The rebound in the credit markets from the COVID-19-induced sell-off early this year has been as uneven as it has been remarkable.
While most companies’ earnings, and by extension the companies’ creditworthiness, took a hit from lockdowns intended to contain the pandemic, some companies held up better than others. Successful companies generally were those that had been in sounder financial positions to begin with, were better able to adapt their operations to serve new customer needs, and/or could reduce costs in the face of reduced activity.
Given their cautious stance going into the pandemic, Vanguard funds were able to take advantage of opportunities that arose in March and April, when bond valuations cheapened significantly even for sectors and companies best positioned to withstand the downturn.
With initial credit market adjustments to the pandemic behind us, Vanguard’s credit analysts and traders expect to see further opportunities for active management to add value, including in sectors more affected by COVID-19.
Companies remain cautious amid the economic contraction in much of the world. In part because of well-telegraphed market messaging, however, weak second-quarter results didn’t rattle markets too greatly.
Global earnings dropped precipitously in the first half of the year, even though second-quarter earnings were a little better than markets had anticipated. Forecasters may have been overly pessimistic in the absence of guidance from many companies. Some companies managed the pandemic better than expected by cutting costs or adjusting business models through, for example, increased online sales. Others saw increased demand for their services sooner than expected.
Sector trends were typical for a recession, with utilities, communication services, and consumer staples holding up relatively well and energy, consumer discretionary, and financials among the hardest hit.
There were a few nuances this time around, however. In North America, technology, media, and telecom held up exceptionally well. “The pandemic accelerated secular trends that helped the tech sector, such as increased penetration of broadband internet services and growth of cloud-based computing services,” said Scott Miles, a U.S.-based senior North America credit analyst. “Demand for consumer electronics has also been heavier than we expected because many more people are working from home and learning remotely and because of a shift in discretionary spending away from travel and leisure activities.”
Although weaker 2020 earnings will translate to rising leverage, we expect significant performance differences between stronger and weaker companies. That is particularly true for companies that are operating in sectors most affected by social distancing. Capital markets remain fully open to investment-grade issuers, many of which have taken the opportunity to increase liquidity to build buffers for future shocks.
The change in earnings has been calculated by averaging the change in the most recent half-year results compared with the same period last year (e.g., first-half 2020 versus first-half 2019) by sector. Earnings before interest, taxes, depreciation, and amortization (EBITDA) was used for earnings calculations. In the absence of reported EBITDA (e.g., for financial companies), net income was used. Analysis includes Standard & Poor’s-rated companies across the Asia-Pacific region, Europe, and North America that issue bonds. Smaller firms and outliers were screened out of the analysis to smooth earnings volatility, resulting in the comparison of approximately 2,700 global companies.
Sources: Vanguard and S&P Capital IQ.
Vanguard looked at about 2,700 companies, grouped them into ratings buckets, and then compared their earnings in the first half of this year with earnings in the first half of 2019. “The results generally suggest that the higher a company’s rating, the better the earnings it posted,” said Andreas Nagstrup, a London-based Vanguard credit analyst. “Companies in the higher rating buckets—which are often large and have broad sales channels and product ranges, and are geographically well-diversified businesses—may have had more levers to pull to absorb some of the shock brought on by the pandemic.”
The change in earnings has been calculated by averaging the change in the most recent half-year results compared with the same period last year (e.g., first-half 2020 versus first-half 2019) by rating. EBITDA was used for earnings calculations. In the absence of reported EBITDA (e.g., for financial companies), net income was used. Analysis includes S&P-rated companies across the Asia-Pacific region, Europe, and North America that issue bonds. Smaller firms and outliers were screened out of the analysis to smooth earnings volatility, resulting in the comparison of approximately 2,700 global companies. Sources: Vanguard and S&P Capital IQ.
When the credit markets began to seize up in late February and into March, major central banks acted boldly. They rushed to cut interest rates and enact bond-buying programs with the aim of ensuring sufficient liquidity for companies to survive the pandemic’s economic shock and emerge, if not unscathed, at least in a better position than they otherwise would have been.
The central banks’ response had a positive effect on credit ratings. Some companies in pandemic-affected sectors such as airlines, energy, and transportation—which already were weakly positioned in their credit rating category—were swiftly downgraded in March and April. Other companies in these sectors were put on either negative outlook or credit watch negative, signaling an increased risk of downgrades in the future.
“While there may still be further downgrades to come, it is my clear sense that rating agencies are willing to look beyond the weak second-quarter earnings and give companies time to restore their credit metrics,” Mr. Nagstrup said. “We therefore expect a slower pace of ratings migration going forward. The main caveat is that this view depends on the path of the virus.”
The improved liquidity across the investment-grade universe has also helped ease ratings agencies’ immediate concerns about some companies’ prospects, buying the companies time to hold out for a recovery.
Central bankers were so successful in defusing the liquidity crisis that bond issuance reached an unprecedented level in the first half of 2020. Some companies came to market because they needed to shore up their balance sheets, while others in better financial positions issued bonds more as a precaution, because they didn’t know what the markets might look like in six months.
“Our disciplined approach to risk paid off in this challenging environment,” Mr. Nagstrup said. “Toward the end of 2019, we were carrying a fairly low level of risk across our active funds as we viewed valuations in the credit market as being relatively expensive compared to historical levels. We obviously didn’t see the coronavirus pandemic coming, but our conservative positioning did allow us to take on more risk in March and April as the market sold off. That wasn’t the case for some asset managers who were carrying more risk ahead of the pandemic, chasing a few extra basis points of potential return despite valuations being elevated.”
Vanguard’s global team of research analysts and traders were able to analyze the degree to which sectors and companies were likely to be affected by COVID-19. This allowed the funds to take advantage of the major market dislocation and add risk in names where valuations were very attractive relative to their fundamental credit profile.
“The global team did a great job identifying issuers and sectors with attractive risk/reward characteristics and we were able to add a lot of value to the funds and our investors during the first half of 2020,” said Sarang Kulkarni, portfolio manager for Vanguard active global credit strategies.
Vanguard also was able to take advantage of concessions, or discounts on newly issued bonds. “Counterintuitively, during the spring some of the highest-quality names offered the largest concessions because they were among the earliest to tap the market,” said Scott Miles, a U.S.-based senior North America credit analyst. “We took advantage of those opportunities. Later on, lower-quality names that drew on their bank lines of credit during the panic were actually able to raise public debt capital at relatively smaller concessions as markets were healing, so where we had confidence in individual issuers, early and proactive risk-taking on the part of our traders paid off.”
Recovery from the initial COVID-19 economic shock is likely to be gradual and uneven. Revenue growth will likely be modest, so cost management will be key for many companies to grow their earnings.
The risks remain that increases in COVID-19 infections could lead to the reimposition of broad lockdowns that would further hurt economies, and that a vaccine may still be a long way off. Those risks are somewhat mitigated, however, because governments are better prepared now to deal with outbreaks. Moreover, central banks have asserted their readiness to continue to support bond markets, which would likely help support risky assets. Companies have also built up their liquidity buffers to cushion against further market volatility.
Vanguard expects less issuance than usual in the second half of 2020 given the amount of funding raised in the first half. Yet the low-interest-rate environment affords opportunities for firms to refinance to extend maturity profiles, and that is likely to continue throughout the rest of the year.
In sectors less affected by COVID-19, many issuers’ bonds have been bid up to expensive levels, with markets disregarding factors that weighed on valuations before the pandemic. As the global economy slowly normalizes, however, underlying company fundamentals are again becoming the dominant narrative. That may result in lower prices for weaker issuers in sectors such as retailers, and active managers need to be positioned for that, Mr. Nagstrup said. At the same time, some “winners” from the pandemic such as large e-commerce and technology companies may grow even stronger.
In sectors more affected by COVID-19, on the other hand, Mr. Nagstrup notes that opportunities are emerging among issuers beginning to recover. “Their spreads in some cases widened a lot despite fairly solid fundamentals, but we would expect them to normalize and trade more tightly over time.” That could be the case in sectors such as consumer cyclicals and media, where some companies in “losing” segments from the pandemic emerge with more market share, less competition, or improved business models.
It is also worth noting that some sectors will take several years to recover and may not get back to pre-pandemic revenues and earnings. “From an investment implications perspective, let’s not throw the ‘COVID losers’ out with the bathwater,” said Alicia Low, head of credit research for the Asia-Pacific region, based in Australia. “At the same time, let’s be mindful not to simply chase ‘COVID winners,’ as their valuations could well be fully baked in.”
Data are for the period January 1, 2020, to September 28, 2020. Each bar shows the range of corporate bond spreads (option-adjusted spreads) for a sector during 2020. The dots show the corporate bond spread for the sector on September 28, 2020. A spread represents the yield of a bond over and above the risk free rate, as indicated by the yield of a U.S. Treasury bond of the same maturity, that a credit investor earns by holding a bond to maturity.
Sources: Vanguard and Bloomberg Barclays Global Aggregate Corporate Index.
“The credit markets may be a little more challenging going forward and security selection will be even more crucial,” Mr. Nagstrup said. “But Vanguard’s global fixed income team of analysts and traders, with their bottom-up, fundamentals-based credit research process and disciplined approach to risk-taking, makes us well positioned to identify and invest in potential pockets of outperformance as opportunities arise. When investors buy a Vanguard actively managed fixed income fund, they’re gaining access to that potential for outperformance.”
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