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Credit outlook: The rules have changed

Credit outlook: The rules have changed

24-06-2020 | Quarterly outlook

The ‘common enemy’ elicited a massive unconventional, coordinated series of stimulus by policy makers. All rules have changed. Government stimulus is now financed by central banks.

  • Victor  Verberk
    CIO Fixed Income and Sustainability
  • James Stuttard
    Head of Global Macro team and Portfolio Manager
  • Sander  Bus
    Co-head Credit team

Speed read

  • Markets treat Covid-19 as a growth shock, not stagnation
  • The best part of the ‘common enemy’ buying opportunity is done
  • Central bank technicals rule, or will fundamentals strike back soon?
“This is the 50th Credit Quarterly Outlook. After 12.5 years of business cycle and credit cycle forecasting, we like it more than ever before. Why? Because it helps us understand the macro environment. The benchmarking with outside experts increases our confidence and therefore makes us better contrarian investors. We hope it helps you, too, by providing insight on how we manage the assets you have entrusted with us. Over the past decade we have written about a full-blown banking crisis, a sovereign crisis and, most recently, about an oil crisis and a humanitarian crisis. It is exciting to think what the next 12.5 years will bring. At this point, the crucial question is whether Covid-19 has marked a turning point in the behavior of policy makers.”

Victor Verberk, Co-head of the Robeco Credit Team

The economic fallout that we saw in the second quarter of 2020 was unlike anything we have ever seen in our careers. On top of that, an oil supply shock created the perfect storm for risky assets. Markets have since soared and are treating Covid-19 as a growth shock. 

According to Victor Verberk, Co-head of the Robeco Credit Team, a normalization in earnings is needed to justify this rally. 

“We have our doubts that this will materialize. The ‘common enemy’ elicited a massive unconventional, coordinated series of stimulus by policy makers. All rules have changed. Government stimulus is financed by central banks. We have our doubts about that, too.”

As he puts it in Robeco’s latest Credit Quarterly Outlook, which is the fiftieth edition of this publication: “For now we remain constructive on investment grade, but go underweight on high yield again. Technicals rule but fundamentals might strike back. Be ready to buy once more.”

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An unprecedented sell-off – and an impressive recovery

While credit and equity markets experienced an unprecedented sell-off, the recovery has been equally impressive. “With yields fixed at low levels, TINA (“there is no alternative”) rules,” says Sander Bus, Co-head of the Robeco Credit Team. “That means liquidity and risk premia will come and go like tidal ebbs and flows. We might see more major liquidity events. But, given that central banks have instruments in place to intervene, we do not expect another March-like event.”

In this context, it is important that we risk manage our credit portfolios. The question is not per se which positive or negative scenario is the right one. The main question is whether one is rewarded for the risks. Spreads are still above long-term median levels, but there are some caveats too:

  • In high yield there is no average. Next to reasonably priced BB-rated companies, which nowadays have lower leverage than BBB-rated peers, there is a distressed bucket where a significant number of companies will default.
  • When we adjust for almost certain defaults, high yield ETFs and derivatives trade close to the all-time tights again.
  • In investment grade, one needs to be careful of emerging market credit, given that many emerging market countries will have less ability for continued support. 

Debt levels are a concern. According to Jamie Stuttard, Robeco Credit Strategist, “it is helpful to explain that while companies significantly increased gross leverage in recent months (probably to hoard cash), reported EBITDA levels will be dismal in the next few months. This double whammy will increase leverage to new highs.” 

“One could challenge this by stating that, with low yields stretching out over time, debt levels do not matter as much. But access to capital markets does. The refinancing hurdle is key. It seems that for investment grade credit, this hurdle has been partly removed by central banks. For high yield, though, fundamentals rule.”

There is some good news, too. For example, Verberk points out that it seems government schemes are successful in smoothing, extending and moderating SME losses for banks. “On top of that, the last series of TLTROs provided to banks were granted at Libor minus 100 bps! Some trillions of gross lending to banks at Libor minus 100 bps is a grand-scale subsidy. So, provided banks do not shrink their loan books, they get a massive subsidy. For creditors, that provides a good put under the bank, while spreads are attractive.” 

Market cycle | Mapping our view on market segments

Source: Robeco, June 2020

We are in the rare situation that every single company is repairing its balance sheet. Share buybacks are a dirty phrase and even dividends are not safe when receiving government help. Such alignment usually is great for credit markets, of course. It provides a positive backdrop for the valuation of spreads.

Technical support from policymakers means no two-way liquidity

Policymakers would rather throw more liquidity at a fiscal problem than accept defeat. We need to deal with this reality. What are the consequences?

“There is just no two-way liquidity in credit anymore. One has to sell into strength amid mutual fund inflows and buy when central banks are out of the markets for a few days. The golden rules are being contrarian and having a cash balance to defend yourself against outflows,” says Verberk.

Central banks have been effective. One has to give them credit for that. The best example is the Federal Reserve’s corporate credit purchase program, the SMCCF. Bus recalls: “The second time it was announced, with more implementation details, it triggered a second credit rally! The actual purchases are underwhelming, showing that the mere threat of stepping in did the trick. Be aware that the Fed will not buy insolvent companies – and thus far the action has failed to impress”.

For high yield, the technical backdrop is different. Here, a recession means a once per decade purge of weaker issuers, and there are several bear market processes that play out, Stuttard explains. “The total nominal face value of CCC-rated credits normally rises sharply versus B-rated assets, as the weakest entities edge towards the twilight zone between investable high yield and default. That process started in March but in the last two recessions it took years to play out. It seems we have only just started. Notwithstanding central bank liquidity, it would be unusual to see a bear market lasting only 5 weeks, which would equate to 5% of the length of the last two recessionary bear markets.”

Active management is essential

There still is scope to generate good returns, especially in investment grade credit. In high yield, the bifurcation in spreads and the default cycle that still has to start in earnest are holding us back in beta terms.

Within high yield, our preference nowadays is for relatively stable BB-rated companies with a leverage lower than BBB-rated companies. There are also good-quality companies in the automotive sector, as well as in the investment grade category of the banking sector. Even in hotels and leisure there are selective opportunities. In general, though, we have become slightly more defensive in cyclicals, given that in both equities and credit a great deal of good news seems to be priced in by now. 

Verberk concludes: “There will be more buying opportunities ahead. In this environment, active management is the ideal approach.”

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