Janus Henderson Investors: Credit spreads — from reassuringly expensive to scary cheap, and now: just cheap?

Key takeaways:

• Both investment grade and high yield bond spreads have climbed down from their extreme levels just over a month ago. While they were at scarily cheap levels then, they are now perhaps ‘just cheap’.
•  The impressive support from the US and UK governments, helping to create bridge-financing for businesses and individuals, has brought some stabilisation to the markets. In particular, the US Federal Reserve (Fed)’s efforts have been very encouraging for investment grade and high yield corporate bonds.
• Last week saw inflows back into the equity and bond funds. There were many refinancings — rescue finance in effect — in the US high yield markets by well-known entities. We believe that good businesses will continue to attract capital, while those in structural decline will find it much harder.

Note: The indices whose yield and spreads were mentioned by John Pattullo are ICE Bank of America US investment grade and high yield bond indices, on the day of recording, 22 April 2020. Past performance is not a guide to future performance.

Video transcript

From scary cheap to just kind of cheap

Hello, John Pattullo here, Co‑head of the Strategic Fixed Income desk. We did a video on the 23rd of March, really talking about how cheap credit spreads were and what an opportunity there was going forward. Today is now the 22nd of April and we have made considerable progress in an economic sense, in a virus response; and more importantly, in the government response to these extraordinary situations we find ourselves in.

So, for example, on that video back in March, investment grade spreads [over equivalent government bonds] were roughly heading towards four percent over the one percent they were trading at a few months earlier. Today they're trading about 230 to 240 over, in basis points [2.30-2.40%], and high yield simply was trading about 350, went to 1082, and today trades around 800 basis points or eight percent over.

So, what we had said then was credit spreads were reassuringly expensive, they got scary cheap and frankly risk‑adjusted reward was pretty. And now we'd say they’re kind of cheap. We still think there's good value, especially investment grade, and high yield’s pretty attractive here as well. They're not scary cheap, but in our opinion they're cheap.

Significant support through government action in the US and the UK

So, we have made significant progress. This is a war if you like. And we've had a wartime response, really amazing response out of the US government and the UK government as well, really to bridge‑finance the capital that businesses and individuals need to get through this self-imposed coma, which is a very unusual situation.

Any stress test that any analyst would have run would have said, wouldn't have said, well you have zero revenue for three months or maybe six months. So, this is an unusual position but again as credit investors, the Fed [US Federal Reserve] has essentially backstopped investment grade credit. And then recently they essentially backstopped some of the fallen angels and they will be buying some high yield ETFs, which we find massively encouraging.

So, credit we think is backstopped. Equity markets are a much harder call from here because they have bounced quite materially. But we remain fairly bullish on large‑cap, non‑cyclical, sensible, reason to exist, good return on capital businesses. The long‑term, secular winners in investment grade and high yield attract our capital and we remain very wary, as we always have been, on the heavy cyclicals, the capital-intensive businesses, the metal bashing, the autos, the mining, the steel. And we don't do any energy for example, whatsoever; and obviously that has been really good for relative performance. Generally because we don't think that these companies generate a sufficient return on capital to attract our marginal dollar or pound that we are investing.

Seeing some stabilisation — the dust is settling in

The backdrop is stronger. Last week we actually had inflows into equities and bond funds. So, I think there's a lot of stabilisation going on, the dust is settling. You’ve seen a lot of refinancing going on in US high yield. European high yield is a less mature, more fragmented market, but the American market is mature/sensible. So, they have recently refinanced, rescue finance really, known names in the shipping industry, in the entertainment/theme park industry, and even in the cinema industry.

So, AMC got financing around 11 or 12 percent, slightly to our amazement — no recommendations given here whatsoever — compliance [reasons]. But we generally [are] of the view that good businesses will attract capital, they will pay up to get refinanced, like Carnival Cruises for example and they should probably survive, like many gaming names, like some of the theme park names.

Wrapping up our thoughts…

The final point really is who pays for all this? You've seen wartime deficits to a wartime response. I wrote a piece last June, in 2019, saying “Do you remember the Great Financial Crisis?” ie, the one we were still in; because we're still of the view that we are going to move to a world of MMT [Modern Monetary Theory], potentially yield curve control and financial repression; and the post-war deficits were brought down really under financial repression and if you've got time I'd recommend reading that article because I think it's as relevant as ever and particularly relevant to the current outlook.

So, to summarize, Jenna and I, we like investment grade. We like the spreads more than the underlying sovereign bonds. We are interested in large‑cap, quality, high yield businesses, which have got a reason to exist. Many of those might be global companies, many are of course American companies. We're a little bit more shy, we’re massively shy, of the cyclicals and the value businesses — we think there's many value traps out there. We will not get caught in value traps or at least we're certainly trying to avoid that. So, we have no energy. We have no commodities, no mining, no steel, no autos. We just don't do those sectors. We are very much ‘growth bonds’, investing in sensible income. And as I say, we remain fairly optimistic going forwards, because I think there's good opportunities to be had going forwards.

Finally, please contact your sales people if you've got any questions. Fire them in, we’d love to speak to you. Thank you for listening.

Note:

The indices whose yield and spreads were mentioned by John Pattullo are ICE Bank of America US investment  grade and high yield bond indices, on the day of recording, 22 April 2020.  Past performance is not a guide to future performance.