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Discerning dislocations in credit markets

31 March 2020

Markets have been roiled by extreme volatility through the course of March, driving major dislocation between recent price action and intrinsic value.  Andrew Jackson, Head of Fixed Income at the International Business of Federated Hermes, assesses four sectors where pricing and value seem particularly distorted.

Credit spreads have widened dramatically this month, creating opportunities for investors willing to withstand short-term volatility and buy assets on a longer-term view of underlying value. As we assess the road ahead, we are undertaking credit analysis to evaluate:

  1. The economic impact of the coronavirus and lower oil prices on an issuer’s ability to survive and recover.
  2. The likelihood that governments and central banks will let these issuers fail.

While this approach does not insulate returns from further volatility, we believe that modelling upside-return scenarios against estimated recovery analysis on a worst-case basis provides a realistic basis for consideration of “expected outcomes”. Using this framework, we believe the following sectors currently offer a range of potential opportunities.

Banks: too large to fail?

The banking sector has been heavily oversold in response to concerns about a prolonged recession, deteriorating asset quality and the continued drag of lower interest rates. Through the sell off, we believe that ‘national champion’ banks are simply too critical to fail – something that does not seem to have been priced in.

UK banks are this week expecting a dividend and share buyback freeze by the regulator, following Friday’s announcement from the ECB ordering implementation of a freeze across the eurozone. We envisage the freeze being a positive for credit by improving cash flow and do not anticipate an impact on AT1 coupons at this stage.  For European banks, AT1 coupons have a much lower impact than the benefit from cutting dividends on cash flow, the difference of which we would estimate to be around €5.5 billion vs €30 billion.

Further to this and following strong performance earlier this year, banks now seem the obvious place to look for dislocated values – particularly lower down in the capital structure. If the effects of the virus can be contained – and the economic impact is more transient – we believe that banking issuers should recover.

Energy: looking cheap

Oil has taken a hit in recent weeks, breaking below $20 a barrel yesterday, as the failure of the Organisation of Petroleum Companies (OPEC) and Russia to reach a supply-cut agreement added to coronavirus-induced concerns about lower demand.

There is now material pressure on energy issuers’ cash flows and ability to operate. If there is no agreement between OPEC and Russia over the next few months, the highest-cost producers with levered balance sheets will be affected and we will see an uptick in bankruptcies. Similarly, if we do not see federal aid from the US government in the shape of low-interest loans to the industry, marginal-cost producers like US shale firms will have to reduce production and lower costs.

Accessing debt-capital markets will become increasingly difficult for energy companies – potentially even more so than in 2015-16, given lower equity cushions.1 This will particularly be the case for lower-quality issuers.

While the sector’s fundamentals have deteriorated, it now looks extremely cheap. We are on the lookout for: companies with flexible operations, lower breakeven costs, high-quality assets and good liquidity.

Metals and mining: survival of the fittest

Reduced demand for metals and a potential disruption to supply could result in a rise in defaults. There is now significant dispersion between investment-grade miners with less leverage and diversified businesses, and indebted high-yield issuers. Some long-dated diversified miners have seen price discounts over 20 points and could be attractive over a 12- to 18-month horizon.

Declining prices have created opportunities across the sector, but we remain cautious, as prices could continue to fall as more mines close or commodity prices decline further.

All eyes on structured credit

During periods of market turbulence, structured credit is typically a lagging asset class, in which pricing tends to move once other asset classes have already sold off. This has mostly held true for asset-backed securities (ABS) through the current crisis, but the same cannot be said for collateralised-loan obligations (CLOs), where moves have been more closely synchronised with corporate credit.

This is principally because the assets backing CLOs are leveraged loans on corporates; and, second, because the investor base for CLOs tends to be more in tune with the high-yield corporate space, given that the underlying issuers often have high-yield bonds and leveraged loans.

Liquidity in the CLO market has been challenging, with active selling driving some large price moves. While supply continues to outstrip demand, we continue to see downwards shifts in pricing, with a lack of depth in buyers driving dramatic price action. Tough trading conditions have been further compounded by dealers’ reluctance to step up and put their balance sheets to work, and reduced transparency on clearing prices across various levels of the capital structure.

In an environment where liquidity is important, there is potential for some parts of the market to become oversold based on their underlying fundamentals. We are watching this space closely – particularly sub investment-grade tranches – to assess whether structured credit could be an interesting investment opportunity for a dislocated mandate.

1 An equity cushion exists if the value of the collateral exceeds the value of the creditor’s claim.

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