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Fixed income: a focus on fundamentals favours the brave

Markets have been roiled by extreme volatility over the last fortnight. There will clearly be winners and losers in the months ahead, which we believe should create opportunities for investors with a medium-term outlook to find securities that have become dislocated from their intrinsic value – particularly within the banking, energy and mining sectors.

Stormy waters: looking for dislocated credits

Credit spreads have widened dramatically over the past fortnight (see figure 1). As we reflect on these extreme market moves, there may be an opportunity for those investors able to weather further short-term volatility to buy assets whose prices have become dislocated from their underlying value.

Figure 1. Spreads on major credit-default swap indices

Source: Bloomberg, as at March 2020.

A lack of clarity about the intensity, duration and economic impact of Covid-19 means it is difficult to ascertain how far we are from the bottom of the market. Should economic disruption continue, or the asset management industry face large-scale redemptions, there will be more liquidity squeezes and spreads could rise further.

What is clearer is the willingness of central banks and governments to fight the turbulence with coordinated monetary and fiscal stimulus. For investors that have the flexibility to invest with a longer holding period and who can weather mark-to-market volatility over the short-to-medium term, now could be an attractive point to invest in dislocated, higher-quality credits.

We are currently using robust credit analysis to evaluate the economic impact of the coronavirus and lower oil prices on an issuer’s ability to survive and recover. In addition, we are considering 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 puts us in a better position to achieve our expected outcomes.

We believe that partly investing available funds now, while also keeping some reserves on hand, could help us navigate the situation should it deteriorate it further. We now consider the sectors where we think potential opportunities lie.

Banks: too large to fail?

The banking sector has been heavily oversold (see figure 2) in response to concerns about a prolonged recession, deteriorating asset quality and the continued drag of lower interest rates. However, we also believe that ‘national champion’ banks are seen as too critical to fail – something that does not seem to have been priced in.  

Figure 2. Bonds in the banking sector take a tumble

Source: Bank of America, Federated Hermes, as at March 2020.

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 temporary – we believe that banking issuers should recover. Opportunities we have identified include:

Large domestic Italian banks’ additional tier 1 (AT1) or legacy subordinated debt. Italy sits at the epicentre of the Covid-19 outbreak and has become a target for panic-induced selling. We believe the largest Italian banks are unlikely to default, given their domestic focus and the fact that they benefit from a flight to quality in deposits at the expense of smaller, local institutions.

These securities (particularly legacy paper) tend to be less well covered by analysts, meaning there are more opportunities to find cases of mispricing. Prices, currently at about 60 points, could recover to 80-90 (although they could also decline to 50).1

Legacy subordinated debt is currently trading in the mid-30s. The securities are also not comprehensively covered by analysts and tend to offer less liquidity, meaning they are infrequently held outside specialist financial funds. Technical expertise is needed to understand the securities’ capital treatment after January 2022 (when regulation is due to change). Where there are sellers, buyers have the ability to dictate the price. Should the financials funds holding these securities face large-scale redemptions, prices could become more dislocated.

The tier 2 (T2) subordinated debt of mid-sized European banks has been heavily oversold and is trading at 40-50, with a possible target recovery price of 70-80 – although another fall is still possible. Robust credit analysis is needed to select issuers that are less likely to default. One approach could be to invest in issuers across Spain, Portugal, Greece and Italy, which would help diversify default risk – something that is mitigated by investing in T2 paper, which has the potential to offer credit investors some protection.

US and European AT1s and preference shares are currently priced as if they won’t be called, rather than reflecting a call price of par value.  There is some uncertainty about whether banks will call their AT1s or preference shares when they get the opportunity, meaning that there is an opportunity to allocate to those with a higher chance of being called.

The additional tier two or preference shares of selected US banks. Despite the indiscriminate sell-off in banks, we see better relative value in the US compared to Europe. US credits should benefit from the flight to safety, greater liquidity and lower hedging costs which allow cheaper access for foreign investors.

Energy: looking cheap  

Oil has traded as low as $20 a barrel in recent weeks, 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.2 This will particularly be the case for lower-quality issuers.

While the sector’s fundamentals have deteriorated, it now looks extremely cheap (see figure 2). We think this could be a good point to invest in companies with flexible operations, lower breakeven costs, high-quality assets and good liquidity.

Figure 3. Energy spreads are above their ten-year average relative to the high-yield index

Source: ICE BAML, Federated Hermes, as at March 2020. SD is standard deviation, which expresses how much the value differs from the mean. 

We see particular opportunities in the following issuers, some of which have securities that are priced 40-50 points lower than in the middle of February.

Higher quality, investment-grade oil producers. We like issuers with low breakeven costs that could potentially be brought down further, as well as those that with oil hedges in place for 2020. We also see opportunities to invest in firms that have 100% debt coverage based only on proved developed producing3 reserves at current strip prices.4

Other attractive features include strong balance sheets and good liquidity in the form of undrawn revolvers (a line of credit between a business and a bank) and high cash balances. We prefer longer-dated paper which has sold off materially and in some cases trades below the implied asset coverage price (based only on producing proved reserves).

Midstream companies rated BB or above are less sensitive to price moves (see figure 4) as they benefit from long-term fee-based contracts that are more exposed to volumes. While volumes will be affected as firms reduce production, these companies benefit from a minimum volume commitment clause in their contracts, which results in earnings which are not as volatile.  

Figure 4. Midstream companies are more insulated from price movements

Source: Bank of America, Federated Hermes, as at March 2020.

Because these firms pay out distributions to shareholders, they also have the financial flexibility to reduce these as the operating environment deteriorates. These issuers are currently trading near their estimated recovery value, meaning that there should be limited further downside should they default. In addition, they provide almost-free access to a stabilising energy sector.   

Natural-gas producers. We are focused on low-cost producers with high-quality acreage and no near-term debt maturities. These companies should benefit over the medium term as oil production in the US declines, which should also push down associated gas production. This should help stabilise supply-and-demand fundamentals in the natural-gas market.

Metals and mining: survival of the fittest

Reduced demand for metals and a potential disruption to supply should 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 are down over 20 points and could be attractive over a 12- to 18-month horizon.

The decline in prices mean that there clearly some opportunities within the sector (see figure 5). However, we remain cautious as prices could continue to fall as more mines close or commodity prices decline further.

Figure 5. Miners look cheap – but do they have further to go?

Source: Bank of America, Federated Hermes, as at March 2020.

Other corporate sectors to watch

The gaming industry has sold off heavily in recent weeks. However, we see this as a repricing from elevated levels and there is still a risk that some of the companies with less liquidity may not survive.

The auto-rental sector has also suffered. However, this is not an area we plan to allocate to as borrowers may struggle to survive the summer period if normal business does not resume.

All eyes on structured credit

During periods of market turbulence, structured credit is typically a lagging asset class and prices tend to move once other asset classes have already sold off. While this has mostly held true for asset-backed securities (ABS) during the current crisis, the same cannot be said for collaterised-loan obligations (CLOs) which have moved in a much more synchronised manner with corporate credit.

This makes sense for a couple of reasons. First, the assets that back CLOs are leveraged loans on corporates. Second, 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.

As with many asset classes, we recently saw that liquidity was starting to dry up. With investors looking to sell their CLO exposures, there have been some large price moves. Compounding this has been the reluctance of dealers to step up and put their balance sheets to work, as well as the reduced transparency around where clearing prices are for various levels of the capital structure.

While supply continues to outstrip demand, we continue to see downwards shifts in pricing. With a lack of depth in buyers, some of these moves can be dramatic – as we saw last week. 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 – especially the sub investment-grade tranches – to assess whether structured credit could be an interesting investment opportunity for a dislocated mandate.

Risk profile
  • The value of investments and income from them may go down as well as up, and you may not get back the original amount invested.
  • Targets cannot be guaranteed.
  • It should be noted that any investments overseas may be affected by currency exchange rates.
  • This information does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments.
  • Where the strategy invests in debt instruments (such as bonds) there is a risk that the entity who issues the contract will not be able to repay the debt or to pay the interest on the debt. If this happens then the value of the strategy may vary sharply and may result in loss. The strategy makes extensive use of Financial Derivative Instruments (FDIs), the value of which depends on the performance of an underlying asset. Small changes in the price of that asset may cause larger changes in the value of the FDIs, increasing either potential gain or loss.
  1. 1Bond prices are expressed as a % of par value and are then converted to a percentage-point scale. 90 points is 90% of par value.
  2. 2An equity cushion exists if the value of the collateral exceeds the value of the creditor's claim.
  3. 3Proved reserves that can be expected to be recovered through existing wells and facilities and by existing operating methods.
  4. 4The price of a futures strip, or that used to lock in a specific price for a targeted timeframe.

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