Andrew Jackson Head of Fixed Income
Fixed Income Quarterly ReportQ3 2020
360° Credit investing in the coronavirus era: a new Goldilocks scenario?
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Andrew Jackson Head of Fixed Income
As Head of Fixed Income, Andrew leads the strategic development of the credit, asset-based lending and direct lending investment teams, and its multi-asset credit offering.
Commentary The coronavirus pandemic has placed credit markets in a precarious position. Concerns about market fundamentals – the decline in GDP and rise in unemployment, defaults and number of leveraged balance sheets – have so far been countered by injections of liquidity and financial support from central banks and governments. The tug-of-war between the two has created opportunities – and yet for credit markets to perform, we hope that neither element prevails for now.
It’s not V – but is it U? The damage that the coronavirus has wrought on the economy, livelihoods and corporate welfare is vast and has not run its final course, although the unprecedented reaction from central banks and governments has offset some of the pain. On p.12, we compare the stimulus measures to the Marshall Plan, a package which spurred 30 years of global growth, and observe that this year’s response already comes to multiples of the 1948 package.
The final outcome of the pandemic – and the road we take to get there – is yet to be defined. Clearly, the situation could worsen if the virus emerges in subsequent waves or if spending patterns don’t return to normal quickly.
But each time there is a wobble, central banks pump out liquidity and governments announce spending plans – and markets find their feet again. Conversely, the environment could improve if the virus’s virulence wanes, but then helicopter money would fade away, interest rates could rise to contain the rebound and markets might fall again.
Financial commentators have become nervous about pointing out facts that support a bearish narrative. But we must state an irrevocable truth: a ‘v’ is a symmetrical figure that has the same gradient and length on the way down as the way up. By this geometrical standard, we are past the point where a v-shaped recovery is possible.
My view is premised on the fact that market fundamentals are now worse – in some instances far, far worse – than in February. The market recovery (see figure 1) was no natural bounce off the bottom, but a massive upwards push supported by the largest, fastest and most coordinated central-bank intervention in the history of modern finance.
Figure 1. Year-to-date performance of credit and equity indices
S&P 500Year-to-date performanceDecember 2019 February 2020 April 2020 June 2020
Bank of America Merrill Lynch Global High Yield IndexEurostoxx 50
Perf
orm
ance
, reb
ased
to
100
60
65
70
75
80
85
90
95
100
105
110
iTraxx Crossover Index
Source: Federated Hermes, Bloomberg, as at 30 June 2020.
I am not saying that this intervention was unnecessary, wrong or even that there will be a longer-term price to pay. Nor, indeed, have I argued that the recovery will be slow, incomplete, or that irrational exuberance rules the day. Furthermore, I have not weighed in on the accuracy of the most bearish warnings of a second wave of virus infections, rising geopolitical tensions, unprecedented growth in unemployment (see figure 2) and hugely inflated levels of global debt.
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Figure 2. A sharp rise in US unemployment
US unemployment rate, aged 15 and over, seasonally adjusted
%
1960 1970 1980 1990 2000 2010 20200
2
4
6
8
10
12
14
16
Source: Federated Hermes, Refinitiv Datastream, Bureau of Labour Statistics, as at June 2020.
With this in mind, let’s reflect on one of the most remarkable half-year periods in financial markets.
A Rising financial distress has seen a large number of companies and individuals unable to support their debt burdens. Lenders recorded significant losses as the ensuing bankruptcies, defaults and restructurings unfolded. During the second quarter, defaults hit the highest level since the same period in 2009, while the corporate default rate tripled between the first and second quarters.
A Despite the savage economic jolt, many entities and individuals have survived intact, but a significant proportion of this cohort remains at risk of falling into the distressed zone unless a solid recovery arrives soon. In particular, the hospitality, travel and retail sectors are teetering.
A Other, more fortunate companies and individuals are in better shape, buoyed by direct or indirect support measures. Many in this group may have acted to shore up their creditworthiness by cutting dividends, reducing costs or laying off employees. Regardless, ongoing uncertainty, a protracted recovery or a permanent shift in patterns could see many of these companies slide off the edge. A large number of sectors fall into this category, with many corporates already downgraded.
A Elsewhere, a much smaller group of entities has sailed through the crisis almost stress-free, with any risks fully covered by government and central-bank largesse.
A And finally, an even smaller club of companies and individuals are now in a better position than six months ago. Starting from a position of strength, companies in industries such as logistics and technology were well-positioned to capitalise on the changes in behaviour that have been accelerated by lockdowns.
Fundamentally resilientFor now, our focus is on the short-term impacts and the probable, rather than possible repercussions of the pandemic. In particular, we are looking at what will probably be a mild trickle-down effect to single-name casualties, and the volatile-but-containable credit-market adjustments.
Looking at almost any measure of the strength of credit fundamentals, the world is now in a worse position than before the crisis. Yet, importantly, metrics indicate that markets are not in a uniformly poorer state – nor that the situation is so bad that fixed-income investors can’t find pockets of good value.
Indeed, the crisis has highlighted both the relative resilience and value of fixed income as an asset class – although it should be acknowledged that there has been an increase in leverage, reduced debt affordability, downgrades, defaults and below-average historical recovery rates (see figure 3).
Figure 3. Defaults and downgrades
Last 12 months par-weighted default rateExcluding energy
%
2004 2006 2008 2010 2012 2014 2016 2018 20200
5
10
15
20
25
US high yield default rates
Investment grade European net ratings, upgrades – downgrades, % (LHS)
2004 2006 2008 2010 2012 2014 2016 2018 2020
High yield High yield default rates (RHS)
%
%
-60
-50
-40
-30
-20
-10
0
10
20
30
40
0
1
2
3
4
5
6
7
8
Source: Federated Hermes, JP Morgan, as at June 2020.
Last 12 months par-weighted default rateExcluding energy
%
2004 2006 2008 2010 2012 2014 2016 2018 20200
5
10
15
20
25
US high yield default rates
Investment grade European net ratings, upgrades – downgrades, % (LHS)
2004 2006 2008 2010 2012 2014 2016 2018 2020
High yield High yield default rates (RHS)
%
%
-60
-50
-40
-30
-20
-10
0
10
20
30
40
0
1
2
3
4
5
6
7
8
Source: Federated Hermes, Bank of America Merrill Lynch, as at June 2020.
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Perhaps the most important question is whether credit fundamentals have worsened enough to justify another major widening in credit spreads (figure 4).
Figure 4. US high yield: spreads relative to leverage
High-yield credit spreads, per unit of leverage
Bp
s
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
2017
2019
0
50
100
150
200
250
300
350
400
450
500
Source: Federated Hermes, Bank of America Merrill Lynch, as at March 2020.
On the one hand, credit spreads are 50%-75% higher than in the pre-crisis period. Fixed income is one of the few defensive asset classes to offer the prospect of positive returns and many companies seem like good value after making it this far through the crisis without suffering major distress. Furthermore, relative-value opportunities are emerging, while lending strategies have the potential to offer meaningful upside.
But coupled with these positives, there are also material tail risks. These centre around the impact of a second wave and what recoveries will look like after a long period of ‘amend to extend’ agreements. In addition, it is unclear whether central banks will continue to support markets even when the evidence suggests that their actions are not reviving economies, and if geopolitical sabre rattling will make assumptions about future growth untenable.
A balancing act With both perspectives in mind, we find ourselves in the middle ground. Overall, we have a positive view on credit markets – but with caveats. For years, we heard about the Goldilocks economy in which credit thrived when growth was neither too hot nor too cold – much like the infamous porridge. We now think of Goldilocks and credit in terms of epidemiology, where the situation is not too safe, nor too risky.
What does this mean in practice? We expect ongoing volatility, corporate casualties, for sectors to fight for survival and for an appealing trade-off of risks and returns. Both public and private credit markets currently offer rich opportunities (read about these in our relative-value section on p.5). Nonetheless, the level of uncertainty means we also like to support our convictions with hedges.
Fortunately, volatility has fallen considerably, as has the hedge on some credits that others perceive to have minimal risk. Figure 5 shows the value of the options overlay on our
Unconstrained Credit Strategy during the sell-off as an example, when the dynamic, active management of the options book throughout the end of February and March allowed the team to crystallise profits while maintaining convexity and a level of protection.
Figure 5. The value of an options overlay
Notional (RHS)
Active management of the option payers on Itraxx Crossover on the Unconstrained Credit Strategy
26 F
ebru
ary
2020
05 M
arch
2020
13 M
arch
2020
23 M
arch
2020
31 M
arch
2020
Options book average strike (LHS) iTraxx Crossover level (LHS) Delta-adjusted notional (RHS)
Bp
s
No
tional / net asset value, %
0
150800700600500400300200100
0
50
100
Past performance is not a reliable indicator of future results.
Source: Federated Hermes, as at June 2020.
In an environment of unprecedented uncertainty, there is more of a need than ever to take an active approach to fixed income. Investors should be selective, attentive, analytical, paranoid and introspective – all traits that we expect in our analysts and portfolio managers.
The granular, bottom-up work of our analysts has never been more important, and the team has worked tirelessly throughout the first half of the year – and will continue to be fully occupied analysing the results and forecasts of companies who have been operating in the dark throughout global lockdowns.
As a company whose history is steeped in stewardship and engagement, environmental, social and governance (ESG) analysis has been a powerful aid to understanding the unique challenges that our investments face and the paths the team may take in tackling them.
Looking back over the last six months, we are grateful that our risk-minded underwriting within the private-credit space and flexible approach to liquid credit has helped us to deliver the type of performance our clients expect. Moreover, regular communication with these clients has helped us understand the pattern of flows between asset classes and note the particular uptick into those with an ESG or sustainable emphasis.
In closing, we would like to thank all of our clients for their support during this period. While the ultimate outcome of the pandemic remains uncertain, we see a wealth of opportunities to seek out alpha – and look forward to sharing with you our insights and strategy in the months ahead.
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.
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Relative value between asset classes
After a rapid sell-off off in credit markets in February and March, the recovery in spreads has not followed the v-shaped contour associated with a sharp bounce back.
The spreads on credit-default swap (CDS) indices show that the market recovery curve over the past few months has been more akin to a ‘Nike swoosh’ than a ‘v’ shape, with spreads still 60%-80% wider than pre-crisis levels at the end of Q2 (see figure 6). We can also see that the move in investment-grade spreads was higher than for high yield, while Europe outperformed the US.
But a look beyond the most liquid CDS indices shows that there is greater dispersion in spread moves, which range from 20% wider to many multiples more for exposures that are deeper in the capital structure (see figure 7).
Figure 6. Year-to-date spread move in CDS indices
Crisis spread recovery, 21 March to 30 June (LHS)Crisis spread widening, 19 February to 23 March (LHS)Relative spread, 19 February v 30 June (RHS)
800
600
400
200
0
90
80
70
60
50
40
30
20
10
-600
-400
-200
0
CDX highyield
iTraxxEurope
Senior�nancials
iTraxxcrossover
CDX investmentgrade
Bp
s %77 73 80
-355 -314 -46 -48 -48
80% 80%70%
60%68%
584 484
CDX high yield (LHS)Spreads on credit-default swap indices, �ve year:
iTraxx Europe (RHS) Senior �nancials (RHS) iTraxx crossover (LHS) CDX investment grade (RHS)
Bp
s
31 Dec2019
30 Jan2020
29 Feb2020
29 Apr2020
29 May2020
28 Jun2020
3 Mar2020
0
100
200
300
400
500
600
700
800
900
1,000
0
20
40
60
80
100
120
140
160
180
Source: Federated Hermes, Bloomberg, as at 30 June 2020.
Figure 7. Change in credit spreads
Relative spread move 30 June v 19 February, % (LHS) 30 June spread, bps (RHS)23 March spread, bps (RHS) 19 February spread, bps (RHS)
Spre
ad m
ove
, 30
June
v 1
9 Fe
bru
ary
Spread
, bp
s
500
450
400
350
300
250
200
150
100
50
0
3,500
3,000
2,500
2,000
1,500
1,000
500
0
Spreads nearer pre-coronavirus levels
Spreads still at crisis wides
Glo
bal investm
ent grad
e
Glo
bal hig
h yield
Glo
bal �nancials
Glo
bal sub
ord
inated �nancials
Em
erging
market co
rpo
rate (hard)
Em
erging
market no
n-sovereig
n (Local)
Em
erging
marketso
vereign (hard
currency)
Italy go
vernment b
ond
s
Co
mp
osite leverag
ed lo
an
2nd Lien leverag
ed lo
an
EU
RO
CLO
2.0,AA
A
EU
RO
CLO
2.0,AA
EU
RO
CLO
2.0,A
EU
RO
CLO
2.0,BB
B
EU
RO
CLO
2.0, BB
EU
RO
CLO
2.0, B
RM
BS U
K N
C A
AA
RM
BS U
K N
C B
BB
RM
BS U
K N
C B
B
RM
BS U
K p
rime 4-6y
Euro
CLO
equity
Euro
CLO
wareho
use
Junior m
ezzanine 5-10 tranche
First loss 0-5 tranche
First-loss E
urop
ean asset risk transfer
Senior secured
Euro
pean p
rivate loans
Unitranche E
urop
ean private lo
ans
Mezzanine E
urop
ean private lo
ans
Senior E
urop
ean real estate deb
t (A)
UK
& co
re Euro
pe senio
r infrastructured
ebt (B
BB
)
750
55
1,249
600
395
149
770
230
543
170
1,188
315
1,400
159
216403 485
151 120
643
472
550
350
3,000
250300
2,500 2,500 2,500
2,000
Source: Federated Hermes, Bloomberg, Citi, as at 30 June 2020.
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Compared to Q1, the second quarter offered better price discovery as liquidity normalised in public credit markets and more transactions took place in private credit markets. Given that valuations are a better reflection of underlying fundamentals, we can derive a more accurate comparison of relative value (see figure 8).
But an analysis of relative value across investments with similar levels of credit risk provides only a partial perspective. For a more complete picture, our Multi Asset Credit relative value framework assesses a broader range of factors to better account for the structural differences between these exposures (see figure 9). This quarter, we look at the moves relative to both March and the start of the year.
Figure 8. Relative value among BB-rated exposures
Current spread (LHS) Current USD yield (RHS)
Spre
ad, b
ps
US d
ollar yield
, %
Em
erging
market
non-so
vereign (Lo
cal), BB
Em
erging
market co
rpo
rate (hard
), BB
Em
erging
market co
rpo
rate hig
h yield (hard
), BB
Euro
pean senio
r leverage
loans, B
B
Senior E
urop
ean real estate d
ebt, B
B
Senior secured
Euro
pean
real private lo
ans, BB
UK
& co
re Euro
pean senio
r infrastructure, B
B
Euro
pean R
MB
S, UK
NC
, U
K N
CB
B (C
iti), BB
Glo
bal co
rpo
rates, BB
Subo
rdinated
�nancials (C
oco
’s), BB
EU
RO
CLO
2.0, BB
(Citi)
USD
CLO
2.0, BB
(Citi)
Greece g
overnm
ent b
ond
s, BB
US senio
r leverage
loans, B
B
RM
BS G
reek senior, B
B
1,600 12
1,40010
1,200
81,000
6800
4600
400
2002
0 0
159220
350 368 369
471 472 500 500550 568 600
746 770
963
1.9%2.5%
3.8%3.3%
9.9%
5.0% 5.0%5.3% 5.3%
5.8%6.1%
6.3%
7.8%8.0%
9.9%
Source: Federated Hermes, Bloomberg, Citi, JPM as at 30 June 2020.
Figure 9. Our Multi Asset Credit relative value framework, 30 June 2020
76421 3 50
Convertibles
R.E. debt
Europe CLO equity
First loss tranche
Syndicated leveraged loans
Europe ABS mezzanine
Developed government bonds
Trade Finance
Risk transfer
Europe CLO senior
High yield
Mezzanine tranche
Europe ABS senior
Direct SME lending
EM credit
Senior �nancials
Investment grade
Europe CLO mezzanine
Subordinated �nancials
Hybrids
Historic return
Interest-rate sensitivity Liquidity Complexity Alpha potential
Loss-given default Credit fundamentals ValueWeighted score contributions by factor
Technicals Spread volatility Correlation to markets
Q2 Q1 Q4
1
2
3
4
5
6
7
8
9
10
2
1
9
8
3
4
7
6
5
11
12
14
15
16
17
18
20
22
21
14
11
16
14
18
20
21
13
22
12
10
1
3
5
4
6
7
10
17
13
12
15
15
18
21
9
7
20
11
18
2
EM government bonds12 18 N/A
Money market18 17 14
Source: Federated Hermes, as at 30 June 2020.
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In March, credit valuations were at record lows and uncertainty had peaked. As a result, our framework favoured more defensive, higher-quality and liquid exposures. But in the latest period, the analysis reveals a different picture. For example, emerging-market credit now sits at the top of the ranking, having risen from 10th place last quarter.
Several factors contribute to these changes, including a rally in higher-quality exposures, an improved economic outlook that supports valuations of select lower-quality credits and the re-emergence of an illiquidity premium in areas of private credit – particularly in direct lending (see figure 10).
Figure 10. The illiquidity premium of European senior middle-market direct lending
US high yield
The illiquidity premium of European senior middle-market direct lending v:
Q2
2016
Q4
2016
Q2
2017
Q4
2017
Q2
2018
Q2
2020
Q4
2018
Q2
2019
Q4
2019
Bp
s
Euro high yield Euro leveraged loans
-300
-200
-100
0
100
200
300
400
500
600
Source: Federated Hermes, Bloomberg, S&P LCD, World Bank, Bank of America Merrill Lynch Research, as at 30 June 2020.
We now list some of the key themes emerging from the latest quarterly ranking:
A The spreads on liquid cash bonds have widened. Investment grade has recovered the most, aided in part by downgraded names moving into the high-yield universe.
A Emerging-market credit, financials and global high yield, which are more exposed to the weak economic outlook, have lagged. Emerging-market credit’s position is primarily due to its positive value score and it offers a strong spread premium and pick-up in yield.
A Corporate hybrids which pass our robust selection criteria offer attractive relative value. We are happy to collect the premium for lending for longer to companies we like.
A Direct lending has risen up the ranking as transaction activity has picked up and senior and unitranche middle-market margins remain resilient, with the added benefit of stricter covenants and fewer ‘cov-lite’ deals. We see the most value in senior secured loans, where an illiquidity premium has resurfaced.
A Euro CLO mezzanine tranches continue to offer an attractive spread premium, while the recovery in loan prices demonstrates the market’s resilience. Euro CLO AAA-rated exposures offer interesting spreads and 0% coupon floors.
A Both the spreads of commercial mortgage-backed securities and residential mortgage-backed securities moved wider, reflecting continued uncertainty and the prospect of payment holidays ending.
A Bespoke mezzanine tranches have moved wider and are now priced at an attractive level for a higher target-return portfolio. Mezzanine tranches benefit from subordination cushions, which provide some protection against credit losses. This is to the detriment of first-loss tranches, which we are less enthusiastic about.
Despite the attractive spreads on offer, we feel it is too soon to buy into the deepest parts of the capital structure where the risk of material losses is higher. Our preference is to use a diversified portfolio to implement these relative-value ideas, combining substantial liquidity with options to help protect against the downside, in order to create a strategy that we think should be flexible enough to respond to the fast-changing economic environment.
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Q2 2020 score card
0-1 +1 +2 +3 +4 +5-2-3-4-5
Very positive
Very negative
Economic outlook
A Moved to -3 from -4
Credit fundamentals
A Moved to -3 from -4
Valuations and technicals
A Stayed at +2
Tail risks
Remains at 0
A The market has recovered from its March lows but remains out of sync with the global economy, which is in poor health.
A Without a vaccine, a second wave of infections seems likely. This could trigger more lockdowns, which would derail the economy recovery and depress risk assets.
A High unemployment rates could impact consumption and prevent a return to pre-lockdown levels of output.
A The oil price could crash again if the Organisation for Petroleum Exporting Countries fails to agree a supply cut.
A In the run up to the election, President Trump could initiate more protectionist policies which would likely dampen any recovery in asset prices.
Contents9 Multi asset:
Markets are range-bound and face considerable uncertainty
11 Economic outlook: GDP projections are moderating, but markets are hooked on cheap money
12 The Marshall Plan: Can a historical vantage point place the current crisis in perspective?
14 Fundamentals: Markets may have rallied, but credit fundamentals remain challenged
16 Valuations and technical: Sentiment has been boosted by central-bank liquidity
17 Public credit: Market normalisation is underway
18 Leveraged loans: Loans performed well in the second quarter, although issuance has fallen
19 Structured credit: The full impact of the economic crisis has yet to affect the structured-credit universe
20 Private credit: The private-credit market is opening up, but tight covenants remain important
21 Asset-based lending: Real-estate debt investors face a brave new world as the UK reopens
22 ESG: What is the link between climate action and pandemic prevention?
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9
With the exception of rates1, all asset classes remain in the red year-to-date. Energy volatility meant that commodities performed the worst, while equity and credit markets rebounded in Q2. Traditionally a hedge, rates provided the best year-to-date return, but remained flat over the second quarter (see figure 11).
Figure 11. Asset class performance
Q2
Equity Rates Credit Commodity US real-estateinvestment trusts
Cum
ulat
ive
retu
rn, %
Year-to-date
-40
-30
-20
-10
0
10
20
30
18%
-7%
1%5%
12% 11%
-36%
9%
-24%
-5%
Source: Bloomberg. Federated Hermes, as at June 2020.
We also analysed the three-month rolling correlation of different asset classes to equities. Notably, the correlations of commodities, credit and US real-estate investment trusts have begun to diverge from equities only in the last month (see figure 12).
Figure 12. Three-month rolling correlation with equity
Rates
03/2
019
04/2
019
05/2
019
06/2
019
07/2
019
08/2
019
09/2
019
10/2
019
11/2
019
12/2
019
01/2
020
02/2
020
04/2
020
03/2
020
06/2
020
05/2
020
%
Credit Commodity US real-estate investment trust
-1.0
-0.8
-0.6
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
1.0
Source: Bloomberg. Federated Hermes, as at June 2020.
The aggregate beta of active funds to the MSCI World index – measured across investors like commodity trading advisers (CTAs), risk parity and mutual funds – is currently at 0.39, indicating a neutral positioning. CTAs are neutral on equity and credit, while risk-parity funds are long on both asset classes. However, their positioning has decreased over the last three- and six-month periods (see figure 13).
Figure 13. Active investors’ aggregate beta to equity
CTAActive investors aggregate beta to equity
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
Fourth quartileFirst quartile
Co
ntrib
utio
n to
ag
gre
gat
e b
eta
Risk parity Active balanced Composite
0.0-0.10
0.100.200.300.400.500.600.700.80
-0.20-0.30-0.40
0.39
Source: Bloomberg. Federated Hermes, as at June 2020.
Our exchange-traded fund (ETF) data shows the combined Z scores of ETF flows for each asset over the last three, six and 12 months. Clearly, the demand for precious metals has stayed consistent, suggesting some apprehension in the market.
Equity ETF flows also indicate a risk-off mood, with developed markets recording minor inflows and emerging markets sustained outflows for each period. Credit markets are more bullish and have enjoyed significant inflows over the past three months, primarily within investment grade (see figure 14).
Multi asset
As we pass the halfway point of a turbulent year, markets have recovered a significant amount of their early coronavirus-related losses.
1 Predominantly developed-market government bonds.
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10
Figure 14. ETF flows
Three months ETF �ows, z score
Six months 12 months
-2 -1 0 1 2 3 4
Equity developed markets
Equity emerging markets
Fixed-income investment grade
Fixed-income high yield
US government
EU government
Precious metals
Energy
Commodity
Source: Bloomberg. Federated Hermes, as at June 2020.
While markets are generally trading in a tight range, we continue to seek medium- and long-term- opportunities across asset classes.
Over the medium-term, we use our economic-scenario analysis to determine the direction in which the global economy is expected to head, before identifying the best investments for that scenario. Since the beginning of June, the global economy has moved to quadrant one, where both expected GDP and inflation are trending down moderately. We believe that the best assets to invest in for this scenario would be rates, followed by credit and equity, and lastly commodities (see figure 15).
Figure 15. Economic scenario quadrant
1 25 6
4 38 7
Traf�c light performance indicator:Best Moderate Worst
Germany government bondsItaly government bondsUK government bonds
Canada government bondsUS government bonds
Japan government bonds
US equityGlobal investment grade credit
Emerging market sovereign creditUK equity
Global high yield creditEU equity
Japan equity
Commodity industrial metalsEmerging market equity
Commodity energyCommodity agrictulture
Commodity goldCanada equity
In�a
tion*
GDP*
Tren
din
g u
pTr
end
ing
do
wn
Trending upTrending down
Source: Bloomberg. Federated Hermes, as at June 2020. Based on Bloomberg pooled economists’ one-year forward forecasts for both GDP growth and inflation. These forecasts are then compared to their respective six-, nine- and 12-month averages to determine the current trend. These trends are then bucketed into eight quadrants: for example, GDP trend is the current GDP minus the average. The split between the inner and outer quadrants is determined by the mid-point between the average and the maximum/minimum on each axis. The data period starts from 1956 while the expected asset returns are annualised and are estimated based on a conditional two-factor regression analysis.
For a longer-term outlook, we consider forward-looking valuations across asset classes. Following the post-March market rally, most assets have become more expensive based on their historical valuations. With their historically low yields, rates remain the most expensive and least attractive. Credit – particularly US investment grade and high yield – seems the most appealing in terms of its expected information ratio (see figure 16).
Figure 16. Information ratio v historical valuations
EquityInformation ratio, hedged to US dollar v historical valuations, forward (now)
CreditRates
Value percentile, based on its history, %
Info
rmat
ion
ratio
10080 9060 7040 5020 30100-0.30
-0.10
0.20
0.40
0.600.700.80
0.0
-0.20
0.10
0.30
0.50
USEU
UKJapan
Switzerland
USGermany
UK
Japan
Italy
US investment gradeUS high yieldEU
investmentgrade
EU highyield
Emerging marketgoverment
Source: Federated Hermes, as at June 2020.
In the shorter term, markets have likely reached a crossroads. The rally from the bottom has been ignited by extraordinary monetary and fiscal policies and fuelled by the optimism surrounding the reopening of economies. Now that the marginal impact of the liquidity pulse is waning and investors’ expectations have adjusted to a series of better-than-expected economic data, the good news is largely priced in.
Looking forward, the direction of markets will be a function of the tug of war between two factors. One, the deflationary forces stemming from the real economic damage caused by the coronavirus, and two, the reflationary element resulting from the expectation of more expansionary policy and the human resilience and ingenuity that could find a way through the crisis.
Central banks have made it clear that they will not let credit markets collapse, meaning the floor is likely higher than the one we experienced in March. In addition, credit markets may be less sensitive than equities to the strength of the recovery. Conversely, credit should offer less upside than equities should the recovery prove to be stronger than anticipated.
As a result, we expect credit markets to offer a better risk-reward balance than equities should the recovery be either lower or on par with expectations, and to underperform if the recovery is stronger than expected.
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The global economy is in a strange shape. A v-shaped recovery is looking increasingly unlikely, and a ‘w’, ‘u’ or ‘l’ all remain distinct possibilities. Encouragingly, some advanced-economy metrics – such as Purchasing Managers’ Index surveys and US payroll data – are slowly improving. Yet the contraction in GDP may be prolonged if the virus persists in densely populated nations like Brazil, India and Russia, while a more protectionist US – and stronger dollar – could further harm the world economy.
Even if the US Congress is divided in 2021, it may not be able to prevent further trade restrictions – especially if President Trump is re-elected. His ability to use Section 301 of the 1974 Trade Act without approval from Congress or the World Trade Organisation would curtail other countries’ growth rates. Moreover, competitive retaliations – such as a depreciation in the renminbi – could incite a deflationary flow back to the US.
Such an outcome would hinder any global economic recovery. As figure 17 shows, it took five to six years for the UK and US to return to pre-crisis levels of real GDP after the last balance-sheet recession in 2008-9. Meanwhile, consumers in Japan, Italy and Spain have yet to recover (see figure 18).
Figure 17. Real GDP
90
100
110
120
130
140
USReal GDP, 2007=100
2008 2010 2012 2014 2016 2018 2020
Australia New ZealandUK Japan Eurozone Canada
Source: Refinitiv Datastream, based on national data, as at June 2020.
Figure 18. Real household consumption
85
90
95
100
105
110
115
120
125
130
ItalyReal household consumption, 2007=100
2008 2010 2012 2014 2016 2018 2020
US JapanSpain Germany UK France
Source: Refinitiv Datastream, based on national data, as at June 2020.
This time, the rise in unemployment – US payrolls have fallen by a net 15m since February and the unemployment rate has trebled – echoes the trend seen in the 1930s. The US employment participation rate is also at a 45-year low, showing that the issue is not just job losses, but replacing those leaving the labour force.
Even if 60% of these coronavirus-related job losses prove temporary, the 8% unemployment rate that would result from a full, immediate rehire would be more than double the February figure. Rapid labour downturns, such as that experienced over 2007-9, do not guarantee sharp recoveries. Moreover, benefit cuts and difficulties locating those who need state support could dampen overall spending – as could the problem of spend-thrift returning workers.
The monetary response has been rapid and widespread. Our analysis suggests that quantitative easing (QE) adjusted policy rates are a respective -10% and -6% in the US and UK. This is the loosest stance in nearly three decades-worth of data, with little correction expected in 2021. These low implied monetary-policy settings question the urgency for the Federal Reserve (Fed) and the Bank of England to follow Japan and Europe down the path of negative interest rates.
Economic outlook
A sense that the coronavirus has passed its peak means that GDP projections are gradually moderating from worst-case scenarios. Yet markets are reliant on the pacifying influence of stimulus, and it will be increasingly hard to bring the era of cheap money to an end.
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Meanwhile, central banks continue to take unprecedented steps. The Fed has initiated the use of special-purpose vehicles to buy corporate names, including qualifying fallen angels (issuers downgraded to high-yield status). Meanwhile, the European Central Bank has extended and ramped up asset purchases until the middle of 2021, while the Bank of England has announced an additional £100bn-worth of QE.
Fiscal expansions vary in speed and scale, but the global legacy will be debt. The US, eurozone and UK’s government-debt ratios are twice that of Japan’s when it entered a so-called ‘lost decade’. The UK’s debt-to-GDP ratio has risen from 80% to 100% over the past year, the highest level since 1963. If debt continues to accumulate at this pace and nominal growth fails to increase, the ratio could reach 250% by 2030, a post-war high.
In these circumstances, QE would be even more difficult to abandon – especially as central banks are striving for the status quo. The ongoing precedent for loose policy and governments’ dependence on it suggest we may be little more than half-way through the era of cheap money.
In 1951, the US Treasury-Federal Reserve Accord brought the era of QE to an end. That deal will not be repeated this time around: indeed, money-printing restraints could be loosened further. Either way, in a high-debt world, the challenge will be to keep a clear operational distinction between monetary and fiscal authorities as bond issuance escalates and governments’ addiction to QE builds. Perhaps, we may eventually have to look beyond the English alphabet to describe the shape of things to come.
The Marshall Plan: the historical precedence for stimulus
History is full of crises of global economic significance. While some observers have compared the pandemic to the Black Death in the 14th century, others have looked to a more recent historical example to understand the potential economic consequences.
Ursula von der Leyen, the European Commission President, recently referenced the Second World War in a bid to put the economic damage from the pandemic into context, arguing that the global economy “will need massive investment in the form of a Marshall Plan for Europe.”2
The Marshall Plan emerged out the Economic Recovery Act that was signed into law in 1948 by US President Harry Truman. Named after the US Secretary of State at the time, George Marshall, the US-sponsored plan was designed to fight communism, provide economic assistance to restore Europe’s infrastructure and support the American economy by ensuring Marshall Plan funds were spent on US goods.
During the Second World War, most European economies – including the UK – recorded a fall in economic output3 (see figure 19). To mitigate this, the Marshall Plan transferred over $12.9bn ($128bn in today’s money) to European countries. The largest recipient was the UK, which accounted for almost 25% of the total. The Marshall Plan provided substantial support for the largest European economies. Between 1948-1955, the combined GDP of the five main European countries grew by 6.3% a year.
Figure 19. Annual GDP growth in Europe
USAnnual GDP growth 1940-1955
1940-1943 1943-1946 1946-1949 1949-1952 1952-1955
%
UK France Italy Germany Netherlands
-40
-30
-20
-10
0
10
20
30
Source: University of Groningen, as at June 2020.
Unlike in the aftermath of the Second World War, the enemy is invisible. Yet as in the 1940s, the threat is destroying the global economy. Fitch, a ratings agency, expects the global economy to decline by 1.9% in 2020, with the US, eurozone and UK economies set to shrink by a respective 3.3%, 4.2% and 3.9%. As bad as these numbers seem, the contractions recorded during the war were far worse – for example, US GDP fell by 20.6% in 1946.
2 ‘Do we need a new Marshall Plan to rebuild Europe after Covid-19?’, published by the World Economic Forum on 9 April 2020.3 All GDP data in this chapter are based on 1990 international Geary-Khamis dollars. Source: Angus Maddison at the Groningen Growth and Development Centre,
University of Groningen, as at June 2020.
13
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In the face of the threat from the pandemic, most European economies have put in place fiscal measures. These fall under three categories:
A Immediate fiscal impulse (cash equivalent). Government spending or the cancelation of certain taxes. These measures have an immediate impact on the budget balance without any direct compensation.
A Deferrals of certain payments, including taxes and social-security contributions, which in principle should be paid back later. These measures will improve solvency and the cash flows of individuals. They will have an impact on 2020 budget balances but should be restored later.
A Other liquidity provisions and guarantees. These measures include export guarantees, liquidity assistance and credit lines, which will require company action. This range of support mechanisms shouldn’t impact 2020 budget balances but will create contingent liabilities that may in time convert into expenses.
Figure 20. Discretionary fiscal measures adopted in response to the coronavirus pandemic, as % of 2019 GDP
Immediate Deferral Other TotalLast
update
UK 4.8% 1.9% 14.9% 21.6% 30/04/2020
France 4.4% 8.7% 14.2% 27.3% 18/06/2020
Germany 13.3% 7.3% 27.2% 47.8% 03/06/2020
Italy 3.4% 13.2% 32.1% 48.7% 22/06/2020
Netherlands 3.7% 7.9% 3.4% 15.0% 27/05/2020
Source: Bruegel, as at June 2020.
In order to compare the stimulus measures to the Marshall Plan, we analysed the immediate fiscal impulse across the five main countries that were helped by the post-Second World War economic rescue effort. As figure 21 shows, the coronavirus fiscal response significantly outweighs the Marshall Plan program. In Italy, the immediate fiscal measures are worth almost 18 times the amount the country received through the Marshall Plan.
Figure 21. Coronavirus cash measures compared to the Marshall Plan
Immediate �scal measuresCoronavirus cash measures v the Marshall Plan
UnitedKingdom
France Italy Germany Netherlands
$bn
Ratio
RatioMarshall Plan (today’s money)
0
50
100
150
200
250
300
0x
2x
4x
6x
8x
10x
12x
14x
16x
18x
20x
Source: Federated Hermes, as at June 2020.
Undoubtedly, the current economic crisis pales in comparison to the darkest years of the Second World War. Yet governments across the world have responded at a scale that far eclipses the historic Marshall Plan that subsequently led to 30 years of ‘glorious growth’.4
History is also in the making in other ways. The European Union has endorsed a full package of €1.85trn to support the eurozone (of which €500bn is in grants) – the closest collaboration between most European countries for many years.
4 ‘‘Les Trente Glorieuses’: From the Marshall Plan to the Oil Crisis’, published by The Oxford Handbook of Postwar European History in May 2012.
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Although the dust has yet to settle, the second quarter was marked by record amounts of debt issuance by companies (particularly in the US) and a surge of flows into credit funds.
At the same time, credit spreads rallied, curves steepened, and macroeconomic data improved sharply. The global response to the coronavirus crisis served to mitigate the immediate and acute financial risks – the most injurious of fundamental risks – as cash balances were padded, front-end debt was rolled forward (or exchanged) and refinancing rates declined.
But while central banks and governments facilitated a much-needed breather for industry and capital markets, the long-term effects of this triage are unlikely to be known for months, if not years.
It didn’t take long for casualties to emerge in the period between the market crash and subsequent bounce. Defaults ticked up (see figure 2) and there were high-profile bankruptcies, including Hertz, JC Penney and multiple names in the energy sector. There was also a raft of fallen angels, including Pemex and General Motors, while banks’ balance sheets came under pressure.
Figure 22. US high-yield default rates
Last 12 months, par-weighted default rate by sector%
0 5 10 15 20TransportationCapital goods
Real estateTravelMedia
Food producersHealthcare
MetalsAutosRetail
TelecomsEnergy
Source: Federated Hermes, Bank of America Merrill Lynch, as at June 2020.
Governments and corporates have also significantly expanded their balance sheets from already-high levels (see figures 23 and 24). This, combined with a forthcoming decline in operating cashflows, means that financial leverage is rising. Moreover, operating risks – particularly in the leisure, travel, retail and auto sectors – remain very high, particularly for small and medium-sized businesses. In turn, this is likely to put pressure on banks and some structured products.
Figure 23. Major central banks expand their balance sheets
Bank of EnglandCentral-bank balance sheets
2006 2008 2010 2012 2014 2016 2018 2020
$bn
European Central Bank Bank of JapanUS Federal Reserve Recession
0
1,000
2,000
3,000
4,000
5,000
6,000
7,000
8,000
Source: Federated Hermes, Refinitiv Datastream, based on central bank data, as at June 2020.
Fundamentals
The market sell-off in March sharply reversed in the second quarter as central banks and governments applied triage to banks, industries and capital markets.
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Figure 24. Companies add leverage as earnings decline
High-yield net leverage ratio (net debt/last 12 months' EBITDA)Adjusted leverage
2009 2011 2013 2015 2017 20192007200520031997 1999 20011
2
3
4
5
6
7
8
Ratio %
High yield EBITDA, year-on-year change Adjusted EBITDA growth2009 2011 2013 2015 2017 20192007200520031997 1999 2001
-80
-60
-40
-20
0
20
40
80
60
Source: Federated Hermes, Bank of America Merrill Lynch, as at March 2020.
One of the negative side effects of increasing central-bank balance sheets is debt-service costs. Just as GDP is under pressure, debt-service costs are rising globally. This can be a headwind for global growth, as cash is redirected from investments to pay interest.
Meanwhile, slow economic growth and rising debt can be a major headwind for companies that need growth in order to service their own expanding balance sheets. This compounds pressure on their own debt-service needs, which implies less cash for capital expenditures and research – key inputs for innovation and growth.
Credit fundamentals will remain challenged as it becomes even more difficult for highly levered firms (particularly in coronavirus-affected sectors) to grow into their balance sheets. The strong and well-provisioned will survive, while the weaker will suffer – as we have seen from rising default rates. As a result, we remain largely focused on capital appreciation, security selection and carry opportunities in the areas of higher-quality credit where we see pockets of value.
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Valuations and technicals
Sentiment has been boosted by central-bank liquidity, which prompted an uptick in flows into credit funds over the second quarter. Meanwhile, credit markets still offer attractive levels of convexity.
SentimentAfter the hit to sentiment in the first quarter, the market mood has turned decidedly brighter (see figure 25). Strong positive sentiment has been buoyed by unparalleled support from central banks across the globe, a better-balanced oil market and progress in containing the pandemic. Lower volatility has since increased demand for risk assets in a market where government bonds only offer limited income for investors.
Figure 25. Market sentiment
Morgan Stanley Global Risk Demand Index
Greater con�dence
Greater fear
Dec
18
Dec
19
Aug
17
Oct
17
Aug
18
Oct
18
Aug
19
Oct
19
Ind
ex
Dec
17
Jun
18
Jun
19
Jun
20
-6
-5
-4
-3
-2
-1
0
1
2
3
Ap
r 18
Feb
18
Ap
r 19
Ap
r 20
Feb
19
Feb
20
Source: Morgan Stanley, as at June 2020.
Asset flows Upbeat global credit flows also underscore the rapid turnaround in sentiment from its March lows – a trend fuelled in part by a sharp rise in savings in many jurisdictions. These savings have flowed to the quality end of the fixed-income market, targeting assets higher in the capital structure with mandatory coupons and attractive upside potential. Overall, the technical picture supports credit markets, driven by doubts about the strength of the global economic recovery and the fact that equity-market returns are still dependent on dividends and buybacks (see figure 26).
Figure 26. Fund flows
Bloomberg Barclays High Yield BondETF �ows:
Feb
17
Ap
r 17
Jun
17A
ug 1
7O
ct 1
7D
ec 1
7
Ap
r 18
Jun
18A
ug 1
8O
ct 1
8D
ec 1
8
Feb
18
Ap
r 19
Jun
19A
ug 1
9O
ct 1
9D
ec 1
9
Feb
19
Ap
r 20
Jun
20
Feb
20
Dec
16
Invesco Senior LoaniShares Euro High Yield iShares iBoxx $ Investment Grade
$m
iShares iBoxx $ High Yield
-10,000
-5,000
0
5,000
10,000
15,000
20,000
25,000
Source: Bloomberg, as at June 2020.
ValuationsStrong demand for risk assets and spread products saw valuations pared back in the second quarter. The market still offers plenty of convexity, but investors must focus on avoiding defaults, picking the right macroeconomic themes and identifying single-name credits that are better-positioned for the post-coronavirus world. In the current market, credit is likely to appeal to asset allocators that are looking for income and the potential to capture the upside during a recovery (see figure 27).
Figure 27. Valuations in high yield
Global high yieldEmerging market high yield
EU high yield US high yield
May
20
May
10
Yiel
d t
o m
atur
ity –
yie
ld t
o w
ors
t
Sep
11
Jan
11
May
12
Sep
13
Jan
13
May
14
Sep
15
Jan
15
May
16
Sep
17
Jan
17
May
18
Sep
19
Jan
19
-0.3
-0.1
0.1
0.3
0.5
0.7
0.9
1.1
Source: ICE Bond Indices, as at June 2020.
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The correlation between the cash-bond and synthetic markets has returned to pre-crisis levels, indicating that market normalisation is under way. As investors looked for liquidity during the peak of the volatility, cash bonds significantly underperformed CDS and the relationship between the two diverged to historical extremes.
However, as credit returned to favour in the new risk-on environment, the traditional link between the CDS and cash-bond markets reverted to its normal range (see figure 28). Nonetheless, bonds still offer better value in most capital structures given that cash prices remain below call levels.
Figure 28. CDS v cash bonds
EuropeAverage CDS-bond spread
Jan
10Ju
l 10
Jan
11Ju
l 11
Jan
12Ju
l 12
Jan
13Ju
l 13
Jan
14Ju
l 14
Jan
15Ju
l 15
Jan
16Ju
l 16
Jan
17Ju
l 17
Jan
18Ju
l 18
Jan
19
Jan
20Ju
l 19
Bp
s
US
-300
-250
-200
-150
-100
-50
0
50
Source: ICE Bond Indices, as at June 2020.
The current environment presents a raft of opportunities for stock pickers, especially those able to position their portfolios to capture post-coronavirus cash flows. But markets also appear attractive from a top-down perspective. For example, the homebuilder sector offers good value to investors, given that housing demand is likely to hold up in a low-rate environment (see figure 29).
Figure 29. Homebuilders look attractive
Sect
or
op
tion-
adju
sted
sp
read
/Ind
exo
ptio
n-ad
just
ed s
pre
ad
Homebuilders Homebuilders average -1 standard deviation 1 standard deviation 2 standard deviations-2 standard deviations
2015 2016 2017 2018 2019 20200.5
0.6
0.7
0.8
0.9
1.0
Source: ICE Bond Indices, as at June 2020.
The first quarter of this year was also characterised by a marked liquidity crunch, as financial institutions rushed to secure cash in the first phase of the sell-off. As a result, the most liquid parts of credit markets sold off heavily and prompted investment-grade credit to underperform in March. Since then, the market has refocused on fundamentals and investment grade is now outperforming high yield (see figure 30).
Figure 30. Investment grade outperforms high yield
Op
tion-
adju
sted
sp
read
rat
io
US high yield/US investment grade averageUS high yield/US investment grade
2.25
2.50
2.75
3.00
3.25
3.50
3.75
4.00
4.25
2017 2018 2019 2020-1 standard deviation
1 standard deviation 2 standard deviations-2 standard deviations
Source: ICE Bond Indices, as at June 2020.
Public credit
The relationship between cash bonds and CDS has returned to its usual levels, while homebuilders look appealing in the lower-for-longer environment.
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The S&P European Leveraged Loans Index (ELLI) rebounded strongly in June and closed up 12.3%, after falling almost 15% in the previous three-month period. Loans outperformed European high yield over Q2, although the ELLI still lags the asset class year-to-date.
Among the leveraged-loan sub-groups, B-rated assets returned 14.4%, almost double that of BB-rated loans. However, BB-rated loans have proved more robust year-to-date, falling by just 2.9%, compared to 4.6% for B-rated loans.
The second quarter also saw a material fall in new issuance. In Europe, the total volume of leveraged finance primary dropped to €29bn, the slowest quarter since the final three months of 2018.
Within this, leveraged-loan issuance plummeted from €22.9bn in Q1 to a mere €9.5bn in the second quarter, while high-yield volumes were down slightly from €19.4bn to €17.8bn during the same timeframe (see figure 31). This difference is partly because high yield has a deeper investor base, while CLO managers were mainly focused on actively managing CCC-rated securities.
Figure 31. European new-issue leveraged finance volume
Institutional loans European new-issue leveraged �nance volume
Q32017
Q42017
Q12018
Q22018
Q32018
Q42018
Q12019
Q22019
Q12020
Q22020
Q32019
Q42019
Bill
ions
Pro-rata loans High-yield bonds
0
5
10
15
20
25
30
35
Source: S&P – LCD News, as at June 2020.
Furthermore, many lenders took the opportunity afforded by the coronavirus-related disruption to review offer documents, adding new protections that reversed the previous rise in cov-lite issuances. In the three months to 15 June, issuers made 21 covenant-amendment requests – the highest number since the second quarter of 2009 (see figure 32).
Figure 32. Number of covenant amendments and distressed deals
Distressed deals
Q1
2009
Q3
2009
Q1
2010
Q3
2010
Q1
2011
Q3
2011
Q1
2012
Q3
2012
Q1
2013
Q3
2013
Q1
2014
Q3
2014
Q1
2015
Q3
2015
Q1
2016
Q3
2016
Q1
2017
Q3
2017
Q1
2018
Q3
2018
Q1
2019
Q3
2019
Q1
2020
Covenant amendment requests
0
5
10
15
20
25
30
35
40
45
50
Source: S&P – LCD News, as at June 2020.
Leveraged loans
Leveraged loans bounced back in the second quarter, while lenders took the opportunity to embed new protections into their loans.
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19
At the end of June, the structured-credit market appeared stable after experiencing severe wobbles at the peak of the coronavirus-related panic. This prompted new issues of both asset-backed securities (ABSs) and CLOs, which were all met with enthusiastic investor demand. Yet credit fundamentals have deteriorated and the full economic fallout from the pandemic is yet to affect the structured-credit market.
CLOs remained liquid and trading volumes held up throughout the quarter. Because investor interest moves across the stack at different times, changes in spread compression between tranches can create investment opportunities (see figure 33).
Figure 33. European CLOs: relative value across the capital structure
EURO CLO AAA 5-6 year
February2020
March2020
April2020
May2020
June2020
January2020
EURO CLO AA 7-8 yearEURO CLO A 7-8 year EURO CLO BBB 7-8 yearEURO CLO BB 8-9 year Average
BBB and BB trancheslag the rally in therest of the stack
AAAs remain wideyear to date relativeto the recovery in therest of the stack%
0
50
100
150
200
250
300
350
Source: Federated Hermes, JP Morgan, as at June 2020.
After the initial snap-back in spreads early in April, BBB and BB-rated credits began to lag the market bounce (those rated B traded very rarely at this point). Relative to the rallying iTraxx Crossover index, BBB and BB-rated CLO tranches appeared attractive and we were active in this area early on in the quarter.
However, surging investor interest in BBB and BB-rated tranches later on in the quarter compressed spreads in line with average moves across the capital stack. Elsewhere, AAA-rated securities remained off-trend and were trading at spreads that were almost 50% wider than pre-crisis levels.
To date, very few structured-credit vehicles have hit performance barriers that are likely to ring alarm bells. However, most European CLOs now have high levels of CCC-rated exposures and other deteriorating collateral metrics. Consequently, rating agencies have issued downgrades or put some tranches on watch or negative outlook, although senior tranches remain unsullied for now.
Rising valuations and the active management of CLO portfolios has strengthened the loans market. However, even with the overall sentiment boost, manager selection remains critical.
ABS credit structures continue to function well, although payment-holiday relief – which many debtors have taken advantage of – has created some stress in the market. Investors will be watching to see how many consumers remain on payment holidays at the end of the first three-month relief period.
The level of payment relief varies widely and holidays numbers are linked to the efficiency of the application and approval system in each country. In the UK, the payment-holiday application process is very simple and lenders automatically approve requests. Consequently, about 1.9m borrowers have taken mortgage-payment holiday (MPH) in the UK (this accounts for about one in six of all home loans).
MPH levels of 20%-30% are common in UK ABS pools, although the proportion can rise to 40% or more. In countries where borrowers are required to show more proof that their financial stress is high enough to warrant mortgage relief, MPH numbers are much lower.
We expect MPH levels to fall going forward. Some took a tactical payment holiday as an insurance measure early on in the crisis but have maintained normal income levels and will resume their usual mortgage-payment schedules. As these better-off borrowers revive mortgage payments, cash flows in the ABS market will improve.
However, it is unclear how many payment holidaymakers will roll further into arrears after the current relief period ends. Ultimately, MPH figures will hinge on the underlying employment situation, but we expect arrears to stay higher for some time yet.
Structured securities
The market may have stabilised, but the full impact of the economic crisis has yet to feed through to the structured-credit universe.
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Private credit
After an initial freeze in new transactions, the private-credit market is slowly reopening, although M&A volumes remain well below 2019 levels. Most new transactions have targeted add-on acquisitions by companies in defensive industries, which have weathered the coronavirus crisis better than their cyclical counterparts.
Germany accounts for between 60%-70% of all private-credit transactions in Europe, with Scandinavia, France and the Benelux region making up the difference. Deals have been scant in the UK, Italy and Spain, which have suffered the most from the pandemic and political uncertainty.
Compared to February 2020, new senior secured and unitranche transactions are now priced about 75bps higher and are framed around more conservative leverage structures. On the whole, lender-protection rights for loans issued since the pandemic erupted have increased.
However, there has been some backsliding, For example, rising competition among unitranche lenders has prompted some issuers to ease protections. This is largely when target-return requirements mean they can’t compete on price alone, and is clearly an unwelcome return to the loose loan conditions offered by some providers before the crisis.
Defaults are also on the rise, notably in sectors dependent on consumer spending such as retail, travel, leisure and hospitality. We believe that this trend will continue throughout this year as more businesses suffer from continued economic uncertainty, the winding down of government support schemes and tightening covenants in loan documentation.
In our opinion, success in the private-credit market will hinge on allocating to non-cyclical businesses and the implementation of conservative covenant structures that can provide an early warning of potential problems.
We expect true senior-secured loans, which benefit from substantial equity protection, to offer the most value. Conversely, going down the capital structure in search of higher yields at this time of extreme economic uncertainty puts investors at risk of material loss.
The number of European mergers and acquisitions (M&As) is gradually increasing, but industry- and country-specific risks abound while tight loan covenants have become a necessity.
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21
At the end of the first quarter, the UK government allowed tenants to defer rent payments in order to ease immediate cash-flow issues. This was perhaps also subconsciously because tenants were unable to use their properties – and what is rent, if not simply compensation for the use of property.
In parallel, interest in the eyes of a borrower is compensation for the use of capital. During lockdown, borrowers were still in receipt of the capital invested in their properties – and, as a result, interest on loans was still due and payable. To their credit, most borrowers did make interest payments and some went out of their way to do so. Interest-collection numbers compare favourably to rent-collection statistics over the last three months.
Senior lenders continued to deliver stable income throughout the lockdown. The same is not necessarily true for subordinated lenders. Since the global financial crisis, senior leverage has generally stayed reasonably modest and covenants tightly structured.
As a result, many senior loans experienced a breach of covenant when the pandemic hit. This puts senior lenders in control of these non-recourse structures and generally cuts off cash to subordinated lenders. The double-edged sword of leverage affects anybody that is not in a senior position.
As the storm clouds start to disappear, we are left with a retail landscape that is almost unrecognisable. Some retailers have disappeared altogether, while social-distancing requirements mean that queuing is a common sight.
Conversion rates in shops are at record highs, indicating that browsers have stayed at home. Nonetheless, it is difficult to make money at such reduced capacity and rental expectations will have to come down. Online sales have increased, which is reflected by investor appetite for the sector. We expect logistics yields to tighten, as retail yields widen further (see figure 34).
Figure 34. Prime logistics and retail yields
Shopping centresPrime logistics v prime retail yields, fully converged in Q1 2020:
2012 2013 2015 2016 20172014 2018 2019 2020
0.31%
3.84%
4.95%
5.04%
Of�cesLogistics
%
0
1
2
3
4
5
6
7
8
Average EU bond yields
Source: Savills Research, as at June 2020.
Offices are slowly reopening, but it is unclear how they will be able to operate at full capacity while social-distancing requirements remain in place. The last 100 years of office history has been characterised by increasing density – a trend that is set to reverse, at least temporarily.
As lockdown eases, there is a considerable amount of capital looking for a home. As a result, margins for modestly geared loans on the best properties have not moved out very far – perhaps as little as 25bps. For anything that is more vulnerable to the heightened uncertainty (assets with shorter lease lengths, for example) margins have moved out in the region of 100bps.
Compared to the aftermath of the financial crisis, these are modest margin increases. Yet in the context of central-bank liquidity and the lower-for-longer environment, they are not unattractive relative returns.
Asset-based lending
Most UK property owners have kept up with interest payments during lockdown. However, real-estate debt investors face a changed market as the country slowly reopens.
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The coronavirus pandemic is a reminder of the crucial links between human wellbeing and our shared natural environment, while the crisis has undoubtedly brought the relationship between climate change and human health into even sharper focus.
In particular, the global nature of the current pandemic has flagged the long-term risks we all face in a world where a changing climate raises the likelihood of further disease outbreaks. A growing body of research has shown that rising temperatures and subsequent changes to climate systems have a wide range of negative human health impacts, including the increased spread of infectious diseases.
As with other physical climate risks, chronic or acute changes in the environment can act as a threat multiplier for infectious diseases. The climate-related risk is projected to increase the number of people exposed to infectious diseases by 453-900m by 2080,5 more than half of which will be in Europe.
The most relevant chronic, climate-change indicators for disease propagation relate to temperature, humidity and precipitation. Each of these climate attributes has a positive, non-linear relationship with the spread of infectious diseases.
The Intergovernmental Panel on Climate Change forecasts that these changes will affect the transmission intensity and seasonality of certain infectious diseases, although it is difficult to draw simple causal relationships between these climate variables and the spread of disease.
Some disease vectors, particularly mosquitoes, are well adapted to warmer climates and are sensitive to small shifts in temperature. An increase in temperatures, therefore, will expand the range over which they can survive and transmit diseases such as malaria and dengue fever.6
Droughts and floods, which are likely to increase in severity and frequency as the climate breaks down, will also influence disease patterns. High levels of evaporation and human demand for the liquid resource during droughts increase the likelihood of the remaining water turning stagnant, forming an ideal breeding grounds for mosquitoes and other vectors.
Secondary impacts from extreme weather events, such as changes in farmed land and increasing poverty, will further exacerbate vulnerabilities to infectious diseases.
There is considerable uncertainty about when the coronavirus pandemic will begin to subside. When it does, it is critical that the inevitable economic stimulus has climate mitigation, adaptation and conservation at its heart. A potential $26trn-worth of economic benefits could be realised by 2030, while mitigating the climate-related impact on health and society in the long term.7 Overdue infrastructure spending is likely to feature, and this may allow for an acceleration in the decarbonisation of transport and energy systems.
Governments must reserve a portion of stimulus packages for investing in research and development in sectors deemed the most difficult to decarbonise. Agriculture is often overlooked, but the sector accounts for about 24% of global greenhouse-gas emissions8 and adding more alternative protein to the food mix could reduce the need to continue clearing virgin land for agriculture – a key driver of biodiversity loss and the emergence of infectious diseases.
As our global economy begins to emerge from the coronavirus fog, it is even more critical for policymakers, investors and organisations to fully grasp the crucial relationship between the climate crisis and future health risks.
Beyond supporting the ecosystem services that we rely on for all life and economic activity, investments in decarbonisation, resiliency and adaptation offer solutions to the many social challenges ahead, including in human health.
As a result, the wide-ranging benefits of climate action are as important to understand as the systemic risks – a principle that underpins the engagement activities of our stewardship team, EOS at Federated Hermes. In turn, our Credit team draws on these stewardship insights in order to build a holistic view of the systemic nature of the risks – and opportunities – that all issuers must confront.
ESG
The short-term consequences of the pandemic are becoming clearer for fixed-income investors. However, the underlying challenges of this human health crisis are complex and investors cannot ignore the link between climate action and global diseases.
5 Morgan Stanley, as at June 2020. 6 ‘The 2019 report of The Lancet Countdown on health and climate change: ensuring that the health of a child born today is not defined by a changing climate’,
published by The Lancet on 13 November 2019.7 ‘Unlocking the inclusive growth story of the 21st Century: accelerating climate action in urgent times’, published by The New Climate Economy in 2019.8 ‘Global greenhouse gas emissions data’, published by the United States Environmental Protection Agency.
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. Any investments overseas may be affected by currency exchange rates. Past performance is not a reliable indicator of future results and targets are not guaranteed.
For professional investors only. This is a marketing communication. It does not constitute a solicitation or offer to any person to buy or sell any related securities, financial instruments or financial products. No action should be taken or omitted to be taken based on this document. Tax treatment depends on personal circumstances and may change. This document is not advice on legal, taxation or investment matters so investors must rely on their own examination of such matters or seek advice. Before making any investment (new or continuous), please consult a professional and/or investment adviser as to its suitability. Any opinions expressed may change. All figures, unless otherwise indicated, are sourced from Federated Hermes. All performance includes reinvestment of dividends and other earnings.
Federated Hermes refers to the international business of Federated Hermes (“Federated Hermes”). The main entities operating under Federated Hermes are: Hermes Investment Management Limited (“HIML”); Hermes Fund Managers Ireland Limited (“HFMIL”); Hermes Alternative Investment Management Limited (“HAIML”); Hermes Real Estate Investment Management Limited (“HREIML”); Hermes Equity Ownership Limited (“EOS”); Hermes Stewardship North America Inc. (“HSNA”); Hermes GPE LLP (“Hermes GPE”); Hermes GPE (USA) Inc. (“Hermes GPE USA”) and Hermes GPE (Singapore) Pte. Limited (“HGPE Singapore”). HIML, and HAIML are each authorised and regulated by the Financial Conduct Authority. HAIML and HIML carry out regulated activities associated with HREIML. HIML, Hermes GPE and Hermes GPE USA are each a registered investment adviser with the United States Securities and Exchange Commission (“SEC”). HGPE Singapore is regulated by the Monetary Authority of Singapore. HFMIL is authorised and regulated by the Central Bank of Ireland. HREIML, EOS and HSNA are unregulated and do not engage in regulated activity.
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In The Sultanate of Oman: The information contained in this document neither constitutes a public offer of securities in the Sultanate of Oman as contemplated by the Commercial Companies Law of Oman (Royal Decree 4/74) or the Capital Market Law of Oman (Royal Decree 80/98), nor does it constitute an offer to sell, or the solicitation of any offer to buy Non-Omani securities in the Sultanate of Oman as contemplated by Article 139 of the Executive Regulations to the Capital Market Law (issued by Decision No.1/2009). Additionally, this document is not intended to lead to the conclusion of any contract of whatsoever nature within the territory of the Sultanate of Oman.
In South Korea: Hermes Investment Management Limited is not making any representation with respect to the eligibility of any recipients of this document to acquire the strategies therein under the laws of Korea, including but without limitation the Foreign Exchange Transaction Act and Regulations thereunder. The strategies have not been registered under the Financial Investment Services and Capital Markets Act of Korea, and none of the strategies may be offered, sold or delivered, or offered or sold to any person for re-offering or resale, directly or indirectly, in Korea or to any resident of Korea except pursuant to applicable laws and regulations of Korea.
In Spain: Hermes Investment Management Limited is duly passported into Spain to provide investment services in this jurisdiction on a cross-border basis and is registered for such purposes with the Spanish Securities Market Commission – Comisión Nacional del Mercado de Valores under number 3674.
In United Arab Emirates (Excluding Dubai International Financial Centre and Abu Dhabi Global Market): This document, and the information contained herein, does not constitute, and is not intended to constitute, a public offer of securities in the United Arab Emirates and accordingly should not be construed as such. The strategies are only being offered to a limited number of sophisticated investors in the UAE who (a) are willing and able to conduct an independent investigation of the risks involved in an investment in such strategies, and (b) upon their specific request. The strategies have not been approved by or licensed or registered with the UAE Central Bank, the Securities and Commodities Authority or any other relevant licensing authorities or governmental agencies in the UAE. The document is for the use of the named addressee only and should not be given or shown to any other person (other than employees, agents or consultants in connection with the addressee’s consideration thereof). No transaction will be concluded in the UAE and any enquiries regarding the strategies should be made to Hermes Investment Management Limited in London.
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Federated HermesFederated Hermes is a global leader in active, responsible investing.
Guided by our conviction that responsible investing is the best way to create long-term wealth, we provide specialised capabilities across equity, fixed income and private markets, multi-asset and liquidity management strategies, and world-leading stewardship.
Our goals are to help people invest and retire better, to help clients achieve better risk-adjusted returns, and to contribute to positive outcomes that benefit the wider world.
All activities previously carried out by Hermes now form the international business of Federated Hermes. Our brand has evolved, but we still offer the same distinct investment propositions and pioneering responsible investment and stewardship services for which we are renowned – in addition to important new strategies from the entire group.
Our investment and stewardship capabilities:A Active equities: global and regional
A Fixed income: across regions, sectors and the yield curve
A Liquidity: solutions driven by four decades of experience
A Private markets: real estate, infrastructure, private equity and debt
A Stewardship: corporate engagement, proxy voting, policy advocacy
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