- Risk premiums have tripled. However, the company defaults that will inevitably come are amply priced in now, also because the interests of finance ministers and central banks are aligned with those of credit investors. They will not allow a cascade of defaults to protect jobs.
- As the support measures take hold and new capital is deployed, risk premiums should deflate. Investors who enter the market early in this Great Unwind  (of premiums) stand to benefit.
The lockdown of society to contain the spread of the disease and minimise the death toll, and the deep recession it will trigger, have led to a fundamental re-rating of financial assets including European high-yield bonds. Risk premiums tripled, from a little less than 300bp to a high of about 900bp (see Exhibit 1). Markets seized up as a flood of investors rushing to the exit met few takers.
We believe markets have overreacted and an opportunity has emerged.
The great unwind
The blowout in risk premiums in recent weeks has followed a pattern that is common to most crises. They may jump higher, but they crawl lower.
Those who invest as risk premiums begin to ease from the highs stand to benefit from a significant and sustained decline in the credit risk premium implicit in high-yield bonds.
Macro scenario: putting our faith in policymakers
A global recession is inevitable. A mix of disruptions, a sharp decline in demand, customers being unable to pay and limited access to credit, while bills still fall due, raise the possibility of widespread defaults. While we do not challenge this scenario, we think it is incomplete in three vital respects. These suggest a more constructive outlook for high-yield bonds.
- The politicians are choosing to have a recession only for so long as we cannot control the spread of the virus without shutdowns
Once the authorities can implement an effective alternative strategy, they will do so. In practice, that means some combination of mass testing; increased capacity of the healthcare system; and continued self-isolation of the vulnerable. The social distancing measures can then be lifted and the economy can recover.
- Finance ministers cannot allow a default cascade to happen; otherwise, demand will not recover after the shutdown ends
The interests of credit investors and the authorities are aligned. The cornerstone of the economic policy response to the pandemic is fiscal – that is, the measures put in place to nurse companies through the lockdowns: defer tax liabilities, cover wage-bills, provide cheap credit, and so on. Other measures are designed to speed the recovery once the shutdowns end.
- Central banks will suppress yields and risk premiums and will indirectly boost demand for high-yield debt
Bond buying programmes should both help to suppress yields and contain risk premiums. The ECB may not buy high-yield bonds, but its own research  suggests that purchases of investment-grade paper can have a positive impact on the high-yield market. The scarcity of bonds resulting from central bank buying prompts investors to shift towards similar, but riskier, segments of the market.
Moreover, we can expect investors to begin searching for yield once more. High-yield will appear attractive as a huge proportion of euro-denominated fixed income securities offers negative returns.
Spreads more than compensate investors for coming defaults
A risk spread of 600bp is consistent with an expected default rate of 10% and an expected recovery rate of 40%. In other words, current risk premiums are pricing in an economic scenario on a par with the Global Financial Crisis. It is worth keeping in mind that even in the GFC, with defaults peaking in the low double digits, investors still made a 50% return on their money, including the credit losses.
Current estimates have put the default rate for European high-yield at 5-9% for 2020, followed by a rapid decline in defaults.
- We assume that defaults will be less severe in Europe owing to the low number of issuers from the energy sector in Europe relative to the US.
- Also, we believe the bank-heavy European market will be more willing to work through liquidity solutions than in the US.
- Finally, the bond maturity schedule in Europe is fairly benign as companies have largely refinanced and lengthened their debt maturities.
What will matter most in this recession is the support that companies can count on. We expect the authorities to rise to the challenge to avoid the economy falling into a depression.
However, we are concerned that the capacity to support companies varies significantly. The health of the public finances in the country in which a company is based may be a key determinant of its probability of default.
It takes an active attitude to invest
Passive investments in high-yield can give you exposure to The Great Unwind. However, they leave you exposed to the losses from defaults. An active investor can outperform the market through prudent security selection, minimising such losses.
We believe most of the defaults are likely to occur among companies that were already treading water: businesses that were disrupted beyond repair by technological change, from the struggling fashion retailer to the small car supplier. These are best avoided.
Our approach is based on these principles:
i. Stress test to identify the vulnerable with an assumption of two or even three quarters of severely depressed earnings
ii. Have a bias towards resilience for stable companies and stable sectors (healthcare, telecoms and packaging) and those with sufficient liquidity and balance sheet strength to survive the shutdowns
iii. Identify value to buy quality paper that has become mispriced, taking a long-term view.
We think a robust top-down analysis and a focus on single names enable investors to navigate both strong up and down-markets. These skills will be key to continuing to deliver solid risk-adjusted returns that beat the benchmark.
 Bonds that pay higher interest rates than investment-grade bonds because the issuer’s credit rating is below investment-grade reflecting, for example, high debt ratios. Their credit ratings are Ba (Moody’s), BB (S&P, Fitch) or lower.
 This is an extract of the April 2020 BNPP AM paper European high-yield bonds: Riding the Great Unwind.
 Zaghini, A (2020), ‘How ECB purchases of corporate bonds helped reduce firms’ borrowing costs’, ECB Research Bulletin, 28 January
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.