Corporate bonds to shine as new credit cycle begins

As Covid-19 ravages through impecunious issuers across the fixed income universe, Adam Grotzinger of Neuberger Berman expects the credit cycle to start afresh as stronger businesses survive, take market share, and adopt a bond-friendly approach to using debt.

Neuberger Berman expects ~10% of bonds in the U.S. high yield and emerging market sovereign sectors to default by the end of 2021. And in much the case of “a few rotten apples spoiling the barrel”, this situation is leaving spreads wide open across credit. This provides an opportunity to buy selective, quality issuers at distressed prices.

Meanwhile, monetary policy is helping provide visibility on where the capital destruction will occur, while Grotzinger notes issuers are using cheap debt to term-out or refinance loans at lower interest costs whilst earnings hold up.

In this interview, Grotzinger discusses where the opportunities are in this context and how he’s taking a multi-sector approach to building portfolios.

Watch the video or access the Q&A Format for this interview below.

Q&A Format

Against the backdrop of COVID, global economic uncertainty and record low rates, why are you bullish on fixed income?

Certainly there's a lot of uncertainty out there in the market and in a lot of variables and data points coming out on the economy and how markets are responding to that. Underpinning our view as we look to the end of 2020, and even beyond into 2021, is that the growth outlook on a forward-looking basis really remains supported. And in particular, that's being enabled by low interest rates, ongoing accommodative monetary policy and monetary policy guidance, which has all kind of filtered into general easing of financial conditions. I think if we take a step back and we contrast and compare this environment to say 2008, we're at zero again.

But I think the difference in the reality this time round is that this the zero bound is being predicated by a Fed and a Central Bank environment, which is bringing a lot of credibility to keeping these rates anchored at zero. And that's a very different, and a contrasting environment to 2008 where rates went to zero, but the market was pricing in, in terms of volatility, the anticipation of rising interest rates after the crisis. It’s a very different experience today.

And so when you look through to financial markets, you're seeing things like government bond rates much less volatile as a function of this new Central Bank guidance that we have in particular by the Fed. And that's feeding through in a very strong transmission mechanism into other sectors of the market and how they price given the underlying stability of government bond curves, notably, the credit markets.

But is it fair to say credit is only doing well because of the vast amounts of fiscal stimulus and the Fed buying bond ETFs?

So the first point we'd say is Central Bank policy, and even the fiscal response that was very strong in the beginning, have been important stabilisers to the credit markets. So, we shouldn't underestimate the power and the transmission that that's brought to credit markets. And notably that the most important aspect has been the re-liquification of the credit market so these companies can tap the public debt markets for their balance sheet needs, for their financing needs, and we're not creating liquidity events that translate into solvency events. And so that's been very important.

The Fed's been really active. I mean, notably in Treasuries, notably in agency mortgages, somewhat in credit. They'd set expectation and guidance about the tools and the levers they can pull to continue to stabilise that market. So, yes, to answer your question, it's important, but if we look under the hood one layer further, we're also seeing things on the fundamental side that are encouraging.

On the one end there's defaults, as we would expect in some segments and most vulnerable businesses in this economy, but on the other end the companies that can survive have actually been issuing debt and tapping these markets to buffer their balance sheet and also use debt proceeds, which is encouraging for us, not in an equity friendly fashion, but rather in a creditor friendly fashion. 

So you're seeing less share buy backs. You're seeing greater use of debt proceeds just for terming out debt and refinancing, as an example. And that goes along with some of the earnings profiles of these businesses, which have also at least on the solvent end of the spectrum, been encouraging in terms of cost management and flexible cost structures and how these companies are navigating this COVID reality in their respective economies.

And is that the key for you as a fixed income manager specifically, avoiding the zombies?

Absolutely. And what I would say is, even when we look in the rear-view mirror window, a lot of the perspective on fixed income markets is spreads are tighter in credit markets from March, obviously. But that doesn't kind of go the step further of looking through company by company or rating spectrum differentials, to see that there's still a lot of value out there in the credit markets. And that dispersion is elevated and really taking an active approach to understanding these businesses, understanding their structures, understanding their economic sensitivity to this economy and how they can weather this storm is really important.

And in light of that, the spread has compressed. The spread you're getting from many of these companies, we still think is attractive for the relative risks and the lesser default risks that these businesses have in this reality, and particularly at the start of a new credit cycle for these businesses. Right? The old credit cycle's ended, a new credit cycle has started afresh.

I find that really interesting. What does it mean when you say new credit cycle?

So, a new credit cycle, means that we're going through a default cycle. And we're starting afresh. And so if you put that in perspective, let's look at large markets just as an example, the U.S. high yield market, for instance. We're anticipating around 9% cumulative defaults for this year and into next year, 2021, the high yield EM or emerging market, sovereign market, as another example is going through its default cycle. We're anticipating around 8% defaults. But today, versus maybe at the start of this crisis, we have a lot more visibility into where that capital destruction is going to happen. And a lot of that is in the pricing of the market.

So for instance, the high yield market's pricing for about 10% of the market for a stressed type of environment and a restructuring of capital. And so that leaves a lot of the kind of the, I kind of call it, the performing end of the market, looking attractive in terms of its valuation. And I think in light of an environment where there's yield starvation, that's going to go on for many years now. Given Central Bank policy, the value of that yield premia or that spread premia relative to relatively low default risk is very attractive and in our view, still has room to tighten, both in investment grade markets and in high yield markets.

Exactly how attractive?

So, if we look out 12 to 18 months from now, and we think about the investment grade corporate credit market, and I just use like index level spreads as an example then I see some good tightening opportunities.

We could see spreads going down from the current 120 to 130 basis points' margin back down to historical levels of around 90 basis points. We could see the performing end of the high yield market going back down into a range of spreads of 300 basis points over Treasuries - excluding of course the defaulting issuers.

And let's not forget, this is not only still attractive relative to its historicals, but also relative to just this cash rate level or government bond level, which is benign, negative, or shockingly low just in outright nominal terms. So that multiple of yield you're getting arguably is more valuable today versus a previous couple of years ago.

Of course in any environment diversification is key. Based on that premise, can you explain the role of multi-sector sector portfolio construction?

There are a lot of ways when you say multi-sector portfolio that you can put the pieces of the fixed income market together and achieve different objectives. So let me put my comments in the context of putting together these pieces for an outcome that gives you an attractive return relative to the risk you take and the risk being kind of investment-grade, fixed income risk. So, in kind of a higher quality risk bias. I think the case for that is very strong and it's evidenced in how markets have behaved this year and the opportunity set that's unfolded.

Coming into COVID and the immediate kind of sell-off in markets we saw, it was broad based across fixed income. But I think the question you always ask yourself in fixed income is, where is that value not only most apparent, but where can we monetise that value with high levels of confidence? And in different markets, the answer to that question is going to change. 

In the context of this kind of COVID economy in March, our strong view in multi-sector fixed income was to exploit that cheapness in the high-grade ends of the market. Everything was cheap, but we felt that high grade was the most compelling value. And we had the highest confidence in again, monetising that. And so in hindsight, the March-July period, saw us take advantage of that. We more or less realised gains on that book and actually took profit on those positions coming into mid-late summer. 

The reality in fixed income is that those opportunities continue to morph. So for instance, in July and August now our thoughts have changed to that relative value is shifting. It's moving away from the high grade end of the market, where spreads were wide and attractive to tighter today into more nuanced ends of the credit market that are slightly lower in quality, but more focused on specific segments of the market.

For instance, double-B, high quality, high yield, and selective triple-C issuers that we think actually look like single-B credit quality types of names that can be upgraded through time or in the emerging market space, names that are high yielding sovereigns excluding the problem children of that universe, like your Argentina's or Ecuador's etc. So there's a lot of, let's call it security selection, opportunity in the market still, but you have to sift through a lot of that headline level noise that you get in fixed income.

The universe you’re sifting through has a lot of those ‘problem children’. How do you identify the winners and losers?

So there's really two parts of our process and these both contribute to how we make money for clients.

• Firstly, where do we rotate that marginal dollar to? So kind of what area of fixed income market presents the best relative value? And then when we're within that market that we identify as attractive, how do we screen out the best names and the line items to put in our portfolios in collaboration with our research analysts that are focusing on that day-to-day?
• Secondly, on the asset allocation front, we have a long standing process where simply put, we spend a lot of time with our sector teams that live and breathe in these markets to think about what is our forward return expectation? And not just kind of a number, but what does that return expectation look like? How fat is the left tail? How confident, again, am I in monetising this opportunity?

And so that is really the process here. Not just identifying return, but comparing it to conviction levels and confidence and building portfolios around things that have less left tail risk and kind of more certainty in outcome, or even upside to outcome versus downside. So avoiding massively negative asymmetric returns, and then working with the teams to identify populating those portfolios really on a best ideas, individual, security level basis.

How many securities do you tend to hold for diversification?
It can vary, but I'd say in a well-diversified portfolio, we're looking at five to 600 names. That would include risk-free spectrum, like agency mortgage pools or treasuries or tips in addition to credit, and then in portfolios as well that we manage that are exclusively investing in credit. We'd have a smaller kind of set of holdings. I would put it in kind of the 300 names type of realm. So we certainly are selective in what we're putting into portfolios for clients.

I take it you view the quality government bond part of the market as overvalued?

Yes - that's where I'd say you can question valuation. We would argue it does look overvalued. Could it stay there? Certainly, but kind of the confidence again in monetising any significant return from call it, the U.S. Treasury Market, is relatively low. And the margin for error is high. So, there is return potential there, but I think we have less conviction versus monetising it versus the credit market. 

And it's not to call the end to the role that government bonds have played in the portfolio, but at these levels of yields, your coupon versus kind of the duration risk you have there from a price perspective is just mismatched. And we think there's better alternatives in the market if you're thinking about how to build a risk-free end of the spectrum and a portfolio that gives you a better yield similar, or the same type of liquidity, and less duration risk.

And one of those for us is agency mortgages. We like those compared to nominal treasuries. We also think selective high-grade corporate bonds, particularly with the Fed's support of that market can be an interesting alternative as well, selectively to some of your traditional nominal treasuries.

What’s the biggest risk to the performance of credit?

I think certainly one risk would be just the complete shutoff of the global economy again. That the virus morphs into something different and we go back to a similar lockdown that created the significant economic turmoil that we saw early in this year. We place the probability of that as very low.

Certainly we have a lot of countries now, and certainly companies in the U.S., working on a vaccine. So, it feels like a vaccine will be in the cards here. We'll have to see what the adoption rate is and how that's kind of taken up by the population. But I think a vaccine will enable growth. More fiscal is expected to come as well. And I think fiscal is an important stabiliser, or floor to growth in addition to monetary policy.

So, let's say although growth may not be exciting, we've seen an improvement in the 2020 growth forecast, even from at the beginning of the year, and I think that kind of stabilisation of growth is important. What's more interesting for us in is this kind environment is the differing outcomes for different companies. For us, we’re focusing on where the opportunities are on the liquid end of fixed income and parts of the market where there’s still value.

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