Credit research looms large in the era of COVID-19

In the wake of severe credit-market dislocations earlier this year, Fixed Income Portfolio Manager Mahmoud El-Shaer shares his thoughts on the growing importance of credit research in a still-uncertain environment.

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In the aftermath of the severe credit-market dislocation earlier this year, now seems an opportune time to share my latest thoughts on the growing importance of credit research in today’s still-uncertain environment.

After a decade of beta, what now?

Ever since the financial crisis of 2008, equity and fixed income markets alike have benefited from significant central bank support. One consequence of this “backstopping” has been a substantial decline in borrowing costs for both sovereign- and corporate-debt issuers.

Today, with corporations highly levered and interest rates at historic lows, global central banks have little room to lower borrowing costs any further than they already have. In addition, reduced bank balance sheets have exacerbated bouts of liquidity-induced market volatility.

As a result, we believe that a strategy of purely owning credit beta is unlikely to deliver the returns seen in the 2010s. Increased fundamental differentiation and less-liquid secondary markets, along with sector-specific risks and opportunities, will likely be the main drivers of return in the years ahead. In this context, we believe a solid credit research framework will be critical to take advantage of market dislocations going forward.

Challenging conventional wisdom

As of this writing, the spectrum of potential outcomes for global economies and corporations is wide. As asset owners seek to navigate the current downturn, some are focused on avoiding defaults; others will look to avert downgrades that could force assets to be sold at depressed prices.

Meanwhile, many investors have been attracted to higher-yielding credits, which could now be most at risk of being downgraded following the exogenous shock of the COVID-19 pandemic. Unprecedented monetary and fiscal policy actions have caused spreads to tighten significantly since March 2020 (Figure 1), so credit investors don’t necessarily have a clear path ahead.

Against this backdrop, challenging conventional wisdom on sector and security allocations may be key to generating returns, protecting from downside risks and avoiding (or at least minimising) realised losses during periods of heightened volatility.

FIGURE 1

Global Aggregate: Option-adjusted spread (corporates)

Risks under the surface

While periods of elevated volatility may all share some similarities, each is unique. For example, many investors assume that traditionally defensive sectors (i.e., utilities and health care) are, by nature, better suited to weathering economic downturns. In some environments, however, not only could such an approach mean missing out on potential opportunities in more cyclical sectors, but it could also expose a portfolio to unintended risks.

For instance, a French utility had been at risk of downgrade for some time due to its reduced profitability and slow progress on a restructuring plan. Despite being in a defensive sector and receiving government support, the issuer was downgraded by S&P in June 2020, while Moody’s recently assigned it a negative outlook. Its future cash flows depend partly on nuclear power, which does not qualify for the European Union’s (EU’s) climate-change mitigation policies. As such, this company will lag its European peers in attracting “green” investors, while facing challenges posed by an ageing nuclear fleet and execution risk.

Back to basics

To successfully pursue one’s investment objectives, we believe investors cannot and should not focus solely on avoiding risks. As one credit cycle finishes and another begins, there may be instances where entire sectors could, at least initially, sell off with little differentiation or discrimination among individual names. Often, this leads to the “strong” members of the sector being unfairly punished along with the “weaker” members. The advertising industry has experienced just such a shock recently: Already faced with challenging structural shifts, the current crisis has triggered a sudden, sharp reduction in industry revenues. However, we believe some credits have sold off more than is justified by their fundamentals and may offer investors compelling return opportunities at potentially attractive entry points.

For instance, the conservative management team of a London-based, multinational advertising company is focused on cash preservation and debt reduction. The company has halted its share-repurchase program, cancelled its dividend and reduced capex, while retaining ample liquidity despite having no near-term debt maturities. Its prudent management is apt to be viewed positively by credit-rating agencies, making ratings downgrades unlikely. From a fundamental perspective, the company is well-diversified and has continued to win new business. Due to sector caution and recent issuance, its bonds currently trade wide of its peers and could offer an attractive investment opportunity in a cyclical sector.

Turbulence ahead

Generating returns in certain sectors going forward may require significantly more analysis than has been necessary in the past. As an example, in the wake of the COVID-19 pandemic, the global aviation sector has been under tremendous pressure, following a near-total collapse in air traffic and a bleak medium-term outlook. When analysing aircraft-leasing companies, dedicated credit analysts need to evaluate a range of factors, including average aircraft age, concentration risks by airline and aircraft type, risk and resolution of potential deferrals and repossessions, as well as the elasticity of consumer demand going forward.

Even if some airlines default, their aircraft may not necessarily be retired/impaired, so analysts should consider the implications of alternative options for the lessors, including: airline continues flying through bankruptcy or benefits from a government bailout; or lessor takes possession of the aircraft and releases, parks, or sells it. Understanding the likelihood of each scenario and its possible impacts will be key to avoiding downgrades or even defaults. While we believe the sector has ample liquidity under many scenarios, the risk of a second COVID-19 wave could have major negative implications for airlines.

Capturing value in a wide opportunity set

Being able to perform solid, in-depth credit analysis and execute on its recommendations goes a long way towards extracting value from pricing dislocations — even more so when these dislocations occur across currencies or markets. Portfolios with a truly global perspective and access to a broader opportunity set may gain further value simply by venturing (selectively, of course) into nondomestic markets and hedging the currency risk.

Bottom line

In a world where yields are at record lows, we believe most market participants are unlikely to benefit from the credit-beta returns experienced over the past decade. However, by focusing on capturing value through rigorous credit research, asset owners may be well positioned to achieve their investment objectives and to create opportunities for both return generation and downside protection.

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Andrew Bayerl
 CFA, CAIA

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