While some lockdown measures remain in place in large parts of the world, economies have started to recover from the sharpest, but also the shortest, recession in modern times.
Corporate spreads have come down from their highs in late March, but the bounce back has not been uniform across asset classes. For example, emerging markets have generally lagged high yield, due to their high reliance on oil exports and tourism.
We have always favoured diversification, as that is one of the best ways to help protect investors from unexpected shocks and add resilience to portfolios.
At the beginning of this year, optimism seemed to fuel markets, taking valuations to levels that we felt, in many cases, did not allow any room for disappointment. We obviously did not anticipate the coronavirus pandemic, but the extreme optimism prevalent beforehand made us cautious.
It is in these times that a strong framework for assessing risk and return is especially critical.
One way of doing this is to rely on the concept of concentric circles: that is, to place the most liquid, least-risky asset classes at the centre, and populate outer rings with increasingly less liquid and riskier segments.
Key Points
- A bounce back in stocks has not been universal
- Investment grade debt is among favoured issuers
- Debt from financial stocks is quite promising
Investors should earn increasing risk premium – and potentially higher return over time – as they move out from the centre.
The historic market sell-off in March affected every circle, even the safest asset classes near the centre, but created possible opportunities across them as well.
The volatility cheapened valuations across quality and sectors, lowering the entry point for a broad range of securities.
While this presented potential opportunities for investors, it is important to understand that lower prices do not always mean attractive valuations.
In the case of residential mortgage-backed securities, however, we have benefited from the March volatility, as well as from positive fundamentals (high levels of asset coverage) and strong fiscal and monetary support – especially from the US Federal Reserve.
We remain confident onUS housing market fundamentals, which were already strong overall going into this crisis. Seasoned mortgage-backed security issues also remain resilient as borrowers have built considerable equity in their homes.
Within corporate credit we have been favouring investment grade issuers, which historically have experienced low default rates and can perform well in a broad variety of possible scenarios.
Specifically, financials are one of the areas where we saw opportunity, given the significant volatility many banks suffered in March, despite their strong fundamentals.
For instance, the senior and subordinated debt of core and peripheral European banks has rebounded strongly in recent months, supported by the sector’s higher capital levels and stronger asset quality, relative to previous downturns.
Better fundamentals have also led the banking sector to become one of the vehicles that fiscal and monetary authorities have used to help restart economies around the world.
This has made them the recipients of sizeable and quick support, in the form of cheap liquidity as well as relaxation of some capital requirements, as they have become part of the solution to the crisis, and not part of the problem, as they were in 2007-08.
We also favour traditionally non-cyclical sectors, such as telecom/cable and utilities, given the now wider valuations paired with more resilient earnings profiles.
Similarly, pharmaceuticals and healthcare are also traditionally defensive sectors, and could likewise see increased earnings due to this crisis.
Potential risks
While high yield tends to bear more risk of permanent capital loss through defaults, we believe that there will be opportunities as some investment grade companies are downgraded into non-investment grade.
This group, known as ‘fallen angels’ has already reached almost $200bn (£1.5bn) so far this year, and is likely to continue to increase over the coming months, creating opportunity.
On broader high-yield exposure, investors should be highly selective in order to avoid defaults.
Our focus in high yield tends to be in the higher quality cohort via senior secured positions in sectors such as media, which benefit from low cyclicality and high cash flow generation. However, we expect the US high-yield default rate to reach high single percentage digits in 2020.
Energy issuers will most likely be accounting for the majority of these defaults in the near to medium term.
Indeed, going into the crisis, oil companies were already suffering from excess supply; this has now been compounded with an exceptional demand shock.
Ongoing uncertainties around when lockdown measures will be fully lifted, the future of airline travel and a more remote-based working environment all contribute to the uncertain trajectory of oil prices.
Other sectors, such as non-food retail and leisure, will also face pressure depending on the duration of social distancing measures and the impact of the crisis on consumer demand.
This could lead to an escalation of defaults, although many issuers have liquidity and bank lines or other measures they can take to help avoid default in the near term.
Finally, automobile and airline companies are also heavily impacted and the interplay of exceptional government support needs to be carefully integrated in the analysis.
In summary, while market sentiment has largely turned positive, we remain cautious and emphasise a prudent approach as uncertainty around a potential second wave of Covid-19 infections and another slowdown in growth remains high.
We continue to favour high-quality credit as different parts of the economy will recover at a different pace. Because of this, bottom-up security selection has never been more important.
Eve Tournier is head ofEuropean credit portfolio management at Pimco
