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Our views 09 April 2020

Value from sterling research

By Martin Foden, Head of Credit Research and Matthew Franklin, Senior Credit Analyst

5 min read

As central bank liquidity soothes credit markets following their initial dislocation, and we all begin to settle into new routines, investors’ focus has turned from initial shock to longer term portfolio impacts. It’s hard to underestimate the enormity of the economic shock from measures to slow the spread of coronavirus, which in effect amounts to huge swathes of industry simply standing still.

For many companies, revenues have disappeared whilst a large proportion of their costs remain, leading cash to evaporate from companies and scar once-sustainable balance sheets. Whilst central banks can flood markets with liquidity, they can only have a limited impact on borrower solvency.

So what does this huge shock mean for sterling credit markets? For the weakest corporates this significant stress may prove too much, with even the extraordinary level of support being provided by governments not enough to stop defaults spiking. Equally, as companies hunker down to see them through lock down, there is an increasing risk that unsecured creditors will become heavily subordinated, as firms are forced to offer security over assets to maintain access to liquidity. Indeed, only last week, the large cruise ship owner and operator Carnival had to issue $4bn of bonds secured against its ships at coupon levels that would have been unthinkable weeks ago. So even without default, it is likely that the previously assumed status of certain ‘senior’ bondholders could change very negatively as the crisis develops. The predilection for investors over recent years to buy bonds with no effective covenants provides zero protection against this development.

We will likely also see an increase in transition risk as borrowers’ credit ratings deteriorate. In fact, in the US so far we have seen rating downgrades at a faster rate than the financial crisis[1]. One area of particular concern for investors are those borrowers moving from investment grade to high yield, a dynamic likely to be exacerbated by increased subordination, where pricing deterioration is sharpest. In fact this pricing differential is being amplified by central bank purchase schemes, which have focused on purchasing investment grade corporate bonds only. The potential for transitions is set to be aggravated by the eye watering build up in BBBs over the last decade, increasing from 20% to 37% of the overall investment grade market. And with little of this debt offering meaningful credit protections such as security or covenants, indiscriminate buying of BBB credit can leave bondholders as mere passengers for this bumpy ride.

So how are we responding to the coronacrisis? Times of crisis and dislocation in credit markets always shine the most intense spotlight on credit research processes. Our long-standing focus on the sustainability of our lending position, with a particular emphasis on tangible protections to ensure the seniority of our claim, remains critical. Furthermore, an investment philosophy, focused on exploiting market inefficiencies and building highly diversified portfolios to dampen idiosyncratic credit risk, remains unchanged. For over 20 years this has allowed us to extract additional credit enhancements without compromising portfolio yield. Running highly diversified portfolios with a focus on meaningful bondholder protections, has also helped us in managing liquidity during this market stress, allowing us to better take advantage of market opportunities as they arise. The security and covenants embedded within bonds in our portfolios help to give us greater confidence over their cashflows during these extraordinary times, compared with more conventional unsecured lending. And with investors increasingly relying on corporate bonds as their primary source of income, thanks to sweeping dividend cuts, we believe that an established research process that fixates on security of cashflow is more important than ever

[1] https://www.ft.com/content/253210d5-4a2d-439f-a4a6-204a7f66d445 ‘Rating agencies brace for backlash after rash of downgrades’, Financial Times, April 3

Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the author’s own and do not constitute investment advice. Portfolio holdings are subject to change, for information only and are not investment recommendations.