A U T H O R S
Justin Jewell
Senior Portfolio Manager
Andrzej Skiba Head of US Credit Tim Leary Portfolio Manager Rajat Mittal Portfolio Manager
As we head towards spring and vaccine hopes lift the global
mood, the hunt for income is taking investors to credit markets
in search of high-yielding solutions. With default levels well
contained, demand pent-up and monetary policies supportive,
we are positive on the asset class and predict the continuation
of constructive flow dynamics well into 2021.
Key takeaways
• 2020’s defaults were largely already-troubled names in retail and energy, which fell
after years of struggle. Other sectors only saw small increases on a typical year.
• We’re not expecting a fresh default cycle – a potentially severe liquidity crunch
was averted by policymakers.
• We anticipate 2021 default levels to be around the 5-year median; 3-3.5% in
non-investment grade credit.
• The generosity of government programmes reduced solvency stress in the
corporate & household sector at the expense of government deficits. Solvency
is a potential risk in only a tiny fraction of the market.
• We believe the outlook for high yield and loans is positive. We expect growth to
recover alongside vaccine progress, with ample pent-up demand and supportive
policies. Our market is populated by liquid, well-capitalised names across most
sectors.
• The return potential will likely remain sufficiently attractive for asset allocators even after the strong end to 2020.
Credit investors, particularly those operating in the murkiest corners of leveraged loan and high yield markets, have a habit of being professional worriers. Perhaps it’s the asymmetric nature of the assets we manage, or maybe it’s a result of scarring from the credit cycles we have lived through. Either way, no matter how clear the air we tend to look for trouble.
As 2021 gets underway, there is no shortage of risks to fret over. What if the vaccines don’t work or aren’t taken up quickly enough? What if the recovery is rapid enough to lead to a sharp re-pricing of the US Treasury market? While some of these questions are out of our control, one topic we can thoughtfully address right now is the default outlook.
Within credit, you don’t have to scratch the surface
too hard to find a drumbeat of assertion that there
are bankruptcies to come; that companies will
fail to sufficiently support the debt burdens that
they have taken on, and that there is a coming crisis within corporate balance sheets that could meaningfully undermine returns. To illustrate this mindset, credit rating agencies continue to forecast default rates well into the high mid-single digits in 2021, though they have been softening their views as time goes on.
Our perspective
Scanning a critical eye across today’s high yield and loan markets, we do not share this view.
Examining the evidence, we should first recognise
that there almost certainly will be a pick-up in bankruptcies in the real economy. If nothing else, the data in chart 2 shows that 2020 proved to be
a year of unusually low insolvency filings in almost
Credit investors,
particularly those
operating in the
murkiest corners
of leveraged loan
and high yield
markets, have
a habit of being
professional
worriers.
C H A R T 1 : R A T I N G A G E N C I E S H A V E C U T T H E I R F O R E C A S T S F O R D E F A U L T R A T E S S I G N I F I C A N T L Y
Source: Moody’s as at December 2020
C H A R T 2 : I N S O L V E N C I E S Y T D % C H A N G E C O M P A R E D T O S A M E P E R I O D T H E P R E V I O U S Y E A R
Source: Atradius, as at September 2020 -50 -40 -30 -20 -10 0 10 20 Aus tra lia (J un) Au st ria (Q 2) Be lg ium (j un) Br az il (Jun) Can ad a (M ay ) Cz ec h Re pu bl ic (Jun) De nm ar k (Jun) Fi nl an d (Jun) Fra nc e (A pr ) Ge rm any (A pr ) Hon g Kon g ( Ju n) Ire lan d (Q 1) Ja pa n (Jun ) Ne the rla nds (J un) Ne w Ze al and (Jun ) No rw ay (M ay ) Po la nd (Jun ) Po rt ug al (Jul ) Ro m an ia (Ju n) Ru ssi a ( Q1 ) Si ng ap or e ( Jun ) So ut h Af ric a (Ju n) So ut h Ko re a (Jun) Spa in (Q 2) Sw ed en (Jun) Sw itz er la nd (Jun) Tur ke y ( Jun) Uni te d Ki ng do m (Q 2) Uni te d St at es (Q 2) 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% De c-18 Ja n-19 Fe b-19 M ar -1 9 Apr -1 9 M ay -1 9 Jun -1 9 Jul -1 9 Aug -1 9 Se p-19 O ct-19 No v-19 De c-19 Ja n-20 Fe b-20 M ar -2 0 Apr -2 0 M ay -2 0 Jun -2 0 Jul -2 0 Aug -2 0 Se p-20 O ct-20 No v-20 De c-20 Ja n-21 Fe b-21 M ar -2 1 Apr -2 1 M ay -2 1 Jun -2 1 Jul -2 1 Aug -2 1 Se p-21 O ct-21 No v-21
The authorities’
policy response,
free of
moral-hazard concerns,
was forceful
and orthodoxly
Keynesian
with dramatic
interventions on
both the supply
and demand side,
ensuring the flow
of credit was a key
objective.
all of Europe and North America, while in chart 3 we show more detailed sector-level data from the UK, which highlights the stark drop in new company insolvencies through 2020. As a consequence, we should naturally expect some catch-up and therefore above-average bankruptcy rates in 2021 and 2022.
We should also remember that it is liquidity crunches, not sudden solvency problems, that create credit default cycles. The risk of this was very acute in 2020 – many businesses lost all revenues while their payables could not be easily postponed.
To a visitor from 2019, a simple comparison of 2020 GDP data and default data would be puzzling – how can you have tumbling growth yet
uncharacteristically low default levels? But the authorities’ policy response, free of moral-hazard concerns, was forceful and orthodoxly Keynesian with dramatic interventions on both the supply
and demand side, ensuring the flow of credit was
a key objective. Thus, the most substantial debt growth has been on sovereign balance sheets,
while the corporate sector has benefitted from
furlough schemes and government-backed liquidity programmes.
A similar pattern is visible at the consumer level where the US CARES Act stimulus bill led to a
significant decoupling between unemployment and
personal bankruptcy. Analysis by Harvard Business School argues that on historic correlations, we should have seen an incremental 200,000 personal bankruptcies in the US during 2020.
Source: Insolvency Service, Company Insolvency Statistics, as at 30 October 2020
C H A R T 3 : T O T A L N U M B E R O F N E W C O M P A N Y I N S O L V E N C I E S B Y B R O A D S E C T O R G R O U P I N G
C H A R T 4 : 2 0 1 0 - 2 0 2 0 D E F A U L T R A T E S A C R O S S U S A N D E U R O P E A N H Y B O N D S A N D L O A N S
Source: JPMorgan for US and Euro HY data. S&P LCD for US and Euro Loans data. As at 31 December 2020
0 500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 5,000 2018 Q1 2018 Q2 2018 Q3 2018 Q4 2019 Q1 2019 Q2 2019 Q3 2019 Q4 2020 Q1 2020 Q2 2020 Q3
Industrials Construction Wholesale and retail Transport and hospitality Service sectors Other These figures represent a change in percentage terms as follows: 2019 Q3 vs
2020 Q3 Industrials -45% Construction -52% Wholesale and retail -42% Transport and hospitality -39% Service sectors -36% Other -14% 0.8% 1.7% 1.3% 0.7% 2.9% 1.8% 3.6% 1.3% 1.8% 2.6% 6.8% 2.1% 1.3% 0.9% 1.6% 0.9% 1.2% 2.5% 1.1% 1.0% 1.8% 3.3% 1.9% 0.2% 1.3% 2.1% 3.2% 1.5% 1.6% 2.1% 1.6% 1.4% 3.8% 3.1% 4.1% 6.6% 2.9% 4.9% 2.1% 2.4% 1.1% 0.1% 0.4% 2.6% 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 US HY Euro HY US Loans Euro Loans
As such, a severe liquidity shock has been successfully averted; though looking at public markets we did see a pick-up in defaults in 2020, particularly in the US high yield market, where some already-troubled names in retail and energy fell by the wayside after years of struggles. Defaults were more muted in other sectors, showing only a small increase against a typical year.
How sector skews impact credit
Sector bias within markets has played a role too. The skew towards technology and healthcare in loan markets certainly helped credit quality in 2020, as those saw very limited disruption, and in
some cases even benefitted from the impact of
Covid-19.
After taking provisions in 2020, the banking sector has assumed that it will see growth in
non-performing loans. Arguably, with tighter lockdowns across Europe in Q4 2020, banks will have further forward-looking provisions to take in Q1 and Q2 2021, but thanks to their robust capital base
coming into the crisis, we are confident that banks
are well placed to absorb these losses.
One could assume that high yield debt and loans will see some of the same trends – essentially, there is an overhang of postponed problems from 2020 that will be a central feature of credit markets into 2021 and beyond. But here we disagree with the common assumption and adopt a more optimistic view.
The skew towards
technology and
healthcare in loan
markets certainly
helped credit
quality in 2020,
as those saw very
limited disruption,
and in some cases
even benefitted
from the impact
of Covid-19.
1. When comparing markets with what will happen on banks’ balance sheets, we must remember that the average small business operates with very thin liquidity margins – under a month of liquidity is the median, according to a 2019 client survey by JPMorgan. The ability to re-open and find the working capital to restart in sectors like small restaurants is constrained.
Landlords may show less patience towards small operators with little negotiating power.
The companies we invest in are on a different scale. The levers available in 2020 to shore-up
balance sheets ranged from wide-open capital markets (wide open early on largely thanks to
the US government’s decision to use capital markets as its stimulus conduit) and government-backed bank lending programmes. Public and private equity has also been forthcoming, as neatly illustrated by a prominent US cruise operator coming to equity markets three times last
year. In combination, this has given the vast majority of businesses we analyse the ability to see
through very challenged operating environments to year-end 2021 or beyond into 2022. With vaccines rolling out, we believe finding financing to bridge a gap to recovery should not be
a challenge. This is also helped by the fact that consumer-facing industries were largely in good shape prior to the shock thanks to long-term secular growth trends
2. The exposure at market level to sectors with acute revenue challenges is fairly small. We
are not blind to the changes happening in areas like commercial real estate; the crisis has
accelerated a shift towards online shopping and shown working from home to be more feasible than commonly thought, which has clear, negative and long-lasting implications. This sector
is not financed in our markets. The evidence of pent-up demand in leisure sectors is robust,
whether that be restaurants, holidays or a trip to the pub.
Our outlook is based on two factors:
As such, our expectation for defaults is that they will be not much above average. There will be pockets of stress, banks will likely have some more provisions to take, there may even be outsized returns to support the most stressed borrowers given the extension of restrictions in many countries in 2021. However, we expect the overriding trend to be one of recovery and repair. As always, we run pre-mortem analysis on our views to help save us from post-mortem positioning discussions. Vaccine rollouts and
effectiveness could disappoint – we see this as
the greatest existential risk of 2021. If the vaccine is an unexpected failure that would be disastrous – at the time of writing, Covid is once again more or less out of control across the Western world. Governments could also run out of patience with the largesse they are showing, but we do not see that as likely.
In our view, the biggest hurdle for high yield returns is simply the scale of the 2020 recovery. While the index quality continues to edge higher in high yield. Chart 5 shows that the asset class has a bigger skew to BB bonds than at any point in this cycle, spreads have recovered to 374bps in the US high yield market, 352bps in Europe and average prices in loans are back to 98.625 (as at 15 January 2021). We remain constructive on both high yield and loan markets due to the combination of recovering
credit quality and fund-flow support that ultra-low
rates continue to create. A balanced portfolio today inevitably struggles for income; credit markets are one of the few shorter-duration, higher-yielding
solutions. Technically, therefore, the positive flow
dynamics of 2020 are likely to stay in place in 2021. While returns will likely trail the second half of 2020, we believe spreads can rally beyond what is seen as fair in the current policy backdrop.
There will be
pockets of
stress...however,
we expect the
overriding trend
to be one of
recovery and
repair.
C H A R T 5 : C R E D I T Q U A L I T Y B R E A K D O W N O F T H E I C E B O F A G L O B A L H I G H Y I E L D C O N S T R A I N E D I N D E XSource: BoA Global Markets, Bloomberg. As at 31 December 2020
61% 29% 10% 55% 35% 10% 0% 10% 20% 30% 40% 50% 60% 70% BB B CCC & Below Dec-20 Dec-19
This document may be produced and issued by the following entities: in the European Economic Area (EEA), by BlueBay Funds Management Company S.A. (the ManCo), which is regulated by the Commission de Surveillance du Secteur Financier (CSSF). In Germany and Italy, the ManCo is operating under a branch passport pursuant to the Undertakings for Collective Investment in Transferable Securities Directive (2009/65/EC) and the Alternative Investment Fund Managers Directive (2011/61/EU). In the United Kingdom (UK) by BlueBay Asset Management LLP (BBAM LLP), which is authorised and regulated by the UK Financial Conduct Authority (FCA), registered with the US Securities and Exchange Commission (SEC) and is a member of the National Futures Association (NFA) as authorised by the US Commodity Futures Trading Commission (CFTC). In United States, by BlueBay Asset Management USA LLC which is registered with the SEC and the NFA. In Switzerland, by BlueBay Asset Management AG where the Representative and Paying Agent is BNP Paribas Securities Services, Paris, succursale de Zurich, Selnaustrasse 16, 8002 Zurich, Switzerland. The place of performance
is at the registered office of the Representative. The courts of the registered office of the Swiss representative shall have jurisdiction pertaining to claims in connection
with the distribution of shares in Switzerland. The Prospectus, the Key Investor Information Documents (KIIDs), where applicable, the Articles of Incorporation and any other applicable documents required, such as the Annual or Semi-Annual Reports, may be obtained free of charge from the Representative in Switzerland. In Japan, by BlueBay Asset Management International Limited which is registered with the Kanto Local Finance Bureau of Ministry of Finance, Japan. In Australia, BlueBay is exempt
from the requirement to hold an Australian financial services license under the Corporations Act in respect of financial services as it is regulated by the FCA under the laws of the UK which differ from Australian laws. In Canada, BBAM LLP is not registered under securities laws and is relying on the international dealer exemption under applicable provincial securities legislation, which permits BBAM LLP to carry out certain specified dealer activities for those Canadian residents that qualify as “a Canadian permitted client”, as such term is defined under applicable securities legislation. The BlueBay group entities noted above are collectively referred to as “BlueBay” within
this document. The registrations and memberships noted should not be interpreted as an endorsement or approval of BlueBay by the respective licensing or registering authorities. Unless otherwise stated, all data has been sourced by BlueBay. To the best of BlueBay’s knowledge and belief this document is true and accurate at the date hereof. BlueBay makes no express or implied warranties or representations with respect to the information contained in this document and hereby expressly disclaim
all warranties of accuracy, completeness or fitness for a particular purpose. Opinions and estimates constitute our judgment and are subject to change without notice.
BlueBay does not provide investment or other advice and nothing in this document constitutes any advice, nor should be interpreted as such. This document does
not constitute an offer to sell or the solicitation of an offer to purchase any security or investment product in any jurisdiction and is for information purposes only. This document is intended only for “professional clients” and “eligible counterparties” (as defined by the Markets in Financial Instruments Directive (“MiFID”) ) or in the US by “accredited investors” (as defined in the Securities Act of 1933) or “qualified purchasers” (as defined in the Investment Company Act of 1940) as applicable and should not
be relied upon by any other category of customer. No part of this document may be reproduced, redistributed or passed on, directly or indirectly, to any other person or published, in whole or in part, for any purpose in any manner without the prior written permission of BlueBay. Copyright 2021 © BlueBay, is a wholly-owned subsidiary of
RBC and BBAM LLP may be considered to be related and/or connected to RBC and its other affiliates. ® Registered trademark of RBC. RBC GAM is a trademark of RBC. BlueBay Funds Management Company S.A., registered office 4, Boulevard Royal L-2449 Luxembourg, company registered in Luxembourg number B88445. BlueBay Asset Management LLP, registered office 77 Grosvenor Street, London W1K 3JR, partnership registered in England and Wales number OC370085. The term partner refers to a
member of the LLP or a BlueBay employee with equivalent standing. Details of members of the BlueBay Group and further important terms which this message is subject to can be obtained at www.bluebay.com. All rights reserved.
