Weekly Bond Bulletin

10 December 2020

Full but not overflowing

Positive vaccine news and a rising stock of negative yielding debt has pushed investors into lower quality credit. Despite the strong run of recent performance, we believe valuations could still have more to offer.

Fundamentals

Corporate fundamentals are by no means out of the woods yet, with default rates still elevated and leverage levels at multi-year highs. However, the first rising star since the pandemic began, Ericsson AB, could be a portent of things to come. It is still early days, but in capital markets the direction of travel is just as important as the destination. The downturn phase was sharp, but thanks to central banks and fiscal support, it was also short. As a result, we are now in the best part of the leverage cycle for credit investors—the repair phase. High yield, in particular, is one of the few asset classes where average ratings have improved over the Covid period. While leverage is still high and trailing 12-month downgrades continue to far outnumber upgrades, these metrics should only improve as earnings rebound and issuers focus on debt repayment. Let’s not forget, downgrades to high yield are not always a bad thing. A record volume of debt moving from BBB to BB means that BBs now account for 68% of European high yield and 55% of US high yield compared to 65% and 45% respectively at the start of the year.

Quantitative valuations

While high yield spreads have largely anticipated the improvement in the fundamental outlook, they are still only in-line with their long-term average levels and remain wider than their pre-Covid starting point. Although economic uncertainty persists while the pandemic still rages, in the current environment where 48% of the European investment grade universe is negative yielding, the appeal of an asset class such as European high yield becomes more apparent. Even at a yield-to-worst of just 2.8%, we see room for spreads to tighten further. To capitalise, investors will need to have exposure to the Covid-afflicted sectors, such as travel, leisure, and retail. These sectors are likely to have both winners and losers in the post-Covid world, making careful credit selection crucial.

The stock of negative yielding debt is on the rise

Source: Bloomberg Barclays Global Aggregate Index; data as of 23 November 2020.

Technicals

In terms of European high yield issuance, 2020’s €95 billion of primary supply now stands as the second highest annual total in the market’s history after 2017. However, the more important metric, net supply, is €59 billion year to date, which will set the record if it stands. Another record is the €68 billion volume of fallen angels that has entered the indices this year. As with leverage, we expect these supply factors to improve dramatically next year as debt repayment accelerates and rating trends moderate. Given the extent of November’s rally, it is likely that investor positioning has become longer, which could provide a source of shorter-term volatility given the right catalyst. However, with central banks continuing to provide a key pillar of technical support, the ever-increasing stock of negative yielding debt combined with the anticipated slower growth of the asset class should provide a powerful longer-term tailwind for high yield spreads.

What does this mean for fixed income investors?

We are at the early stages of a multi-year recovery that we believe will provide a supportive backdrop for high yield. Some investors are already pointing to overcrowding and tight valuations, but with a supportive policy backdrop and a grab for yield, we believe high yield spreads can continue to tighten. However, a disciplined approach with a focus on fundamentals is essential, particularly in a post-Covid environment: longer-term structural shifts that have been accelerated by the pandemic will create opportunities to be capitalised on, but there will also be risks to avoid.

About the Bond Bulletin

Each week J.P. Morgan Asset Management’s Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.

Click here to read more about our FQT capabilities


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10 December 2020
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