High Yield Market Update

Coronavirus contagion and energy sector weakness have contaminated the high yield market as fears surrounding the COVID-19 pandemic and sliding oil prices have resulted in a broad risk-off sentiment. Since the outbreak began to spread, the market has traded off over fears of longer-lasting global economic weakness. While it's challenging to quantify the magnitude of the human and economic effects of COVID-19 at this stage, we are diligently monitoring certain industries and actively exploring discounted single-name opportunities with attractive risk-adjusted return potential.

High yield market recap

After holding in early on, fears about the lingering effects of the coronavirus and its ultimate influence on economic disruption led to high yield bond prices moving aggressively lower. High yield spread levels have widened over 450 basis points since mid-February landing at 827 bps OAS as of March 16 according to the Bloomberg Barclays US High Yield Index. Energy and travel-related industries such as leisure, lodging and airlines, experienced the largest spread widening.

In general, there's been a flight to quality in the bond market and as a result, higher-quality credit has held in modestly better than lower quality. Volatility continues to rise with the CBOE Volatility Index (VIX) spiking to levels last witnessed during the global financial crisis. Within high yield, lower quality or Caa-rated spreads have moved above 1500 bps. The amount of bonds trading at distressed levels rose by the most since December 2018 according to JP Morgan. Yields have pushed higher with the yield-to-worst moving from around 5% in mid-February to over 9% as of March 16 based on the Bloomberg Barclays US High Yield Index.

Monitoring infected industries

We have seen a broad risk-off sentiment across most sectors and industries with almost all high yield names wider on spread. We are closely monitoring certain sectors and industries with heightened downside risk.

Energy: Energy is clearly in the middle of the cross-hairs as a demand shock is being met with a supply shock and causing drastic price movements. The unexpected OPEC fallout and price war actions between Russia and Saudi Arabia shocked the markets, resulting in extreme energy sector weakness and volatility. As crude has fallen due to demand concerns, the sentiment around the high yield energy sector has turned negative. This has caused a broad repricing with the high yield energy sector with the sub-index down about 25% year to date as of March 12.

With no near-term agreement in sight, weak prices are likely to extend through this year. All segments of the energy sector will likely be affected by low oil prices. 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 prices.

  • Independent energy: The effect on cash flow and the balance sheets of US shale and other producers will likely be severe. Most will reduce spending in response, lowering production later this year. Default rates could accelerate, and large fallen angels could enter the high yield market.
  • Oil field services: The oil field service sector will likely be affected by reduced industry capital spending, but many of these names already traded at stressed levels.
  • Midstream: Midstream companies could face challenges with higher counterparty risks from exploration and production (E&P) customers and slower growth.
  • Refining: Reduced travel and economic activity could pressure refinery utilization rates and margins, partially offset by lower input crude oil costs.

We expect large integrated companies with solid balance sheets and low-cost profiles may be more resilient, but could still be challenged maintaining their high dividend levels. Downgrade and fallen angel risk increased as the Saudi Arabia/Russia spat will likely put pressure on the US energy sector. Our energy analysts are stress-testing their credits, but our default assumptions have increased. For reference, JP Morgan's base case scenario assumes crude oil returns to $40/barrel in the second half of 2020 which could lead to 24% cumulative default rate for the energy sector which makes up about 10% of most high yield indices.

We are closely monitoring investment grade energy credits as well given the increased probability of credit downgrades and fallen angel activity. The length of time that oil prices stay depressed and the feasibility of investment grade companies to pull other levers, such as dividend/capex cuts, will be key determinates from the rating agencies. Valuations reflect some of this concern with spreads for BBB-rated energy bonds at multiples of other industrial BBB paper.

Basic industry: Metals/mining and some of the basic industry sectors have also been weak. As concerns around China economic growth increase, these sectors tend to be very cyclical and investors are lowering expectations for 2020 earnings.

Travel-related credits: Credits tied to travel have also been underperformers. In the high yield market, this includes the airlines, lodging companies, cruise ship operators, casinos and rental car companies.

While the markets grapple with finding a bottom, we continue to leverage our research team to look for attractive opportunities. Refer to our Special Report: Economy Showing Mild Symptoms of the Coronavirus for our research team's views on industries and sectors most likely to experience significant consequences from coronavirus.

Assessing liquidity

Historically, on average, we've seen bid/ask spreads for high yield at 50-75 bps. In the past few weeks, with the heightened market volatility, liquidity has deteriorated in high yield, although still not materially different than past "stressed" high yield markets. One complicating factor has been the high yield ETFs' impact as somewhat indiscriminate buyers and sellers is translating into greater price movement on relatively low volume. While markets are moving constantly, we believe it is still possible to buy and sell normal trade lots within the context of the expanded bid/ask spread.

Looking ahead

We are fundamentally reassessing the industries directly impacted by COVID-19 and looking for credits with good risk-adjusted return potential. We view the disruption as transitory and expect the Fed to continue to offer monetary support. We have not materially changed our portfolio positioning at this time. However, estimating the magnitude of the economic impact is challenging, given it's almost impossible to determine the medical effects of the virus, the longevity and breadth of the spreading, the impact on supply chains, as well as end consumer demand. In addition, self-imposed or government-imposed quarantines further complicate the economic forecasting.

Using our research-intensive process, we continue to rationally assess the economic and financial market implications of COVID-19. During turbulent markets, we will rely on our disciplined and steadfast approach as we navigate market volatility, search for attractive buying opportunities and seek to mitigate downside risk.

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Specific sectors mentioned do not represent all sectors in which Aegon AM US seeks investments. It should not be assumed that investments of securities in these sectors were or will be profitable.

Aegon AM US may trade for its own proprietary accounts or other client accounts in a manner inconsistent with this report, depending upon the short-term trading strategy, guidelines for a particular client, and other variables.

There is no guarantee these investment or portfolio strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest over the long-term, especially during periods of increased market volatility.

Investments in high yield bonds may be subject to greater volatility than fixed income alternatives, including loss of principal and interest, as a result of the higher likelihood of default. Value of these securities may also decline when interest rates increase.

This article contains forward-looking statements which are based on the firm's beliefs, as well as on a number of assumptions concerning future events, based on information currently available, and are subject to change without notice. These statements involve certain risks, uncertainties and assumptions which are difficult to predict. Consequently, such statements cannot be guarantees of future performance and actual outcomes and returns may differ materially from statements set forth herein.

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Kevin Bakker

About Kevin Bakker

Kevin Bakker, CFA, is co-head of high yield and a portfolio manager responsible for US and global high yield trading and portfolio management. 

Ben Miller, CFA

About Ben Miller, CFA

Ben Miller, CFA, is co-head of high yield and a portfolio manager responsible for US and global high yield trading and portfolio management.