Resilience in credit

Investor resilience has come under severe strain in 2020; perhaps to levels not experienced since the darkest days of the global financial crisis. But as we move into the second half of the year, market signals and economic reality have become seemingly oblivious to one another, including in many areas of the credit market. This disconnect raises questions, and investors would do well to remember that complacency has no place for anyone trying to build resilience into their portfolios.

When looking at primary market activity and yield movements, one could almost be forgiven for thinking the market meltdown in March was a strange anomaly. Global investment-grade corporate issuance reached $2.8 trillion in the first half of the year, according to Refinitiv data, up 39 per cent year-on-year and on track to break records; global high-yield issuance stood at $259.8 billion by the end of June, up 19 per cent compared to 2019.

Meanwhile, yields on the Bloomberg US Corporate Investment Grade Index were close to 2.2 per cent – 70 basis points lower than where they started the year. These levels were probably outside most investors’ projections for the asset class, but not completely beyond the realms of possibility.

They look more perplexing, however, when you consider that yields spiked to over 3.8 per cent in March. The high-yield market saw even more dramatic moves: from January 26 to March 26, the yield on the Bloomberg US Corporate High Yield Index more than doubled to 10.3 per cent. To put that in context, the last time the yield was over ten per cent was in 2009. And despite recovering some ground, it was still close to seven per cent by the end of June.

Policymakers restore order

Valuations have clearly been underpinned by the much-needed policy interventions of central banks and governments to support economies and companies devastated by COVID-19. For example, France and Germany announced the state would guarantee certain loans, and the US Federal Reserve’s (Fed) intervention on the US corporate bond market is helping many companies stay afloat, by keeping their borrowing costs artificially low.¹

“In that regard, it has not been different from the last ten years, in that it is not a true reflection of the economic situation. The underlying economics would suggest a lot more companies should go bankrupt,” says Colin Purdie, Aviva Investors’ chief investment officer for credit.

Illustrating just how precarious the economic situation is, the International Monetary Fund in June revised its forecast for global GDP to a contraction of 4.9 per cent this year, considerably worse than the three per cent estimated contraction it announced just two months earlier.

Although credit rating agencies were quick off the mark in downgrading companies due to the deteriorating economic conditions, there will undoubtedly be another round to follow the first and a rise in defaults.² On July 1, Fitch announced that the number of defaults in the first five months exceeded the full-year number for 2019, and that the pandemic fallout will erase more than $5 trillion in revenue from its global corporate portfolio in 2020. “At the current rate, the annual volume of corporate defaults could exceed the record set during the global financial crisis in 2009,” the agency added.

Nothing lasts forever

Such gloomy projections serve to highlight that government support programmes won’t last forever, and the impact will be felt in the medium term. When policy support is removed, companies with unsustainable business models will come under pressure as it becomes more expensive or even impossible for them to borrow. At that point, the aftermath of the COVID-19 crisis will reveal some major differences with the situation companies have enjoyed in the last ten years.

Take the airline industry. The sector could be changed permanently as companies question the necessity of business travel now that extended lockdowns and the use of technology have put paid to the belief clients need face-to-face interactions to maintain relationships. Individuals' own attitudes to travel may also change as a result.

“In the short term, the crisis hasn’t changed anything on credit markets, but in the medium term it will. Changes will come through, both on the company side in terms of who is sustainable and who is not, and also in terms of the voluntary or forced changes to behaviours and consumer trends,” adds Purdie.

Building resilience into portfolios

When it comes to investing, he says resilience in such a challenging environment is about taking appropriate levels of risk, commensurate with clients’ expectations: “It’s not about running away or being overconfident; it’s about understanding the markets and companies you invest in, and ensuring you adapt to the current environment. In many ways, resilience comes from having a strong process in place to give you the confidence to take as well as manage risk.”

Strong fundamental analysis coupled with robust portfolio construction can deliver a structural advantage over benchmarks. Portfolio construction aims to optimise risk-adjusted returns and to embed diversification and resilience into the investment process, identifying the best way to put idiosyncratic ideas into practice.³

“What has helped us in the first instance is that our process is based on strong fundamental analysis: we invest in companies that we know and like. The markets have benefited from stimulus for a number of years, which has led to a lot of companies coming into market, both high yield and investment grade, but it’s important not to get carried away with that and to focus on the fundamentals,” says Purdie.

Investment managers can tend to be optimistic about their ability to forecast performance, creating a bias toward riskier allocations. Portfolio construction helps identify and mitigate those biases, using tools like sensitivity analyses of portfolios under multiple scenarios. These show the level of risk taken in pursuit of returns and what can happen to a portfolio when the central investment thesis does not play out. It is a good recipe against overly optimistic assumptions.

Building in resilience also rests on diversifying the drivers of returns, keeping a close eye on correlations, which can change over time, and stress-testing portfolios.

For instance, even though no one could have seen COVID-19 coming, credit markets have seen a steady decrease in liquidity over the last decade,⁴ so adapting their approach to allow for periods of illiquidity could have given investors comfort when markets sold off brutally in March.

“You shouldn’t rely on the fact you can liquidate your portfolio quickly, which means you need to be comfortable holding it for the medium term if the situation demands that. That’s why we do thorough cash-flow analysis and are constantly looking at the strength of the balance sheet. When we put companies in the portfolios, we want to have the confidence that, if something does come out of the blue, we are still comfortable holding these names,” says Purdie.

Playing where the puck is going to be

Looking at longer-term fundamentals, resilience also means having a business model that can adapt to reflect changing conditions and consumer trends. History is littered with examples of companies that resisted change and did not survive; from Kodak to Blockbuster. Purdie says a common characteristic of resilient companies is that they remain on the front foot and focus on the longer term.

“Companies doing better in this environment are those that have technological solutions. Retailers that can’t have people in their shops are not going to do very well in a lockdown. But a retailer that has a strong online presence and has really embraced that market will do better,” he says.

To quote Canadian ice-hockey player Wayne Gretzky: “A good hockey player plays where the puck is. A great hockey player plays where the puck is going to be.” Applying the analogy to businesses, resilient companies are those with the foresight to move ahead of market trends. It doesn’t necessarily need to be a revolution, but it should be an evolution.

V-shaped, w-shaped or society-shaped

Looking at the credit market as a whole, we prefer high-quality names given the economic backdrop. The investment-grade sector currently looks slightly more attractive than high yield because most of the central bank support mechanisms are aimed at those companies, which also helps explain why investor flows are continuing to come in. Default rates are expected to rise, and probably more so in the US than Europe given the different types of stimulus injected. Avoiding the losers will be critical for portfolio resilience.

Figure 1: Moody’s 12-month default forecasts, before and after COVID-19

“If you buy the high-yield market as a whole, you’re taking exposure to these potential defaults, and that will eat away at your returns. However, if you run an active strategy and have the ability to avoid losers and pick winners, there are still attractive opportunities,” says Purdie.

At a sector level, given the pressure on economies, some areas are coming under particular scrutiny. “We don’t want to invest in sectors where we don’t have clear visibility on the path forward. We don’t think market pricing means we are getting adequately paid to take that risk right now,” says Purdie.

In that sense, although there is currently much debate about the shape of the economic recovery, for long-term credit investors this may not matter as much as the structural economic and societal trends that are emerging.

Sectors like restaurants, travel and leisure are all impacted by the pandemic, either because of government restrictions or voluntary behavioural changes. For example, will people go to a cinema to see films, or will they start going straight onto paid streaming sites? Will restaurants have to set tables further apart? If they do, to what extent will their profit margins go down? If the two-metre rule is reduced to one metre, capacity can go up and businesses that may not be viable at two metres may be viable at one.

It is important to look for companies that are less impacted by these changes, and for those that will benefit. “What have people not stopped doing during lockdown? Picking up the phone every two minutes, checking the internet, their email and so on, so technology companies are doing well. That is why the US stock market is doing so well, as it is tech-heavy, but even in credit markets, tech companies are doing well,” says Purdie.

Futhermore, defensive sectors such as healthcare and pharmaceuticals, which have historically done well during recessions, are continuing to perform. There are also opportunities in financials, despite residual investor scepticism of the sector that date backs to the financial crisis. 

“Financials are in a much better place than in 2008. Banks have got far more capital and liquidity, and generally far less risk on their balance sheets, so we are much more comfortable with banks today. Then, when you look at how governments are trying to channel money into the economy, some of the banks are being used as quasi-public policy agents. It’s in governments’ interest to have strong, stable, functioning banking systems,” says Purdie.

Stronger ESG practices mean more resilient companies

There will also be sectors that lose. The US energy sector is a case in point. It was first impacted by the oil price war between Russia and Saudi Arabia in the early part of 2020, but it faces a far bigger problem on the demand side. The fall in demand during lockdowns was sizable, and because the global economic outlook remains poor, Purdie thinks the US energy sector will continue to be challenged.⁵

Longer term, the trend is not supportive either, as economies slowly but surely decarbonise, and demand moves away from oil and to sustainable energy sources. That is where environmental, social and governance (ESG) analysis comes in; taking non-financial factors and applying them to sector and company analyses to try and understand how trends are evolving.

Investor engagement has a key role to play in encouraging oil companies to evolve their business models away from fossil fuels towards renewables.⁶ Companies that are forward-looking in this regard are the ones that will come out stronger.

“Is legislation going to get any easier for oil producers? No. Are we going to see an increase in consumer demand for oil? No. All the stimulus in the European auto sector is going to electric and hybrid vehicles, none of it is aimed at diesel and petrol cars. COVID-19 has brought it into focus, but it is a longer-term trend that, hopefully, a due process will have identified before,” says Purdie.

In terms of car companies, he thinks those that are on the front foot and embracing electric-vehicle technology are the ones that will be around for the longer term, while those sticking with internal combustion engines will eventually disappear. “Either market sentiment is going to move against them, or they will be regulated or litigated out of business,” he says.

ESG helps uncover those long-term trends that COVID-19 has put in the spotlight, from the low-carbon transition to pushing the diversity agenda and the continued importance of good governance – recently illustrated by Wirecard going into insolvency, less than 18 months after an accountancy scandal revealed in the Financial Times.⁷

“How much more important are people going to think ESG is from an investment perspective, from a company perspective? Whether it’s to do with plastics, whether it’s to do with aeroplanes, COVID-19 throws into very sharp relief the fact people want to do things differently. They want to live life slightly differently now, and they will embrace these trends going forward. Creating resilient credit portfolios will be contingent on understanding that,” adds Purdie.