Credit sits above equities within the capital structures of companies, and in its traditional form takes priority during bankruptcies (and therefore provides a greater degree of protection). The ‘must pay’ nature of credit coupons – in other words, the fact that firms are contractually obliged to pay them – has helped the asset class deliver attractive risk-adjusted returns over time.
In the current macroeconomic environment, there is a considerable amount of uncertainty about future earnings. Because of this, companies need to pull the levers that are within the control and focus on preserving liquidity. This includes reviewing capital expenditure programmes and cost structures, as well as drawing revolving credit facilities when possible. In addition, firms need to review their priorities for capital allocation and reduce shareholder returns in order to stabilise their credit profile and ensure they retain access to capital markets.
Figure 1 shows how market expectations about future dividends have changed significantly since the end of February. Cyclical sectors like energy, metals and mining face a significant hit to earnings, while the banking industry may face regulatory hurdles that limit its ability to pay dividends. All these sectors pay large dividends, which helps explain why future expectations have declined.
Figure 1. The market expects dividends to decline
Source: Bloomberg, as at April 2020.
Credit has repriced significantly since 21 February and central banks are focused on stabilising the higher-quality part of the market through bond-buying programmes and other injections of liquidity. While default rates are picking up – and the number of fallen angels, or issuers downgraded to high-yield status, is increasing – spreads are hovering around 1,000bps, which is typically a good entry point for medium-term investors. Going forward, we believe that credit will come into focus as an asset class with assured income and the potential for capital appreciation as markets recover from the current drawdown.