Weekly Bond Bulletin
Moving to the next phase
While the course of the Covid-19 pandemic continues to cause great uncertainty, could volatility in European high yield spreads present an opportunity for fixed income investors?
With positive surprises across most sectors, European high yield third-quarter earnings so far appear to confirm the trend of recent months: companies are holding up better than had been expected back in the first quarter. Loose monetary and fiscal conditions have helped corporate issuers to amass cash piles through both banks and capital markets. As a result, 2020 is likely to end with realised defaults of no more than 3%, which is remarkable when considering this year’s economic shock. There is still significant fundamental risk posed by the incremental debt that has been raised to fund additional liquidity requirements, and by the uncertain path to a sustained earnings recovery as infection rates rise again. A repeat prescription of further mobility restrictions to lower reinfection rates accompanied by an extension of fiscal measures to support demand would help pave the way for spreads to tighten, but under such a scenario some sectors are unlikely to be spared. While third-quarter results and ratings momentum, in aggregate, suggest that the cycle has reached its low point, weak credits across many sectors, including retail, travel, and leisure, could have further to fall.
Since the March wides, European high yield spreads have retraced by 426 basis points (bps), which represents a 72% recovery. Since the start of the second quarter, spreads have been trading in a range of around 440bps to 500bps. The top of the range has tended to be met with renewed buying, given the global grab for yield that has been supporting markets for many months now. This practice should continue while technicals remain supportive. To move through the lower end of the range would likely require a fundamental improvement to the trajectory of the pandemic. A vaccine approval, for example, could alleviate the pressure on high yielding credits in stressed industries, such as consumer discretionary and airlines. Looking at spreads today, we think that the most compelling argument for high yield valuations can be made against European investment grade spreads, given the BB part of the European high yield market trades at a ratio of 2.7 and a spread discount of 222bps, with 1.5 years lower duration.
The spread discount of BBs vs. BBBs is above average
Source: Bloomberg; data as of 28 October 2020.
More than EUR 150 million has flowed out of European high yield over the last three months, as appetite among investors to add risk has waned amid uncertainty over the US election outcome. However, the ongoing earnings season, half-term holidays and the seasonal reduction in new issuance as we head into the last two months of the year mean that supply dynamics should remain supportive. It still also seems likely that the overriding technical backdrop of policy support, coupled with the search for yield (given that negative yielding debt globally is now at all-time highs at almost USD 15 trillion), should prove supportive for spreads.
What does this mean for fixed income investors?
With high yield technicals holding steady as we prepare to enter the next phase of the credit cycle, fundamentals and valuations are the main focus. From a fundamentals perspective, its important to distinguish between those sectors that remain resilient to a Covid world, and those that may be unattractive now but stand to gain significantly from a vaccine breakthrough. For now, caution is warranted in the latter category given that we still have no clear vaccine timeline. In terms of valuations, meanwhile, we need to examine valuations in the context of a range that looks fairly well established. While the continued macro uncertainty sets a plausible lower bound for near-term spread tightening, the necessity of a strong fiscal and monetary response to bridge economies to the end of the pandemic is likely to put a ceiling on any spread widening. Against this backdrop, fixed income investors may want to take advantage of European high yield volatility while it lasts.
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
NOT FOR RETAIL DISTRIBUTION: This communication has been prepared exclusively for institutional, wholesale, professional clients and qualified investors only, as defined by local laws and regulations.
The views contained herein are not to be taken as advice or a recommendation to buy or sell any investment in any jurisdiction, nor is it a commitment from J.P. Morgan Asset Management or any of its subsidiaries to participate in any of the transactions mentioned herein. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit and accounting implications and determine, together with their own financial professional, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.
J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide.
To the extent permitted by applicable law, we may record telephone calls and monitor electronic communications to comply with our legal and regulatory obligations and internal policies. Personal data will be collected, stored and processed by J.P. Morgan Asset Management in accordance with our privacy policies at https://am.jpmorgan.com/global/privacy.
This communication is issued by the following entities:
In the United States, by J.P. Morgan Investment Management Inc. or J.P. Morgan Alternative Asset Management, Inc., both regulated by the Securities and Exchange Commission; in Latin America, for intended recipients’ use only, by local J.P. Morgan entities, as the case may be. In Canada, for institutional clients’ use only, by JPMorgan Asset Management (Canada) Inc., which is a registered Portfolio Manager and Exempt Market Dealer in all Canadian provinces and territories except the Yukon and is also registered as an Investment Fund Manager in British Columbia, Ontario, Quebec and Newfoundland and Labrador. In the United Kingdom, by JPMorgan Asset Management (UK) Limited, which is authorized and regulated by the Financial Conduct Authority; in other European jurisdictions, by JPMorgan Asset Management (Europe) S.à r.l. In Asia Pacific (“APAC”), by the following issuing entities and in the respective jurisdictions in which they are primarily regulated: JPMorgan Asset Management (Asia Pacific) Limited, or JPMorgan Funds (Asia) Limited, or JPMorgan Asset Management Real Assets (Asia) Limited, each of which is regulated by the Securities and Futures Commission of Hong Kong; JPMorgan Asset Management (Singapore) Limited (Co. Reg. No. 197601586K), this advertisement or publication has not been reviewed by the Monetary Authority of Singapore; JPMorgan Asset Management (Taiwan) Limited; JPMorgan Asset Management (Japan) Limited, which is a member of the Investment Trusts Association, Japan, the Japan Investment Advisers Association, Type II Financial Instruments Firms Association and the Japan Securities Dealers Association and is regulated by the Financial Services Agency (registration number “Kanto Local Finance Bureau (Financial Instruments Firm) No. 330”); in Australia, to wholesale clients only as defined in section 761A and 761G of the Corporations Act 2001 (Commonwealth), by JPMorgan Asset Management (Australia) Limited (ABN 55143832080) (AFSL 376919).
For U.S. only: If you are a person with a disability and need additional support in viewing the material, please call us at 1-800-343-1113 for assistance.
Copyright 2020 JPMorgan Chase & Co. All rights reserved.