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August 2020 / INVESTMENT INSIGHTS

Global High Yield Bonds Continue to Offer Value

Opportunities remain despite recent spread tightening

Key Insights

  • Despite spread tightening, there is still value in the high yield bond market— although the nature of the opportunity set has changed.
  • There are opportunities to invest in companies in sectors that have been hit hard by the coronavirus, but which have the cash flow to emerge stronger.
  • Car parts manufacturers and casinos could be among the firms to rebound strongly.

After widening dramatically at the height of the coronavirus market sell-off in the spring, high yield bond spreads have narrowed again in response to aggressive government stimulus packages and improving economic data (see chart). The question is: given that valuations have recovered, is there still value in the high yield market?

We believe there is, but we also acknowledge that the nature of the opportunity in the high yield market has changed. Although credit spreads have yet to recover to their pre-coronavirus levels and therefore have room to rally further, this may not occur for a while yet and, when it does, it is likely to be much less dramatic than the tightening of the past few months. The great buying opportunity that arose when high yield bonds sold off aggressively in the early days of the coronavirus shock has passed.

Instead, we expect a period of slowly improving conditions as life gradually returns to normal in most countries. Further outbreaks of the coronavirus are likely, but these will probably result in localised lockdowns rather than the country-wide restrictions imposed during the first wave – and will therefore be significantly less damaging to the global economy. A vaccine may become widely available early next year, but even if it does not, we believe that governments and health authorities will have the tools to deal with new outbreaks without resorting to draconian measures. In this environment, spreads may hover around current levels, with pockets of volatility, for some time to come – meaning that attractive income is still available.
 

Global high yield bond spreads: selloff and recovery

Global high yield bond spreads: selloff and recovery

As of July 31, 2020

Past performance is not a reliable indicator of future performance.

European High Yield—ICE BofA European Currency High Yield Constrained Excluding Subordinated Financials Index; US High Yield—J.P. Morgan Domestic High Yield Index; EM Corporates—J.P. Morgan CEMBI Broad Diversified Index. Source: J.P. Morgan & Bank of America/Merrill Lynch  

Automakers and casinos could be set to bounce back

An improving economic environment is not a risk-free one, however. Large numbers of high yield issuers have been hit very hard by the coronavirus shock and some will never recover. Based on an in-depth analysis of the balance sheets of all the companies we follow, we are anticipating a default rate of 9% for the US high yield market in 2020, and around 5% for the European high yield market. Although they are lower than the 12.2% and 6.1% default rates respectively predicted by rating agency Moody’s[1].

Assuming we are correct in anticipating a slowly improving economic environment, which high yield sectors offer the most potential in our view? Defensive sectors such as packaging and cable have delivered strong performance during the crisis and we think it will probably continue to perform relatively well, albeit not to the same degree as before. Instead, we think the next phase of the recovery will most likely be led by companies in sectors that have been hit hard by coronavirus and are currently trading at a significant discount, but which have the cashflow to weather the storm and emerge stronger.

The automotive sector, for example, has been severely impacted by the coronavirus because of forced factory closures, its dependence on discretionary spending and the collapse of some of its key markets, particularly in Asia. Rating agencies have downgraded billions of dollars’ worth of debt owed by automakers and the sector continues to face steep challenges, but it also offers significant potential upside. In particular, manufacturers of auto parts such as seats and other interior features are trading at significant discount and appear in a good position to recover strongly. All cars require interior parts, so 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 coronavirus pandemic, physical gaming companies such as casinos have been forced to close and are trading at significant discount. 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. The services sector in general is broad and diverse, and has a number of attractive and idiosyncratic companies with the potential for considerable upside in our view.
 

Fallen angels have deepened the opportunity set

It is not just a matter of identifying the sectors with the potential to rebound, however; 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. Another company in the same sector that has a stronger balance sheet and better cash flow may be able to weather the storm and emerge stronger the other side. We do not believe that the amount of leverage a company has is particularly important in determining its ability to survive a crisis; what ultimately matters is its ability to meet its coupons and interest payments until its revenues recover.

Identifying such companies will be the key to successfully navigating the high yield bond market in the period ahead. For those who can, there will be plenty of opportunities available. Rating agencies are likely to continue downgrading large quantities of BBB bonds to high yield, depending on the path of the economic recovery. Automakers, leisure, restaurants, hotels, airlines and retail firms will bear the brunt of this. Among these fallen angels will be some multibillion-dollar companies whose business models remain robust and whose liquidity will enable them to survive until demand picks up again. There are also many smaller, long-standing high yield issuers whose prospects were steadily improving before the coronavirus crisis and will continue to do so afterwards.

Although spreads have tightened, we believe that the additional spread offered by BB bonds over BBB-rated debt adequately compensates investors for the additional credit risk. What’s more, if we are correct in our view that any future outbreaks of the virus are likely to be met with only localised 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.

 

IMPORTANT INFORMATION

This material is being furnished for general informational and/or marketing purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, nor is it intended to serve as the primary basis for an investment decision. Prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources' accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date noted on the material and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

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August 2020 / ASSET ALLOCATION VIEWPOINT

Global Asset Allocation: The View From The UK - August Insights
202008-1304415
RELATED FUND
SICAV
Class I USD
ISIN LU0133083492
A bottom-up portfolio that seeks to capture enhanced returns from a diversified global portfolio of income bearing, high-yield securities from around the world, including emerging markets. The portfolio seeks to generate income and growth over the long term. View More...
3YR Return
(Annualised)
3.30%
Avg Coupon
6.47%
FACTSHEET
Fund Size
(USD)
$1.4b
Avg Maturity
6.24 yrs
Avg Duration
3.37 yrs

April 2020 / INVESTMENT INSIGHTS

High Yield Investing During Volatile Times

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High Yield Investing During Volatile Times

Spread levels can signal attractive return potential

By Michael Della Vedova

Michael Della Vedova Portfolio Manager

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