Global High Yield Fund -- Fund Manager Interview
Q: Global central banks have collectively expanded their balance sheets in 2020 to support the economy. With debt levels rising and central banks approaching their limits, what’s the base case for markets and economies going forward?
A: The coordinated efforts by Central Banks basically kept the credit markets functioning. The action taken by the US Federal Reserve to create the Credit Facilities (specifically, the Secondary Market Corporate Credit Facility, SMCCF), the Bank of Japan’s creation of the Special Program to support corporate financing and the ECB’s decision to lend freely all allowed companies to issue debt to function during the early stages of the pandemic. Most importantly for high yield was the SMCCF - this was the most important monetary tool that the high yield market has ever witnessed! By supporting companies’ access to funding, the draconian predictions of massive default did not materialize.
As the market and economies move away from these monetary policies, fiscal policies take center stage. Fiscal policy will need to remain supportive and flexible until a safe and durable exit from the crisis is secured. In the U.S., as an example, you are seeing Congress agree to further support individuals to bridge the gap from early vaccine administration to when a good majority of the world has been vaccinated. So, the base case for economies and markets going forward will be pent-up demand, which will drive a significant increase in Global GDP at a macro level all the way down to much improved earnings for corporations at the micro level. We believe corporate earnings will rebound strongly and interest rates will rise gradually throughout the year.
Q: The U.S. Treasuries market took investors on a bumpy ride in 2020, with yields plunging to historic lows early in the year before a partial grind back in the second half. How do you expect yields will change in 2021? How will that impact the HY market in general?
A: We expect yields to gradually increase in 2021, moving to around 1.75% to 2% by the end of the year. We expect yield curves to steepen as the Central Banks will remain accommodative keeping short rates anchored. The high yield market has two important shock absorbers against rising rates – its relatively short duration and the spread cushion. High yield typically shows remarkable resilience to rising rates in past episodes. We think high yield has the ability to offset most of the expected higher rates better than almost all other fixed income asset classes.
Q: According to S&P Global Ratings' latest data, global corporate defaults surged by 91% in 2020, hitting an 11-year high but below 2009 levels, driven mostly by companies in the U.S. and Europe. What are your default estimates for 2021, especially for HYs?
A: Yes, many companies defaulted in 2020, and a good percentage of those companies were in the energy industry or COVID-impacted sectors such as retailers. But with monetary policy support and now significant fiscal support and the efficacy of the vaccines, default rates have come down dramatically and are well below their peak levels – we believe we have seen the peak.
Leverage, interest coverage, operating margins and free cash flow will all be significantly stronger in 2021. These improved metrics, along with capital markets that are allowing significant refinancing, will keep defaults coming down. Moody’s default forecast is 4.66% for the next 12 months. Our forecast is for defaults to be only 3% for 2021. Our forecast is influenced by a number of factors; increased liquidity on company balance sheets after record issuance in 2020, the trend of higher rated and lower default ratio BB companies coming to market, the favorable vaccine news, and a distressed ratio of about 2.5% as of 02/09/2021 (distressed ratio = market weighted ratio of number of issues trading at a spread over 1,000bps).
Q: What factors do you expect will impact the credit market? What is your outlook for spreads?
A: Clearly yields for all fixed income assets are low, including high yield; but keep in mind, spread levels are higher than they were pre-COVID. The total return in the high yield asset class over the next 12 months will be mostly income and much less capital appreciation. Our outlook is that spreads will move down to around 300 to 325 basis points by the end of 2021 – not significantly tighter but tighter nonetheless. Please remember, much of the world has rates that are at or below 0%, so even with yields that are less than 4.5%, there will be continued demand for high yield.
Some of the main factors that support the credit market (more specifically, the high yield market) are 1)decreasing defaults 2)expectation that credit metrics reached a trough and will see dramatic improvement and 3)the actual implementation and administering of the vaccine to the world population.
Q: How will you position the fund amid this environment?
A: Though the year is young, and much uncertainty still awaits, we do think that high yield is well positioned to be a leader in 2021 in terms of fixed income returns despite historically low yields and spreads. With regard to portfolio construction, we don’t want to aggressively reach for yield, yet we want to ensure we have selectively found securities that provide additional upside as the world slowly moves past the COVID-19 pandemic. Therefore, we are comfortable moving to a slight yield advantage. In regards to quality, we currently like single-B’s the best, but we will also selectively add to our CCC exposure. Our favorite sectors at the current time are gaming, energy, building materials and metals. These are sectors that were more impacted by COVID and should see the strongest recovery coming out of COVID as they have not been structurally altered. We also like sectors that have proven to be strong cash-flow industries through all time periods such as cable, food and beverage, and packaging. We see similar value between the US and Europe and we plan to very slightly increase our allocation to the Asia region.
Q: What downside risks should investors be aware of? How will the fund protect investors from the risk?
A: We believe the most imminent threat (downside risk) COVID-19 currently poses is not as much the mutations we are seeing, but a failure to outpace them. In order to do that we have to move swiftly with vaccinations as many of the vaccines appear to be largely effective against the mutations. So long as we achieve adequate distribution and continued uptake over the next two to three months, we should expect a relatively sharp decline in severe cases, hospitalizations, and deaths. This is a risk our team follows extremely closely as it could negatively impact the market, but we currently view this as a low probability event. The fund typically invests in slightly more liquid issuers, thus we believe we would be able to efficiently de-risk the portfolio should mutations or vaccine distribution become a more imposing threat.
Darrien Smith, CFA
Principal Global Investors