Recalibrating the rulebook: a focus on fundamentals

The velocity of the moves in credit fundamentals and spreads – and the unbridled reach for cash from banks, corporates, and asset managers – is testament to how profoundly blindsided the economy was by the relentless spread of the coronavirus. 

While the monetary and fiscal policy responses will benefit many higher-quality companies, others will disappear altogether or be forced to restructure their debt. Financial risks will rise as debt-service obligations become more burdensome and some companies will struggle to grow into their capital structures.  

First and second-quarter earnings are set to decline by a record amount. There has also been a dramatic spike in downgrades, which are taking place at ten times the rate of upgrades within the high-yield market.

As thinly capitalised firms are locked out of refinancing markets, it is inevitable that there will be a rise in defaults. In an instinctive move to survive, companies have defended their balance sheets by cutting dividends, cancelling share-repurchase programs and reducing operating and capital expenditures. 

Firms have also drawn on their revolving credit facilities (RCFs) at an unprecedented pace. Between 9 and 27 March, the share of RCF draws went from 11% to 64.3%. Coincidentally, 56 of the 198 companies were downgraded. 

Banking: in the eye of the storm 

To help formulate our broader view of market fundamentals, we have looked at one of the sectors most affected by the crisis: banking. We see the industry as a as bellwether for the future state of credit markets.

We currently see an opportunity to invest in financials. Banks have lost about a third of their market capitalisation since the sell-off began and their debt instruments have experienced some of the greatest losses of any sector. However, markets do not seem to have factored in their strong capital position or balance-sheet strength, as well as the support they have received. 

Although the asset quality of banks has deteriorated over the last quarter, liquidity coverage ratios for the largest US banks are four-times higher than they were before 2008. Even accounting for more stringent calculation criteria, tier one and tier two ratios are also materially higher. In addition, US money-centre banks have suspended their significant share buyback programs, while capital buffers have been dropped in Europe. 

While there is uncertainty about loan performance and support for banks and borrowers, we believe the sector offers considerable value – particularly the larger ‘national champion’ banks, which will be used as the transmission mechanism for stimulus. 

Viral volatility: seeking opportunities amid the turmoil 

There is considerable uncertainty about the effect of the virus, while the impact is highly correlated across geographies, industries and asset classes. The potential outcomes are too severe to only affect equities and credit-market fundamentals have undoubtedly been impacted. 

It is clear that we will see more volatility – both above and beneath the surface – in the months ahead, which suggests there is unlikely to be a symmetrical recovery such as the one we witnessed after Q4 2018. Companies with less leveraged balance sheets are not as likely to be affected in the longer term, but in some sectors even the most defensive issuers could default in the absence of external support. 

In this environment, we find ourselves faced with more nuanced and idiosyncratic stories across sectors, geographies and sub-asset classes – an incredibly fertile ground for our Credit and Private Debt teams. Flexibility, clarity of thinking, a diligent underwriting process and avoiding complacency will all be essential. 

This is not a ‘buy the dip’ situation, and credit analysis will be at a premium. Our credit analysts have been working diligently alongside our engagement professionals to recalibrate the inputs in their models and in some cases completely rewrite them.

At the international business of Federated Hermes, we take an active, high-conviction approach to investing – something that history suggests has the potential to perform well in volatile periods. While we are mindful that the lows are likely not behind us, we remain optimistic about the potential to generate supernormal alpha in credit markets over the next 12 months.

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The value of investments and income from them may go down as well as up, and you may not get back the original amount invested.

For professional investors only. This is a marketing communication. The views and opinions contained herein are those of the Credit Team at the international business of Federated Hermes, and may not necessarily represent views expressed or reflected in other communications, strategies or products. The information herein is believed to be reliable, but Federated Hermes does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. This document has no regard to the specific investment objectives, financial situation or particular needs of any specific recipient. This document is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Figures, unless otherwise indicated, are sourced from Federated Hermes. This document is not investment research and is available to any investment firm wishing to receive it. The distribution of the information contained in this document in certain jurisdictions may be restricted and, accordingly, persons into whose possession this document comes are required to make themselves aware of and to observe such restrictions. 

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