Executive summary
In times of great uncertainty, it is not uncommon for companies to suspend or withdraw forward-looking guidance. Given the magnitude of recent market volatility as well as the uncertainty associated with the spread and ensuing impact of COVID-19, we believe this applies today to our ability to provide guidance about expected returns for credit markets. While it’s theoretically possible to identify best-, base- and worst-case scenarios for credit markets, we think time is better spent putting this sell-off in context with previous sell-offs and educating our readers about trends to watch.
The negative returns for credit markets from equity’s peak on February 19 through March 23 are staggering. High yield bonds and senior secured loans are down -21.5% and -20.6%, respectively. The velocity and magnitude of the declines are also impressive. Both markets have recorded multiple “worst ever” days, measured by both percentage decline and spread widening, sometimes in rapid succession. When viewed through just the lens of sub-investment grade credit market performance, surely it must indicate that something is fundamentally wrong with these markets. How could there be so many large down days without some kind of liquidity crisis or broken market mechanism?
In our view, these returns need to be put in context with what’s going on in the broader equity and fixed income markets as a sanity check on sentiment. Credit markets are not melting down in a vacuum. In fact, the declines in equity markets are perhaps even more impressive, with the S&P 500 down nearly -34% since its high and recording its worst two days since 1987’s Black Monday within two days of each other. Said simply, there is a reason that credit markets are down. Equity markets are crashing and investor sentiment for risk assets has turned decidedly negative.
This sell-off in credit is not like 2015, when both high yield bonds and senior secured loans recorded negative annual returns on the back of a meltdown in energy credit while the S&P 500 was positive. It’s also not like 2008, when high yield and loans captured 78% and 102%, respectively, of the drawdown in the S&P 500 in the fourth quarter compared to 64% and 61% through the recent equity bottom on March 23. In our view, the lower downside capture of high yield and loans today compared to 2008 is also striking considering that other areas of the fixed income market that are generally perceived to be higher quality are also deeply negative. Investment grade corporate debt and municipal bonds, which posted positive returns of 1.5% and 0.74%, respectively, in the fourth quarter of 2008, are currently down -12.4% and -9.4% through March 23. Much like we have written in previous outlooks, credit markets are following equities, not leading, and the decline has been dramatic, yet orderly. If there’s one thing that seems out of place, it’s the decline in investment grade corporates and municipals, not the decline in high yield bonds and senior secured loans.
Credit markets do face issues in light of the anticipated decline in the global economy combined with the dramatic price shock to oil. Corporate revenue and cash flow growth had slowed significantly in 2019 and is almost assuredly going to be negative in 2020. Outflows from retail mutual funds in both high yield and loans have occurred at a record pace, adding to downside pressure in a weak market. Collateralized loan obligation (CLO) managers, the largest buyers of senior secured loans in the market, may find it difficult to issue new deals, further dampening demand for the asset class. Energy issuers, while down from 16% in 2014, still comprise roughly 11% of the high yield market today. And default rates, which have been below long-term averages for years, are surely set to rise. These are several examples of challenges the credit markets will face over the coming quarters. Ultimately, either further deterioration or eventual recovery in many of these stats will dictate returns for the market over the course of this year.
With such pervasive negativity, where is there room for optimism? Past performance is never a guarantee of future results, but buying into credit markets when spreads are this high has historically rewarded investors. In particular, in the 25 instances where high yield spreads widened beyond 900 basis points (bps), as they did on March 18, median annualized 1-, 2- and 3-year forward returns were 37%, 26% and 21%, respectively. There has never been an instance in all 25 historical occurrences where 1-year returns were negative. Furthermore, the high yield and loan markets have never had back-to-back negative annual returns. In our view, this data is not that surprising in the context of economic cycles over the past 35 years. While drawdowns and recessions are painful, eventually the economy stabilizes and credit markets recover.
Ultimately, we believe that investors that can remain active and tactical within these markets will be poised to outperform. Both a continued decline and an eventual recovery will not be even. Sectors that are extremely out of favor will eventually represent the best opportunities for investors that can properly analyze the companies poised to survive. Returns by rating will shift at different points in the cycle, traditionally with riskier names leading the decline before higher-quality names start the inevitable recovery. Returns for high yield bonds versus senior secured loans may also be uneven, presenting opportunities for investors that can shift between markets.
Lastly, with yields for high yield bonds and senior secured loans now exceeding 11%, where else are investors going to turn for income? With Treasury yields below 1%, options are going to be more limited for investors that have historically looked toward traditional, investment-grade-rated fixed income solutions. While we believe there is too much uncertainty today to make a prediction about returns for high yield bonds and senior secured loans, we think a combination of these factors will eventually draw investors back to the market and potentially reward those with a longer-term investment horizon.
