A credit cycle like no other

A credit cycle like no other

Unprecedented policy actions delay but do not eliminate the need to address fundamental challenges many issuers face. As the COVID-19 shockwaves continue, we expect some sectors to perform comparatively well while others struggle, with opportunities arising among both groups.

Global Credit: Midyear 2020

Initial phases
The broad and deep credit selloff in response to the initial COVID-19 shock, and the dramatic retracement since, are just the initial phases of a highly unusual cycle.
Driving dispersion
The sector-specific nature of the shock and the unevenly distributed benefits of policy support are likely to drive significant dispersion in credit performance.
Capital solutions
In traded credit, we see opportunities in sectors such as energy, European autos, and Chinese property.

The first half of 2020 structurally transformed the world we live in, with repercussions that will take more than a few quarters to come into focus and years to fully comprehend. The global pandemic disrupted lives and livelihoods while rapidly injecting uncertainty into the economic outlook. Credit was not immune when the shock hit, and a highly correlated selloff in March left few places to hide.

Deconstructing performance thus far in 2020

Total Returns for credit markets this year and current yields

Total Returns for credit markets this year and current yields

Source: Bloomberg, JP Morgan, S&P LCD. 6/30/2020. US IG = Bloomberg Barclays US Corporate Index, Global Fixed Income = Bloomberg Barclays Global Aggregate Index (USD-hedged), Asia IG = JP Morgan Asia Credit Investment Grade Index, EMD Corp = JP Morgan Corporate EM Bond Index, EU IG = Bloomberg Barclays European Corporate Index (USD-hedged), Asia HY = JP Morgan Asia Credit Non-Investment Grade Index, EMD Sov HC = JP Morgan Emerging Market Bond Index, US HY = Bloomberg Barclays US High Yield Index, US Loans = S&P LCD Leveraged Loan Index, EU HY = Bloomberg Barclays Pan-European High Yield Index (USD hedged), EMD Sov LC = JP Morgan GBI-EM Global Diversified Index (USD hedged), Global Equities = MSCI ACWI. The figures shown relate to past performance. Past performance is not a reliable indicator of current or future results. Yield represents index yield to worst for fixed income and credit indices, and dividend yield for Global Equities.

However, global central banks and governments stepped in to provide enormous fiscal and monetary policy support to bridge the economic shutdown and mitigate systemic risk. In the short term, these actions resulted in a fast and significant price recovery. (See the Deconstructing performance chart.) Longer term, uncertainty and risks remain as government policy actions delay but do not eliminate the need to address fundamental challenges many issuers face. Together with the sector-specific nature of the shock and the unevenly distributed benefits of policy support, those challenges are likely to drive significant dispersion in credit performance. Among other consequences, this will increase the need for non-traditional funding solutions. (For more on the policy backdrop, see Policy Revolution, a June 2020 whitepaper from the BlackRock Investment Institute).

Credit enhancing

For issuers, extremely low interest rates plus asset purchase programs that include higher quality corporate debt have lowered borrowing costs and increased financial flexibility. For investors, however, this mix makes income hard to find. In fixed income, the Barclays Global Aggregate Index yield ended the second quarter at 0.95%, near its all-time low.1 Going forward, we believe credit will be called upon to fulfill a larger proportion of investors’ income requirements, and we expect this will increase demand across both public and private credit.

Value opportunity in traded credit

Since the wides of the crisis on March 23, credit spreads have retraced 60-80% of their pre-crisis levels. (See the Rapid retracement chart.) The high yield credit markets moved from pricing in over 50% of the market defaulting to approximately 30% today. Despite this move, spreads remain near the 80th percentile over the last decade, which is still a potentially attractive entry point. Importantly, greater dispersion in underlying markets between the highest quality credits and those with more challenged business models or COVID-impacted sectors is increasing idiosyncratic opportunities. Our fundamental research team is evaluating companies across many sectors globally to drive alpha generation.

Rapid retracement, but we expect dispersion to grow once again

Global credit spread change: since 2020 tights (in bp) and % retracement since 2020 wides

Global credit spread change: since 2020 tights (in bp) and % retracement since 2020 wides

Source: Bloomberg, JP Morgan, S&P LCD, 6/30/20.

Examples of where we see pockets of value in today’s markets include:

  1. Global energy. Markets have been particularly hard hit this year as the Saudi / Russian price war occurred simultaneously with a demand drop caused by the pandemic. US credit markets carry the most significant exposure to energy, and this double black swan event forced energy companies to pivot business models. A 70% decline in the oil price to under US$18/barrel at the April lows forced capital spending reductions of ~40%, and exploration and production (E&P) companies chose to shut-in non-economic producing volumes. Although oil prices have more than doubled to ~US$40/barrel since the lows, many businesses are not viable long-term at this commodity price level. While some management teams may be able to deliver the increased efficiencies needed to survive below US$50/barrel oil, the 2022 maturity wall is likely to become the next major driver of restructuring activity for the sector.2
  2. European Autos. The sector is experiencing structural change as the European Union’s fiscal stimulus seeks to promote electric vehicle (EV) development over traditional internal combustion and premium cars. We expect to see further integration of sustainability priorities into public policy actions, particularly in Europe. In autos, the major original equipment manufacturers (“OEMs”) with greater scale are generally better placed to take advantage of the transition, although most OEMs are not yet prepared to ramp up EV production. EV development requires significant and sustained capital expenditure outlays, and with fewer moving parts, value chains must shift to focus more on technology and innovation to reduce car weight. Traditional engine and gearing parts suppliers must adapt to survive, and while this is a longer-term secular trend, public policy can serve to accelerate change.
  3. China property. China is experiencing a recovery in growth earlier than many other markets due to the earlier shutdown timeline related to COVID-19, and China property developers have seen sales and construction rebound back towards pre-virus levels. The sector is primarily reliant on local Chinese consumer demand, which continues to expand. While construction and sales were delayed in 1H20, we are beginning to see a pick-up in sales momentum. Developers have taken advantage of the relaxed financing conditions to improve liquidity positions and lower financing costs, while also reducing land acquisitions due to the uncertainty around the pandemic. Valuations look attractive relative to comparable global markets, and locally between offshore and onshore property bonds.

Financing and refinancing across public and private companies

Market uncertainty over the last few months has led to considerable supply from companies looking to shore up capital reserves during the period of economic disruption. Year to date over US$2.1 trillion of new corporate supply has been issued across global investment grade and noninvestment grade credit markets, now 60% ahead of last year to date.3 This is mostly in the investment grade end of the market, where access to capital is rarely cut off and where the biggest benefit from fiscal and monetary policy has been felt. Further down the ratings spectrum, the ability to access the capital markets becomes more idiosyncratic, and bespoke solutions or nuanced deal structures may be required to satisfy lenders.

In the private direct lending markets, the 2.5-3y average life of transactions means middle market borrowers from the 2015-2017 vintage deals must return to the market to refinance. In the post-COVID environment senior secured loans are being underwritten to relatively higher yields with better lender protections in the form of tighter financial covenants. This should improve deployment opportunities for investors putting capital to work going forward.

Capital solutions for stressed and distressed companies

The global pandemic is likely to create the largest stressed and distressed investment environment since 2008. Credit markets have more than doubled in size over the last decade. The volume of high yield and loans trading at distressed prices is historically high, and the marketimplied five-year forward cumulative default rate for CCC issuers is over 60%.3 (See the Distressed debt volume chart.) Issuers entered the crisis with elevated leverage ratios, and the significant economic disruption and changes to the growth outlook put greater pressure on a larger universe of companies in need of capital solutions. We expect this to play out over the next two-plus years, with a wide range of potentially attractive investment opportunities. Although many distressed funds were raised well in advance of this market selloff, we believe the need for capital still well outstrips the available supply, creating attractive potential opportunities to provide unique financing solutions.

Distressed debt volume has exploded this year

Value of HY bonds and bank loans trading at distressed levels

Source: JP Morgan, 6/30/20. High yield bonds are considered distressed when trading below 70 cents on the US dollar; bank loans when trading below 80 cents on the US dollar.

Where to from here?

The outlook for the rest of this year is highly uncertain, and we will learn an enormous amount in the next few quarters about corporate behavior, the impact of government policy stimulus, and the trajectory of the COVID-19 virus while restarting and adapting economic activity. Consumer sentiment, the government’s policy response, and the trajectory of growth in the wake of the virus will factor meaningfully into the outcome of the November US presidential election, and uncertainty ahead of that election will likely contribute to a more cautious recovery and a more volatile investment environment.

Examples of where we see pockets of value in today's markets include:

A slower than anticipated recovery due to more cautious consumer behavior, resulting in higher credit dispersion and spread volatility.
Elevated risk premiums and tighter covenants for lending in both public and private markets which will create new opportunities to earn attractive income.
Growing demand for bespoke capital solutions that cannot be financed in the traditional public markets which will increase the need for lockup capital.
James Keenan
Chief Investment Officer & Co-Head, Global Credit
Tim O’Hara
Co-Head, Global Credit