He notes: “We’ve seen a contraction across earnings, revenue growth and interest coverage, along with an increase in leverage. The key takeaway here is that fundamentals have weakened and that has contributed to a rise in defaults and a tremendous surge in “fallen angels” – debt downgraded from investment-grade to high-yield ratings.”

Mueller says: “Fed support has kept the market in check. Softer fundamentals have contributed to a big pickup in defaults, which began to increase sharply in March and continued to climb in Q2 and thus far in Q3.

“We’re seeing distress across most sectors, though it is most pronounced in energy. Through the end of Q2, $191 billion of previously investment-grade-rated debt was downgraded to high yield.1 That is a hugely meaningful number, and we think it will continue to climb. However, credit facilities launched by the Federal Reserve (the Fed) will help mitigate this situation. In effect, what the Fed has done is help ensure that fallen angels do not overwhelm the high-yield market. We think what prompted the Fed’s actions here was the downgrade of Ford, given the size of the company and how large an employer it is. Notably, as a whole, fallen angels performed extremely well during the second quarter.

“Yet, at the end of June, the default rate for the overall high-yield market was at a 10-year high, at 6.2%. Energy constituted 46% of the last 12-month volume of bond defaults. As of June 30, energy was 63% of all high-yield bonds trading below $0.50, and 48% of all bonds trading below $0.70. We expect a continuation of this default trend, and we’ve keeping a close eye on a number of credits in this sector.

“At the end of 2019, energy represented 12.5% of the high-yield market. Now, it’s 13%, but this includes 4% from fallen angels that entered the index this year. If we exclude fallen angels, the legacy energy index is almost 30% smaller relative to year-end 2019, and this is due to the depreciation of bond prices and defaulted companies that have exited the index.

“Unfortunately, we think the outlook is clear as mud. The fundamentals are pretty bleak, with high US unemployment, at around 80 million people. It’s getting better sequentially, but obviously, from a historical perspective, unemployment is quite high.

“As we’ve discussed, defaults have accelerated, particularly in the energy sector, and recovery is slow. However, countering all this is the Fed and US government, which have passed $3.7 trillion in stimulus for a variety of different programs, and they’re not done should the need arise. Meanwhile, the European Central Bank (ECB) has issued $2 trillion in stimulus, and these global central banks have done this over the course of only a few short months. That’s lit a fire under the US high-yield market and caused a rapid move toward recovery, including spurring some robust flows into the asset class.

“While central bank and fiscal stimulus represent a significant silver lining, we also think it’s important not to ignore the risks inherent in the high-yield market and global economies as we face the ongoing challenges of the coronavirus, compounded by difficult geopolitics,” says Mueller.

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1. Source: JP Morgan as of June 30, 2020.

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Stephen C. Concannon, Co-Director of High Yield Bonds Portfolio Manager, Jeffrey D. Mueller Co-Director of High Yield Bonds Portfolio Manager and Dónal Kinsella,  Institutional Portfolio Manager Sub investment grade credit, at Eaton Vance present their views on high yield markets in a recent insight paper.

They note: “Following the strong April rally, we see choppy waters ahead for high yield.

“Fundamentals for high-yield issuers are weakening markedly against the backdrop of a sharp contraction in global economic activity – unknown in its extent right now – and which governments and central banks, on their own, cannot halt.

“We anticipate the pending global recession will last for several quarters.

“We believe investment opportunities do exist across European and US markets and that active, selective exposure to US and global high-yield securities at this juncture will continue to benefit clients. Further volatility in high yield likely – our thinking is to take advantage of this, adding prudently to risk

“There are four areas of opportunity that we see right now for global high-yield investors. The first is primary issuance. A lot of challenged companies have had to come to the market looking for short-term financing to ensure they can get through this pandemic, and this has offered some really good opportunities for high-yield investors to lend to companies that we think are good quality businesses over the long term.

“The second is the European markets. We think that on a like-for-like basis, credit spreads in Europe are looking a little bit more attractive than they are in the US at the moment.

“The third is fallen angels – companies that have been downgraded from investment grade. We’ve seen a slew of downgrades in the US and European markets, increasing the size of the overall investible universe. We think sensibly investing in companies that have the ability to bounce back to investment grade will be a great way to generate returns from here.

“The fourth area of opportunity is the energy sector – right in the middle of the storm! Defaults will increase in this sector, in our opinion, but returns from bonds in this sector that do not default will also, in our view, be significant.

“Looking ahead then, while we do envisage further bouts of volatility in the near term (those needing to make an allocation now will need a strong nerve), we think market returns on a 12-month view will be relatively attractive in a historical context.

“For the Eaton Vance high-yield team, in particular, we believe our strong capability in terms of fundamental analysis combined with a top-down overlay will remain a positive for clients in an investment environment where the dispersion of returns within the market is likely to be significant.”

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