Mike Cho and Jonathan Manning, investment-grade portfolio managers at Aviva Investors, look at the themes that will shape the asset class in 2021.
1. Subdued global growth, continued government and central bank support, and the relative safety of investment-grade credit as an asset class may put it in a sweet spot in 2021.
With prospects of a vaccine shining a light at the end of the tunnel for economies and many sectors, central banks could pare back some of the extraordinary stimulus measures taken to combat the economic effects of COVID-19, creating uncertainty for credit spreads.
Central bankers insist support will remain in place well into 2021 to avoid a premature tightening of monetary conditions
However, central bankers insist support will remain in place well into 2021 to avoid a premature tightening of monetary conditions. They will likely be slow to withdraw stimulus; particularly as mass distribution of vaccines may not materialise until the second half of 2021. Such continued easing should be supportive for credit spreads.
In addition, global economic growth may remain subdued until mass vaccinations get underway, reducing the risk of an inflation burst and monetary tightening. Such a scenario may create a sweet spot for investment-grade credit, as subdued global growth, continued government support and the relative safety of the asset class are all likely to be positive factors for at least the first half of 2021.
2. Demand for investment-grade bonds is expected to remain strong in 2021 and supply may return to lower, pre-pandemic levels. However, as growth recovers and policy uncertainty fades, we could see an increase in mergers and acquisitions (M&A). This would present risks to certain names and sectors, though companies may take a more disciplined approach to their balance sheets. Overall, the supply and demand dynamic should remain positive.
Unprecedented corporate debt issuance in 2020 was met with strong demand by global investors in their search for yield and given the relative safety of the asset class. In 2021, new issuance will likely be materially lower and closer to pre-pandemic averages, as companies revert to their usual levels of new borrowing and refinancing activity.
Companies may be more disciplined in their balance-sheet management over the next year
On the other hand, the perceived less business-friendly elements of the Democratic agenda are now unlikely to pass, be they higher corporate taxes, more stringent banking regulation or fracking bans. This could boost companies’ expansionary instincts in the search for new growth opportunities, including M&A activity. This presents risks for bondholders, although recent experiences with rising leverage and the liquidity crunch at the peak of the COVID-19 crisis in March suggest companies may be more disciplined in their balance-sheet management over the next year.
The strong demand seen in 2020 is expected to remain largely intact, bolstered by ongoing central bank support and investors’ search for yield, offering positive technical support that could offset some of the corporate risks. On balance, conditions in 2021 could have a modestly positive impact on spreads.
3. A divided US government could create a goldilocks scenario for investment-grade credit as the prospect of disruptive legislation becomes more remote, while the new administration could look to ease trade and geopolitical tensions.
A divided US government may be a positive factor for investment-grade credit, as potentially disruptive legislation now looks off the table for many sectors, including energy, healthcare and banks. This reduces certain tail risks for the investment-grade market.
The new US administration is likely to take a more measured approach to trade disputes
The new US administration may also look to defuse geopolitical tensions and certain trade wars. At the very least, it is likely to take a more measured approach to trade disputes and should seek multilateral solutions, giving businesses a smoother ride and more visibility to prepare for changes. Such an environment would be supportive for investment-grade companies with international exposure.
4. While conditions for 2021 look positive for investment-grade credit spreads, valuations are fair or rich in many areas, which limits upside potential. As ever, selectivity on companies and sectors will be important.
As interest rates remain low to negative and the global search for yield continues, higher-yielding areas of the market look more attractive, such as corporate hybrids and subordinated financials.
Balance sheets are more robust than a few years ago and continue to strengthen
In terms of sectors, we are positive on banks globally but particularly in Europe, especially when factoring in valuations. Balance sheets are more robust than a few years ago and continue to strengthen, and Europe is seeing a lot of consolidation, especially in the periphery, all of which is positive for the sector.
In the US, COVID-19 sensitive sectors such as energy have lagged the spread recovery and could be a pocket of upside potential should we see a global recovery and sustained higher oil prices, though security selection within energy will be key. Other sectors most affected by COVID-19, such as aerospace and certain consumer cyclicals, have scope for further recovery and spread tightening as well, though vaccine deployment may determine their pace of improvement.
We also see opportunities in some non-cyclical sectors like healthcare and technology, media and telecoms, where we especially like BBB credits with attractive carry where companies are deleveraging following a merger or acquisition.