27 February 2020

Actively Selective in Junk Land

By Walter E. Kilcullen

As equities continue to sell off and credit spreads widen from historically full valuations, the coronavirus/COVID-19 outbreak and related fears of a longer than anticipated containment period and greater scope of impact remind investors just how important it is to do the work. By work, of course, we’re referring to the bottom-up, fundamentally driven credit-intensive research that Western Asset invokes into our high-yield positioning and relative value assessments we vet on a running basis.

Prices have changed in the past few days related to the COVID-19 situation as lingering uncertainty about the global effects to growth persist. Despite what were seen just last week as powerful positive technicals (retail inflows, net negative supply) in the asset class, market sentiment shifted swiftly to an old-fashioned risk-off environment (i.e., “sell it if it’s not down enough or prudent to raise cash before the outflows mount”). As a result, the primary market has closed for the foreseeable future and 4Q19 corporate earnings, specifically for those credits more global in nature, have been accompanied by either a reduction in forward guidance or, in some cases, pulled guidance altogether.

Uncertainty can turn investor sentiment on a dime—stocks follow suit as revenue generation lost, or at a minimum postponed, does not bode well for equity stories given their need to show growth at current multiples. Credit analysts need to stress their working models to capture future downside potential to free cash flow generation expectations and rerack the relevant credit metrics to assure risk is appropriately priced. Dynamic, active managers of high-yield are then presented with the opportunity to source total return investments as forced selling from passive funds pushes prices lower despite the notion that credit fundamentals haven’t changed materially over the course of a few days or even weeks.

Western Asset thrives in an environment where weak technicals override the evident stable fundamentals of bond issues noticeably higher in yield due to this new-found elevated volatility. Junk bond professionals recognize that it is the income generation—the ability for a company to service its debt—that matters first and foremost. We can look to history for relevant examples: the flash crash in 2010 which lasted about the duration of a boxing match, the downgrade of the US in 2011 which bred several days of bargain hunting and the taper tantrum period in 2013 when high-yield bonds traded down in lockstep with correlated US Treasuries, to name a few. Even though the underlying credit profiles in these instances hadn’t eroded one iota—all of these were opportunities to buy solid credits at depressed prices. In the end, we believe it’s the fundamentals that win out, which is why companies with catalysts for deleveraging and better borrowing costs remain definitively on our radar. This is clearly not the time to blindly bid and go all in on day two or three of severe weakness brought upon by the looming pandemic. However, we will do the work, screen the opportunity set at meaningfully different valuations, and be ready to add exposure as we see fit … when we see fit.