- Default risk in the leveraged finance market is rising as the coronavirus spreads and rapidly declining economic activity leads to near-term corporate liquidity issues. We believe energy, restaurants and retail companies present the highest risk.
- Distressed ratios have increased, but we believe most of the perceived risk is already reflected in discounted bond prices.
- Cheap valuations may present attractive idiosyncratic buying opportunities for managers able to thoroughly analyze and price downside risk.
As the coronavirus infection rate steadily climbs, so does the likelihood of increasing corporate defaults. While containment efforts are halting economic activity, the combination of a rapidly changing economic backdrop and the uncertainty around when the virus might slow makes it challenging to formulate concrete projections. We expect an uptick in leveraged finance defaults in 2020, primarily within consumer-related industries most exposed to the virus. In addition, unprecedented actions from OPEC+ are expected to lead to an increase in oil supply. This, in conjunction with lower demand from reduced economic activity, has caused oil prices to decline meaningfully and therefore we expect increased defaults in the energy sector.
Deteriorating economic backdrop
With a large portion of the US economy effectively shut down, it's now clear that a sharp contraction in economic activity is upon us. Further, plummeting oil prices have weighed heavily on markets, most notably, high yield debt—energy only comprises about 3% of the leveraged loan market so the effect is minimal. Given the fluidity of macro-level events and the lack of a clear coronavirus resolution, it is challenging to pinpoint the duration and severity of the recession. At this point, we believe we will see at least one to two quarters of negative US GDP growth and a sharp spike in unemployment.
The considerable strain on the economy is likely to lead to near-term corporate liquidity issues as businesses struggle with rapidly declining cash flows. The ability of companies to weather this downturn will depend on their existing liquidity and access to capital markets. Looking further out, the unprecedented fiscal and monetary stimulus that have already been announced globally will dampen the impact of the recession, but the timing of the resolution will ultimately determine the shape of the future recovery.
Monitoring distressed companies
Against a rapidly deteriorating macroeconomic backdrop, investors have fled risk assets for perceived safe havens like US Treasurys. As a result, leveraged finance markets witnessed unprecedented spread widening in March, leading to a growing number of securities trading at distressed levels. The current distress ratio, defined as the percentage of high yield corporate bonds trading below $80, sits at 23% and is near 2001-2002 levels (Exhibit 1). The vast majority of the weakness has been within the energy, MLPs, gaming and manufacturing sectors (Exhibit 2).
Exhibit 1: Distress ratios now at 2001-02 levels
Source: Credit Suisse, Moody's. As of March 25, 2020.
Exhibit 2: Distress ratios by sector
Source: Credit Suisse. As of March 25, 2020.
While the fundamentals have deteriorated, we believe the extreme selling and subsequent spread widening were somewhat overdone in certain segments. Downgrade and default risk is rising, but we believe the vast majority of companies have the wherewithal to survive until the economy rebounds. Given most of this risk appears to be priced into high yield corporate bonds already, we think current spread levels are attractive and present potential buying opportunities for long-term investors.
High yield bond default risk is rising
As the coronavirus containment efforts halt business activity, the likelihood of increased corporate default activity seems unavoidable. Using basic assumptions, one can infer implied high yield bond default rates from current spreads. Based on spreads as of March 26, the current market is pricing in a 12-month default rate of about 10% and, excluding the energy sector, a default rate of over 8.5%. For context, high yield defaults reached 13.4% during the 2008 financial crisis, according to Moody's.
At Aegon AM, we see very few triggers or reasons why the vast majority of high yield companies would file bankruptcy in 2020 and believe the market-implied rates are somewhat high. We expect defaults to move higher, but will likely end the year below these market-implied levels of about 10%. In particular, we believe the ex-energy implied default rate of 8.5% looks especially high. We believe if defaults do hit 10%, it will likely be mid-2021 at the earliest.
Assessing leveraged loan default risk
While our outlook for leveraged loans is generally similar to high yield bonds, notable differences are worth considering when evaluating default risk. Further, the CLO-fueled growth in the loan market coupled with aggressive underwriting has resulted in a market that is remarkably different today than during the last financial crisis.
About 82% of the leveraged loan market is covenant-lite compared to 15% in 2008 according to S&P LCD. Lack of financial covenants may allow issuers to kick-the-can and prolong defaults. Yet, loans today are lower-quality than in the financial crisis with Bs and CCC-rated exposure almost double that of 2008 levels with leverage levels notably higher. Higher leverage means higher interest expense, which can drain liquidity, and cause more unsustainable capital structures, posing increased risk of defaults. That said, near-term maturities likely won't be a catalyst for defaults as less than 10% of the market matures through 2022.
Despite lower energy exposure in the leveraged loan market relative to high yield, the loan market has more small borrowers which could increase default risk as these companies typically have fewer levers to pull. A major wildcard is private equity sponsors, which back a majority of loan market borrowers and may be willing to deploy dry powder to extend their runway by injecting new equity or buying back debt at a discount.
Default outlook across the most vulnerable industries
We expect that a majority of leveraged finance issuers with ties to consumer discretionary spending will see a material drop in revenues and earnings in the near- to medium-term, leading to increased risk of defaults. However, given the recent sell-off, we believe most of the perceived default risk is already reflected in bond prices. Below we provide our views on default risk across the industries most affected by the coronavirus.
We expect a material increase in defaults in this sector in 2020. The broader energy sector finds itself in the midst of the perfect storm: an ongoing spat between Russia and Saudi Arabia that's resulted in material increases in supply, a global recession that's causing a cyclical drop in demand, and fears that secular demand for oil is nearing its peak as alternative forms of energy take hold.
With oil prices plummeting, the sentiment around the high yield energy sector has turned extremely pessimistic. Most notably, independent energy and oil field services have experienced the greatest spread widening as the credit outlook for these industries deteriorates against a backdrop of sliding oil and natural gas prices.
Restaurants & Retail
The default outlook for the restaurant and retail sectors is rather bleak. The nationwide shutdown of non-essential restaurant and retail businesses is placing severe strain on these businesses, and a recovery in revenues once the shutdowns are lifted is highly uncertain given the ongoing recession.
The federal fiscal stimulus bill includes a $377 billion small business rescue plan, but restaurants and retailers large enough to tap into the leveraged finance markets may be too large to qualify in many cases.
The default outlook for healthcare is mixed. Hospitals, in particular, will benefit under the federal fiscal stimulus bill. The bill includes at least $117 billion in emergency support for hospitals and veterans' health care to help hospitals cope with the sudden elimination of high-margin elective procedures as well as an increase in expenses needed to treat people infected with the coronavirus and an influx of uninsured patients.
The default outlook for the gaming sector is mixed. Many gaming operations around the world are shut down amidst the ongoing global coronavirus crisis, and like restaurants, the recovery post-shutdown is uncertain. Some issuers will have access to liquidity, while others will struggle with highly levered balance sheets.
Leisure & Lodging
The default outlook for the leisure and lodging sectors are mixed. The cruise sector is particularly vulnerable to defaults given almost all cruise operations around the world are shut down, and a recovery in future cruise demand is very uncertain. We would expect the lodging, rental/timeshare, and theater sectors to recover more quickly than cruises, although some operators could face liquidity issues depending on the duration of the shut down.
Metals/mining and some of the basic industry sectors have also been weak, resulting in a rising expectations for defaults in these sectors. As concerns around economic growth increase, these sectors tend to be very cyclical and investors are lowering expectations for 2020 earnings.
The expectation for defaults in the auto sector is increasing as expectations for global auto sales drop materially below current levels. US seasonally adjusted annual rate (SAAR), for example, has been near 17 million for the last several years, but many estimates suggest a drop to 12-14 million going forward.
The outlook for airline defaults has improved now that Congress agreed to include $25 billion of loans to the sector in the federal fiscal stimulus bill that has passed the Senate, although the details of how the loans will be extended are still murky. Existing liquidity issues have been magnified by rapidly falling demand as air traffic and bookings continue to decline. As a result, rating agencies are coming out with negative watches on many airlines. The potential for downgrades has increased, but default expectations appear to be dropping given the coming federal aid.
Housing/ Building Materials
As millions of Americans lose their jobs and millions more face declining income, the demand for new homes and remodels/renovations will likely decline. However, the lack of housing oversupply, along with better positioned company balance sheets and liquidity profiles should allow the sector to better manage the slowdown in activity. Also, historically low mortgage rates should continue to benefit consumers. Therefore, the outlook for defaults in the homebuilding and building materials sector is not as pronounced as it was in the prior cycle.
Finding opportunity amidst the volatility
Fundamentals have turned in the short term and we anticipate leverage to spike higher for many companies, but we think the vast majority of companies have the wherewithal to survive until the economy rebounds. We also believe the recently passed fiscal and monetary stimulus has the potential to shorten the duration and severity of this downturn, although that will depend on length of time the COVID-19 virus plagues the US economy. It's also encouraging to see companies take prudent and proactive approaches to accessing and shoring up liquidity to help bridge the gap.
While downgrade and default expectations have increased, much of this is already being reflected in high yield bond and loan prices. Current high yield spread levels occur infrequently and buying into this market weakness has historically resulted in strong subsequent returns. For example, when US high yield corporate spreads have crossed over 800 basis points, the average annualized returns over the next 12 and 24 months were 30.3% and 21.6%, respectively (Exhibit 3).
Looking ahead, certain distressed bonds may present attractive idiosyncratic buying opportunities for managers able to thoroughly analyze and price downside risk.
Exhibit 3: US high yield spreads over 800 basis points and subsequent returns
|Trailing 12 months||Trailing 24 months|
|Number of positive return periods||21/23||23/23|
|Number of negative return periods||2/23||0/23|
Source: Bloomberg Barclays as of February 28, 2020. Past performance is not indicative of future results. Based on monthly data for the Bloomberg Barclays US Corporate High Yield Index from January 1994 to February 2020. Reflects the trailing 12- and 24-month annualized returns following periods when the index option-adjusted spread increased above 800 basis points at month end.
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