Credit Seen as Priced for Perfection Even as Risks Loom in 2021

Credit markets are priced to perfection, but money managers still see plenty of risks ahead for U.S. corporate debt in 2021.

Yields for the junkiest of junk bonds, those rated in the CCC tier, fell this week to their lowest levels since September 2014, as investors grow hopeful about Covid-19 vaccines and reach for yield. Speculative-grade bond yields are broadly close to record lows as well.

But before life returns to normal, a lot can still go wrong: vaccine rollouts can be delayed, the new coronavirus can continue to spread, and many companies may find themselves facing steep revenue drops with little hope for much more fiscal stimulus.

“Ultimately what you’re trading is the dangerous waters between a vaccine, a brighter day, to the current issue with the virus,” said Greg Peters, head of PGIM Fixed Income’s multi-sector and strategy.

Here are some of fund managers’ top concerns heading into 2021:

Virus Worsening

Coronavirus cases are still surging globally, sending more economies into lockdowns and reinstating restrictions. While there are now three companies that have reported significant progress on vaccines, there’s no guarantee of a timeline of their distribution.

If the disease continues to spread without an end in sight, more companies could face credit ratings downgrades and even insolvency, PGIM’s Peters said. The risk is more pronounced in leveraged loans and the lower-end of the high yield spectrum because those companies have higher debt loads, while BBBs and BBs have the most risk-adjusted value, he said.

Muted Fiscal Response

With Joe Biden as the next president and Republicans still potentially maintaining control of the Senate, it’s not completely clear that Washington will pass a large fiscal stimulus to help the economy recover from the pandemic. That will likely continue to challenge sectors hit hardest by Covid-19, like airlines, theaters and commercial real state, said Jim Schaeffer, global head of leveraged finance at Aegon Asset Management.

“This had a dramatic impact on the consumer and we’re a consumption-driven economy,” Schaeffer said. “This was really a year where we as consumers have changed the way we spend and what we spend on.”

Investors are reassessing whether Janet Yellen as Treasury Secretary in the Biden administration would pave the way for a larger fiscal stimulus. She would likely join Chairman Jerome Powell’s policy of lower-for-longer interest rates, as well as expanded government spending.

Dismal Recovery Values

Investors tend to recoup less of their losses when defaults are higher, and there have been a whopping 227 bankruptcy filings this year by companies with at least $50 million of liabilities, according to data compiled by Bloomberg. That’s the highest since 2009.

A growing number of companies finance themselves mainly with loans, leaving little, if any, unsecured debt to help absorb losses for senior lenders. That means being atop a capital structure isn’t much better than being at the bottom. Issuers have also gotten more aggressive in their debt documentation, stripping away investor protections and fudging earnings projections to make them rosier than reality. That also leaves lenders more vulnerable should those estimates backfire.

“There are other companies that are frankly probably funding really more from a zombie state and will eventually need to restructure,” said Christian Hoffmann, a portfolio manager at Thornburg Investment Management. “You’re seeing recovery rates that are just in abysmal levels.”

Expiration of Fed Facilities

While investors largely agree that the Federal Reserve’s corporate credit facilities were mostly unused and that winding them down shouldn’t have much of a near-term effect on the market, they’re still concerned about removing a key “psychological backstop” when coronavirus cases are surging again, threatening more lockdowns.

“By removing the programs, the impact is more on sentiment and is therefore a poor outcome for an economy that is still facing near-term uncertainties,” said Steven Oh, global head of credit and fixed income at PineBridge Investments.

Strategists noted that the front-end of the investment-grade market was particularly susceptible, where the Fed concentrated most of its purchases.

©2020 Bloomberg L.P.

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