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Coronavirus crash: Why the sell-off in high yield bonds has been overdone

09/04/2020

The global market sell-off that we have witnessed in March 2020 has been vicious. High yield bonds have been no exception, as many investors have looked to turn riskier assets into cash amid the coronavirus pandemic.

Yet has the sell-off gone too far? I would argue that it has, presenting an exceptional opportunity for investors who can take a long-term view.

There will be bad news…

High yield corporate bonds are, of course, those issued by companies seen as more likely to default or, in other words, to be unable to keep up with interest payments or repay bondholders in full over the life of the bond. By definition, we therefore expect some investments to fail, even in good times.

Many companies will undoubtedly now fold as a result of the sharp downturn in global economic activity, leaving their creditors – bondholders among them – out of pocket. Some sectors will feel the pain especially hard, not least airlines and tourism.

Energy companies, especially those involved in the exploration and production of oil and gas, are also facing a double hit from falling demand and higher supply, which pushed global oil prices below US$30 a barrel. In brutal financial conditions, many energy companies – US shale producers among them – look certain to default on their debt. Given the energy sector’s size, this will have a bearing on default rates across the high yield bond market overall.

… but the news isn’t all bad

However, not all sectors will struggle in this coronavirus-led downturn where consumers and workers have to stay at home. Companies in the technology and media sectors, as well as those in the healthcare or packaging sectors, might even do quite well.

So long as businesses are not derailed, they should be able to make their bond repayments. The same should be true of companies in western Europe and North America that can access enough government support to tide them over until the pandemic abates.

The degree of policy support pledged across developed economies to avert economic collapse should not be underestimated. As well as government support for businesses and extra fiscal spending to pep up the economy, central banks have pledged to buy up bonds.

Admittedly, high yield corporate bonds will not be among those directly purchased, but there will be a trickle down benefit as higher prices on government bonds and investment grade corporate bonds will make their high yield counterparts look more attractive, in relative terms, and so support demand.

A ‘once-in-a-cycle’ opportunity

It is impossible to say when high yield bond prices will reach their nadir, or whether they already have. There is a lot of bad news, and there will be more to come. But I am convinced that following an indiscriminate sell-off that has defied logic, the pain for investors must already be priced in.

Falling prices have pushed up yields – the prospective annual income from a bond as a proportion of its price – on high yield bonds to levels not seen since the global financial crisis, just over a decade ago. The whole sector is being priced as though it is distressed debt (bonds from companies that are either in bankruptcy or on the verge of it.)

It is imperative to remember that income is, of course, a key element of prospective total returns for high yield bond investors. Decade-high levels of income on offer through regular coupons are, in my view, fair compensation for the heightened risk of defaults.

Looking at the high yield market as a whole, prices seem to reflect an expectation of the worst-case scenario resulting from the ongoing pandemic. The effects of the virus are all too real, but fiscal and monetary support gives the global economy a good chance of avoiding a protracted recession.

I therefore believe that the recent market turmoil has thrown up opportunities for high yield investors that are only seen once in a market cycle.

Past performance is not a guide to future performance.

The value and income from a fund's assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested.

The views expressed in this document should not be taken as a recommendation, advice or forecast.


The information on this website is for Professional Investors only. Specifically, the information on these pages should not be used or relied upon by the public of Hong Kong or any other type of investor from any other jurisdiction.

 

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