Coronavirus - Impact on the High Yield Market

Investors have become increasingly concerned about the longevity of the Coronavirus, and the negative impact it is having on the global economic environment.  Risk assets sold off last week, with the S&P 500 Index and Russel 2000 Index down 11.44% and 12.01%, respectively.  The high yield market has not been immune to the severe risk-off sentiment driven by coronavirus fears, although the impact has been a bit more muted. As of the end of Tuesday, USD/EUR currency hedging costs are now 1.64% (assuming 3M FX forwards).  For reference, we have not seen hedging costs this low since 2016, while the historical high of almost 3.5% was hit in late 2018.

The ICE BofA US High Yield Index returned -2.74% last week, with triple-C rated securities leading the selloff with a -4.34% return, underperforming single B’s (-2.86%) and double-B’s (-2.35%).  Spreads widened 138 bps to 504 bps just in the last week alone.  While high yield has certainly been weaker the last couple of days, selling in the market has been orderly and disciplined.  We have not seen any real forced selling pressure, nor have we seen any significantly large blocks for sale.  At this point, it appears that most of the selling has been from ETFs. Despite the large outflows from the ETF’s last week (approx. -6 billion), and a large Investment Grade downgrade into high yield, the technical supply/demand picture still seems remarkably resilient for now.    

 

Fundamentals

The Coronavirus will have a negative impact on the fundamentals of the US high yield market, however the severity of that impact is still to be determined.  It certainly will have a bigger impact on certain parts of the markets more than others, and the breakdown of sector returns from last week reflects which sectors have the potential to experience a bigger impact than others.    

 

Comparison of Total Returns of as 29-Feb-2020

Source: BofA Securities as of February 29, 2020

Energy:  Clearly, the Energy sector is the most pressured after oil prices dropped to below $45/bbl and natural gas prices remain under $2/MMbtu.  Under this price environment, the capital structures of a majority of E&P and Oilfield Services companies are not sustainable for a longer period of time. 

Leisure, Gaming:  Other sectors that underperformed last week include Leisure and Gaming, both of which could see some negative results if the virus influences people to stay at home instead of spending money outside the home in the form of Cruises, Casinos, theatres, concerts, hotels, etc.    In our analysts’ meetings with Gaming management teams last week, all cited it was too early to see any impact.  However, as fear increases, the risk of people cancelling or postponing vacations and trips increases. 

Transportation:  Airlines and companies connected to the airline industry will likely be impacted, even if the contagion of the virus underwhelms, due to the fear that has already begun to limit travel.  The Airlines sub-sector is a very small part of the US high yield universe, however there are other companies connected to the industry, such as car rental companies and companies focused on travel logistics, that will also be impacted. 

Retail, Consumer Products:  In a worst-case scenario where people avoid populated areas, the secular trend of more purchases being done online and lower mall-traffic will only intensify.  The more likely impact however is already occurring, as disruptions in the supply chain due to China’s shutdown will have a big impact on apparel and consumer product companies.  Approximately 30% of apparel comes from China, and we are hearing that the recovery/ramp up has been slow due to labor shortages and supply shortages.  One retailer, Limited Brands, stated on their call that they estimate “delays of 2 to 4 weeks, principally related to lingerie and apparel merchandise for the spring season”.  Although companies have a diversified finished good sourcing base by country, we estimate 50-70% of garments coming from southeast Asia use fabric from China.    

Chemicals:  We would expect certain global chemical companies, that were just about to recover from the trade war, to be negatively impacted.  Ineos, a basic chemicals company, stated on their call that the impact has been surprisingly limited so far.  They also noted that while the virus will subdue demand coming from China (negative impact on pricing), it will also affect supply since China produces a lot of chemicals (positive impact on pricing).

Healthcare:  This sector could have a mixed impact, however we see it as a slight negative.  Hospitals could see increased volumes, however the cost of training and staffing could weigh negatively on margins.  Importantly, there is the risk that elective acute surgeries could be delayed, impacting margins for hospitals and Surgery Centers.  Disruptions in the supply chain could also have a negative impact on procuring medical supplies, which can increase costs for healthcare providers and potentially delay procedures, both of which would have a negative impact on profitability.    

Cyclical sectors such as Metals & Mining, Auto, and Steel:  It probably can go unsaid, but a slowdown in the economy from the virus will have a negative impact on cyclical industries. 

 

Other considerations

  • One of the biggest arguments for the relative value and technical strength of the US high yield market has been the global search for yield.  This narrative has only become stronger in the past week, as global yields have plummeted even lower. 
  • As last week’s sell-off progressed, the odds of central bank action increased.  Market’s rallied on Monday with the expectation of a central bank response.  On Tuesday, the Fed cut rates by 50 bps in the first emergency move since the 2008 financial crisis.  This will provide further technical support for the market.  In addition, given that the Fed has more “dry powder” in the form of rate cuts than other central banks, we expect currency hedge costs to drop for international investors, most notably European investors.  This will make all US fixed income asset classes more attractive, including US high yield, and we would expect inflows into the market from such areas. 
  • One point of clarification:  In the financial press, and some sell-side strategist reports, the point is made that credit markets are frozen.  We believe this is a very big exaggeration.  While it is true that the high yield market did not print a new issue last week, we still believe the majority of companies could issue debt at this time at coupons well inside of historical levels.  That said, given market weakness, no management team would like to print a deal in this environment, and would prefer to just wait until things settle.  As supply dwindles, the technical strength of the market increases.    
  • As the average yield and spread in the market increases, it’s important to note the underlying driver of how that is happenings.  Up to this point, it is largely being driven by credits that may be impacted by the virus.  Companies with lower risk of this event have sold off, but only slightly.  With the impact of the virus still unknown, the situation is extremely fluid and changing day to day.  This means that the relative attractiveness of the companies that will be most impacted is very case-by-case, and credit selection will be key.  If the impact of the virus worsens, we would expect default rates to rise in 2021, largely driven by the Energy sector.

 

Current US High Yield Spreads and Yield

Source: ICE BofA ML US High Yield Index as of February 29, 2020

 

Coronavirus Impact on the European High Yield Market

We expect the Coronavirus to have a meaningful negative market effect over the next quarter due to the technical of fund outflows and limited street inventory. While we don’t have containment as a base case, we assume that the situation will be brought under control by mid-summer despite the virus has an ability to transmit in hotter climates. Under that assumption, quarterly economic growth is expected to rebound by year end, such as via an inventory restocking through the supply chain or via central bank policy stimulus. Global GDP may be lower than previously expected for 2020 but we currently assume that the negative impact on GDP growth will be contained within the year.

Cognoscente of this being a brief summary, we summarise the impact broadly into demand issues like ‘travel’ and industries involving ‘groups of people’, and potential supply issues such as the automotive sector.

For the travel industry, weak demand is expected to result in poor utilisation of much of the industry’s fixed capacity. Many transport services, such as airlines are highly operationally levered, such as high fixed plane-lease costs.

Effects of staying at home relates primarily effect retail, restaurant and entertainment industries for the European high yield market.

In Automotive space we have seen first guidance cuts come through from select suppliers highlighting risks to supply chain and impact on sales due to 92% decline in Chinese car sales during the first two weeks of February. The magnitude of the coronavirus effect inside and outside of China remains unclear at this stage as it’s still not contained. In response to widespread factory shutdowns in China, IHS cut global production outlook for 2020 to -1.9%. Most companies’ have based their outlooks around IHS’s revised estimates, and we believe there’s risk to downside if virus spreads more widely and causes disruption on a global scale. Higher quality credits with strong liquidity position and limited exposure to China are expected to outperform weaker high beta names in the near term as market digests Covid-19 impact.

A further theme to note, given deteriorating markets, is that negative idiosyncratic issues are generating meaningful underperformance.

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