Recalibrating the rulebook: a focus on fundamentals
Credit fundamentals have worsened since the market sell-off began, although central banks could provide some companies with a soft landing and many firms have drawn on their credit lines in a bid to stay afloat. In our latest edition of 360°, we discuss the uptick in defaults and downgrades and consider what this means for fixed-income markets.
The velocity of the moves in credit fundamentals and spreads - and the unbridled reach for cash from banks, corporates, and asset managers - is testament to how profoundly blindsided the economy was by the relentless spread of the coronavirus.
While the monetary and fiscal policy responses will benefit many higher-quality companies, others will disappear altogether or be forced to restructure their debt. Financial risks will rise as debt-service obligations become more burdensome and some companies will struggle to grow into their capital structures.
First and second-quarter earnings are set to decline by a record amount. There has also been a dramatic spike in downgrades, which are taking place at ten times the rate of upgrades within the high-yield market.
As thinly capitalised firms are locked out of refinancing markets, it is inevitable that there will be a rise in defaults. In an instinctive move to survive, companies have defended their balance sheets by cutting dividends, cancelling share-repurchase programs and reducing operating and capital expenditures.
Firms have also drawn on their revolving credit facilities (RCFs) at an unprecedented pace. Between 9 and 27 March, the share of RCF draws went from 11% to 64.3%. Coincidentally, 56 of the 198 companies were downgraded.
Energy and banking: in the eye of the storm
To help formulate our broader view of market fundamentals, we have looked at two of the sectors most affected by the crisis: banking and energy. We see these industries as bell weathers for the future state of credit markets.
We currently see an opportunity to invest in financials. Banks have lost about a third of their market capitalisation since the sell-off began and their debt instruments have experienced some of the greatest losses of any sector. However, markets do not seem to have factored in their strong capital position or balance-sheet strength, as well as the support they have received.
Although the asset quality of banks has deteriorated over the last quarter, liquidity coverage ratios for the largest US banks are four-times higher than they were before 2008. Even accounting for more stringent calculation criteria, tier one and tier two ratios are also materially higher. In addition, US money-centre banks have suspended their significant share buyback programs, while capital buffers have been dropped in Europe.
While there is uncertainty about loan performance and support for banks and borrowers, we believe the sector offers considerable value - particularly the larger ‘national champion' banks, which will be used as the transmission mechanism for stimulus.
Meanwhile, the energy sector was under pressure even before the oil-price war erupted between Russia and Saudi Arabia. This was cataclysmic for oil prices, and most keenly felt by North American producers and their support infrastructure.
There is currently a substantial imbalance between supply and demand. North American producers with weak liquidity and balance sheets can now only hope for direct government support. Bankruptcies within the sector have already started and we expect them to increase, irrespective of how markets recover. Energy accounts for 10% of the US high-yield market and this will have material implications for credit markets.
We still see opportunities within the energy sector and particularly like midstream companies that lack direct exposure to commodity-price volatility, are protected through long-term or minimum-volume commitment contracts and are able to postpone growth projects and reduce distributions. Producing firms of scale with low break-even costs, strong balance sheets and good liquidity are also attractive and have the potential to weather lower prices.
Viral volatility: seeking opportunities amid the turmoil
There is considerable uncertainty about the effect of the virus, while the impact is highly correlated across geographies, industries and asset classes. The potential outcomes are too severe to only affect equities and credit-market fundamentals have undoubtedly been impacted.
It is clear that we will see more volatility - both above and beneath the surface - in the months ahead, which suggests there is unlikely to be a symmetrical recovery such as the one we witnessed after Q4 2018. Companies with less leveraged balance sheets are not as likely to be affected in the longer term, but in some sectors even the most defensive issuers could default in the absence of external support.
In this environment, we find ourselves faced with more nuanced and idiosyncratic stories across sectors, geographies and sub-asset classes - an incredibly fertile ground for our Credit and Private Debt teams. Flexibility, clarity of thinking, a diligent underwriting process and avoiding complacency will all be essential.
This is not a ‘buy the dip' situation, and credit analysis will be at a premium. Our credit analysts have been working diligently alongside our engagement professionals to recalibrate the inputs in their models and in some cases completely rewrite them.
At the international business of Federated Hermes, we take an active, high-conviction approach to investing - something that history suggests has the potential to perform well in volatile periods. While we are mindful that the lows are likely not behind us, we remain optimistic about the potential to generate supernormal alpha in credit markets over the next 12 months.
The value of investments and income from them may go down as well as up, and you may not get back the original amount invested.
For professional investors only. This is a marketing communication. The views and opinions contained herein are those of the Credit Team at the international business of Federated Hermes, and may not necessarily represent views expressed or reflected in other communications, strategies or products. The information herein is believed to be reliable, but Federated Hermes does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. This document has no regard to the specific investment objectives, financial situation or particular needs of any specific recipient. This document is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Figures, unless otherwise indicated, are sourced from Federated Hermes. This document is not investment research and is available to any investment firm wishing to receive it. The distribution of the information contained in this document in certain jurisdictions may be restricted and, accordingly, persons into whose possession this document comes are required to make themselves aware of and to observe such restrictions.
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Author profile
Andrew Jackson, Head of Fixed Income
Andrew joined the international business of Federated Hermes in April 2017 as Head of Fixed Income. He is responsible for leading the strategic development of the Credit and Direct Lending investment teams, and developing a multi-asset credit offering capable of accessing all areas of the global credit markets for pension funds and other long-term institutional investors.
Andrew joined from Cairn Capital, where he was Chief Investment Officer. In this role, Andrew was responsible for the development of the asset management business, which included designing new products and managing the investment teams, including strategy, portfolio management and research. He has managed assets across the spectrum of global credit and fixed income. He was previously vice president within the European credit structuring team at Bank of America and has held roles with Fitch Ratings and PricewaterhouseCoopers. Andrew holds a BSc degree in Mathematics & Theoretical Physics from Kings College London.