High yield bonds: from liquidity to sustainability?

In early 2020, a considerable number of corporate issuers had to face severe liquidity issues amid the COVID-19 lockdowns imposed across the world. The subsequent response from governments and central banks has been unprecedented as they provided virtually unlimited support through monetary accommodation and fiscal stimulus. Thanks to massive quantitative easing/bond buying programs that included sovereign, investment grade and even high yield bonds, central banks managed to inject historic levels of liquidity in the market and established themselves as the buyers and lenders of first and last resort.

Compensating for frozen cash flows

As a result of this important back-stop, corporates had the opportunity to raise additional debt – made affordable either by state guarantees or central banks policies – to compensate for the frozen state in their cash flows. Indeed, in the second half of 2020, high yield issuers in the US and Europe successfully issued large amounts of debt irrespective of their fundamentals and their balance sheet status. While this helped flatten the default curve in the short term, it did not prevent from credit deterioration and downgrades. After all, though central banks’ liquidity injections proved very helpful, they cannot guarantee revenues or profits for corporate issuers of debt, especially in a market presenting huge challenges for operational efficiency and productivity amid confinements and social distancing.

As we head into 2021, high yield markets should continue to benefit from the strong liquidity provided by central banks while vaccine developments and fiscal stimulus should allow us to look through near term fundamental deterioration and to focus on the reopening of economies from the second quarter of 2021.

Focus on debt sustainability

However, it is important to note that a portion of this “feel-good”/ positive scenario has been priced, as witnessed by the compression in spreads and yields over the past few months and over the medium term, we do keep in mind that pricing the pain will be just as important as pricing the gain. As the effects of fiscal and government stimulus start declining, fundamentals and idiosyncratic risks are expected to move to the forefront and a liquidity-driven rally is likely to make way for a context where debt sustainability is paramount.

Secular trends such as climate change, digitalisation and de-globalisation, that have been present over the past years, have seen a dramatic acceleration and a greater impact as a result of the Covid crisis. This has resulted in an even more challenging and disruptive environment for corporates as they have been forced to revise their business models and implement structural changes. Companies have had to invest considerable resources in digital transformation, thereby increasing disruption in sectors like retail, commercial real estate and travel. Globalisation has yet again been challenged and companies had to redesign their supply chains creating dispersion among regions and industries like transportation. By making our lives tolerable during the pandemic, technology has confirmed its crucial role for the foreseeable future, and the leadership will undoubtedly be strongly contested by the US and China. Finally, the world’s focus on the climate change will require major alterations in all sphere of consumerism, with the energy, autos and utilities sectors set to literally reinvent themselves over the next decade.

Big opportunities for active managers

We believe these structural mega-trends will have a lasting impact and generate substantial disruption within the corporate universe. We expect the high yield market to be particularly affected considering the higher levels of leverage and greater exposure to bankruptcies, delinquencies and defaults. However, this disruption will result in strong opportunities for those issuers that are able to successfully adapt to the challenges presented. Certain sectors are likely to benefit from key sustainability challenges and regulatory changes that have come about. As a result, we are very likely to see increased dispersion in the market among sectors, regions and issuers, with debt sustainability becoming an issue for many, resulting in a strong separation between winners and losers.

In this challenging environment it will be crucial for investors to exercise a high level of diligence in order to select the right opportunities in a market where dispersion will be omnipresent. Active management and a high level of selectivity based on bottom-up research is vital. Furthermore, traditional analysis will need to be supplemented by greater focus on issues like governance, which will be a key metric while assessing the adaptability of a business model. Analysis of social factors will gain prominence as a company’s interaction with its workforce and with society will be significant amidst the rise of de-globalisation. Finally, the consequences of regulation surround climate change and its impact on sectors/issuers will need strong consideration when analysing the key sustainability challenges that are present. These aspects will have a direct impact on the creditworthiness of issuers and their ability to repay their debt over the medium to long term.

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