At peak spreads in March, the market had priced in an implied default rate as high as 50% (current levels imply ~35%). Since then high-yield and investment grade corporate bond issuers have been busy issuing new debt and restructuring existing debt in an effort to provide them with additional liquidity as the economy works though the major recession caused by the COVID-19 pandemic. In addition, state and local governments are experiencing severe shortfalls in sales and income tax revenues and face severe budget challenges as they reach fiscal year end June 30 and plan budgets for 2021.

In today’s challenging environment, where can advisors find opportunity for their clients in the fixed income markets?

Uncharted Territory
Over the past few months, we have seen turmoil in the credit markets along with historic fiscal and monetary policies implemented in an attempt to stabilize markets and the economy. New, unprecedented monetary policy has already been executed as the Fed is purchasing municipal and corporate debt. Additionally, bond indices delayed rebalancing at the end of the first quarter for the first time ever.

It is no surprise the majority of the economic hit has been almost solely COVID-19 related; but as with other financial crises, adversity breeds opportunity. We believe the following four areas can provide superior returns:

1. Blue-Chip Investment Grade Companies
This may be a simple answer, but given that Treasury rates are at historic lows, companies have been refinancing short term debt and commercial paper to longer term debt in an effort to build liquidity. These well run and strong balance sheet companies are willing to pay a premium to do this given rates are historically low. As spreads on longer duration bonds return to normal, this will be an area with substantial total-return potential. Although these companies have had little interruption to their business, they are still looking to extend their debt obligations and take advantage of low interest rates.

2. Rescue-Type Bonds For High-Quality Borrowers
These companies are similar to the ones above, but have a greater disruption in business activity due to COVID-19. They are still strongly positioned in the market to capitalize when things normalize, but in the interim are seeking additional liquidity during a time where little to no revenues are being generated. These issues are paying higher interest rates with beneficial covenants and strong call protection to act as “liquidity insurance” for these companies. Most are secured bonds with collateral and a priority position in the capital structure. Combining higher rates, excellent collateral plus call protection allow an investor to lock in higher rates and drive significant returns.

3. Distressed Corporate Bonds
As mentioned, current spreads are indicating approximately a 35% default rate. However, this is over 10% higher than experienced in previous financial crises. Given that, there is opportunity in companies that may have been over levered, but continue to have a good business plan. Some of these companies have already missed payments on outstanding debt and valuations have dropped aggressively. Many of these issues can now be purchased relatively cheap due to the assumed higher risk they pose. However, we expect that not all of these will enter a full-blown default, and those that have a well-planned restructuring process should thrive in the long run. Fundamental credit analysis is crucial in identifying potential winners in this space.

4. Opportunistic/Distressed Municipal Bonds
Corporate bonds are not the only hard hit area of the credit market. Many municipal revenue bonds are also experiencing shortfalls as normal business activity has been interrupted during the COVID-19 lockdown. Such bonds finance essential services such as hospitals, transportation and other infrastructure. While there is uncertainty with respect to how quickly economic activity will return to normal, we believe the essential nature of these services  suggests that many such municipal securities will  see a recovery in valuation over time as economic activity resumes. Of course, as with corporate credits, fundamental credit analysis is critical in selecting the best opportunities.

A widespread panic and overreaction in the markets is bound to happen from time to time. However, discourse provides opportunity. One can choose to follow the herd, or seek tactical ways to provide returns given the situation. In previous downturns, we typically experience a recovery in the bond market quicker than equities in terms of return of principal. We strongly believe there are ample opportunities in the credit markets, which can outperform over the coming years and we are dedicating our resources to finding the best investments for our clients.

Guy Benstead is a fixed income portfolio manager for Shelton Capital Management.