High-yield bond spreads have narrowed again in response to aggressive government stimulus packages and improving economic data, after widening dramatically at the height of the Covid-19 market sell‑off in spring. The great buying opportunities that arose when high-yield bonds sold off aggressively in the early days of the coronavirus shock have passed, but there is still value in the high-yield bond market.
Large numbers of high-yield issuers have been hit very hard by the coronavirus shock, and some will never recover. One could see a default rate of 9% for the US high-yield market in 2020 and around 5% for the European high-yield market. Assuming it is correct to anticipate a slowly improving economic environment, defensive sectors such as packaging and cable have delivered strong performance during the crisis and are expected to continue performing relatively well.
However, the next phase of the recovery will most likely be led by companies in sectors that have been hit hard by the coronavirus and are currently trading at a significant discount, but which still have the cash flow to weather the storm and emerge stronger. Identifying such companies will be the key to successfully navigating the high yield bond market in the period ahead.
Some sectors were downgraded by rating agencies, but they offer significant upside potential. For example, the automotive sector has been severely impacted by the pandemic because of forced factory closures, its dependence on discretionary spending, and the collapse of some of its key markets, particularly in Asia. In particular, manufacturers of auto parts, such as seats and other interior features, are trading very cheaply and appear in a good position to recover strongly. These firms have good prospects regardless of the extent to which electric cars disrupt the market.
While online gaming companies have performed well during the Covid-19 pandemic, physical gaming companies, such as casinos, have been forced to close and are trading very cheaply. There may be an opportunity to invest in casino firms that have enough liquidity to survive for at least two years and reap the benefits as lockdowns are eased.
It is worth noting that it is not just a matter of identifying the sectors with the potential to rebound, but it is also important to identify the likely winners and losers within those sectors. A firm with a weak balance sheet and poor cash flow is unlikely to survive a steep, industry-wide fall in demand, particularly if it lacks the ability to raise new capital. The amount of leverage a company has is not particularly important in determining its ability to survive a crisis. What ultimately matters is the ability of a company to meet its coupons and interest payments until its revenues recover.
Although high-yield bond spreads have tightened, we think the additional spread offered by BB-rated bonds over BBB-rated debt adequately compensates investors for the additional credit risk. What’s more, if any future outbreaks of the virus are likely to be met with only localized lockdowns, the high-yield bond market is likely to benefit as consumers slowly resume their former spending habits and a number of badly hit sectors begin to recover.
Mike Della Vedova is the portfolio manager for European high-yield bond strategy and global high-income bond strategy at T. Rowe Price.