 months currently stands at 8.5%, indicating a trend of further deterioration from June, as the demand destruction of the pandemic impacts the most highly levered companies.
While our forecast is not perfect, we find it helpful to compare it to what is implied by current market prices. At mid-year, the yield spread on the Merrill Lynch High Yield Index stood at 6.46% above Treasuries. We can divide that spread into two components, a liquidity premium and a default premium. If we assume a long-term average liquidity premium of 3.00%, this leaves 3.46% to compensate for default risk. With some simple recovery assumptions (Assumes 20% recovery on energy defaults and 40% recovery on non-energy. Weighted 15% energy/85% non-energy.), this implies the market is pricing in a default rate of about 5.5%. At first glance, this seems worrying given our much higher default expectations.
However, let’s revisit the liquidity premium. It may not be fair to assume investors should earn an “average” liquidity premium in this market. The sheer quantity of liquidity provided by central banks is enough to challenge this assumption. The U.S. Federal Reserve (Fed) alone has $485 billion in fresh equity capital from the U.S. Treasury. It has used a leverage ratio of 10x in measuring its asset purchase ability for credit assets.