Bond yields going ‘ever lower for ever longer’

An increasing number of corporate bonds are falling down the ratings scale, and default rates are picking up. How many are in the last chance saloon, just awaiting their ultimate demise, and should investors be worried?

As the global economy went into lockdown back in March, the ratings agencies responded with a wave of downgrades. The credit quality of the global corporate bond market as a whole fell the most it ever has since the birth of high yield (popularly known as junk) bonds in 1977.

Companies that were previously rated investment grade – household names such as Ford, Renault, Rolls-Royce, Royal Caribbean, Kraft Heinz, British Airways, Marks & Spencer – are set to fall from grace in record numbers, tumbling over the cliff from BBB into BB, or junk territory.

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At the same time, the ranks of CCC-rated bonds, near the precipice of default, also swelled.

To some degree, bond markets have priced in the risk of a second wave of the virus in these high yield bonds, but a lot of uncertainty remains about how high default rates will go and for how long.

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In the US high yield market, default rates reached 6.3% in August, up from 2.9% before the pandemic struck. Clearly lockdowns and continued social distancing have hurt some industries more than others.

Ratings downgrades have mainly hit the leisure, transportation, retail and energy sectors, and have been less pronounced in more defensive industries such as healthcare, telecoms and media.

These downgrades have swelled the ranks of companies rated B- and lower, which now account for roughly a third of all high yield debt.

Companies with a B rating are generally considered to have the capacity to repay creditors, but adverse economic conditions could impair their ability or willingness to do so.

Once they fall from this perch, they are seen as vulnerable and dependent on favourable conditions to meet their obligations.

It goes without saying that in the current environment of economic uncertainty, this is not a safe place to be.

On negative watch

As economic activity improved into the second quarter, both actual ratings downgrades and the amount of debt on negative watch for potential downgrade slowed significantly.

Generous and timely support from governments and central banks has lessened defaults over the near term, but all support to date adds to existing debt piles at a time when basic revenue is lacking.

This could lead to a more prolonged period of higher defaults than would be the case in a typical recession and recovery cycle.

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Our view is that the risk of a more drawn-out period of higher defaults will remain as long as the world is still waiting for a Covid-19 vaccine, and that most of the hard-hit sectors are likely to continue to see further downgrades over the next 12 months.

The ratings agency S&P estimates that default rates will rise to 12.5% for US high yield issuers by March 2021.

The key question now is what’s already priced in? Generally speaking, valuations have risen a lot from their March trough, when the additional yield that investors were demanding for investing in US high yield was a massive 10.9 percentage points.

That spread has since roughly halved to about 5.5 percentage points at the time of writing. But we shouldn’t be fooled by the headlines.

Overall spreads seem to be returning to more typical levels, but the pandemic has dealt a big blow to credit markets. US high yield spreads are still significantly above pre-crisis levels, as the credit quality of the whole sector has been dragged lower by the sheer volume of downgrades.

The still-elevated spreads are in effect pricing in the risk of a potential second wave of coronavirus that could push default rates even higher and potentially for longer.

Until the pandemic is contained, social distancing and other restrictions will continue to delay the eventual recovery in default rates. There may well be some attractive opportunities among some issuers.

But for high yield as a whole, the risk of higher defaults for longer seems to us to outweigh a bit of extra yield, even when bond yields in general seem to be going ever lower for ever longer.

Bryn Jones is the head of fixed income for Rathbones

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