American car rental company, Hertz, was one of the largest firms to be undone by Covid-19 after defaulting on its debt and filing for bankruptcy in May 2020. Hertz has been in operation for over 100 years, employs around 38,000 staff globally and is an institution within the travel industry. Yet at the mercy of poor management decision-making, growing debt obligations and declining revenue, it became one of Covid-19’s first corporate casualties.
Hertz was far from unique - Covid-19 dealt global economic activity one of the sharpest, deepest shocks in living memory, leading to a dramatic sell-off in credit markets in the first quarter. While every sector was affected, spread widening was sharpest in those most vulnerable to disruption from Covid-19 related restrictions, including Consumer Discretionary, as well as Energy following the collapse of the oil price. A huge wave of defaults seemed possible. The chart below highlights the tremendous level of spread widening within the historically safe area of investment grade credit.
Investment grade spreads
Major credit agencies were quick to respond. In March 2020,1 more than $400bn of investment grade debt was downgraded by at least one notch by one rating agency. This level is comparable to other monthly spikes experienced during periods of market stress, eg the Global Financial Crisis. However, as a proportion of the index, the downgrades were considerably smaller, at 6% versus 30%.
Corporate defaults have risen, but much less so than initially feared in the early stages of 2020.
There is still risk and fragility out there, and rock-bottom yields don't offer much room for error. Different sectors have been impacted in vastly different ways. This is why we advocate an active approach to high yield.
Get in touch with our experts to understand more or read a case study.
At this point, the question on investors’ minds was – how bad can it get?
It was anticipated that the European speculative-grade corporate default rate would reach 5% in 2020 and 8% in 2021.2 Projections were even more concerning for US markets, with an expected default rate of 12.5% by March 2021 – higher than the dizzying heights experienced during other crises in recent decades, including the Global Financial Crisis of 2007-09 and the Dot-Com Bubble Burst of 2000.3
Then a funny thing happened: things didn’t turn out anywhere quite as bad as first thought.
While corporate defaults (across investment grade and high yield markets) did increase in 2020, reaching an 11-year high, the total number of defaults (226) was lower than originally expected and what was recorded in 2009 (266) and as a proportion of the total market.4 For context, the annual global issuance of corporate bonds has averaged £1.3tn since 2008. This is double the annual average between 2000 and 2007.5
Why were corporate defaults lower than expected?
We believe that several factors have contributed to this:
Accommodative monetary and fiscal policy
The scale of monetary and fiscal policy response by central banks and governments globally has been enormous:
- Quantitative easing programmes have supported the refinancing environment and assisted issuers in meeting their debt servicing obligations. There have been record levels of issuance across investment grade and high yield markets as companies have paid down debt or held cash in anticipation of lower revenues for the foreseeable future.
- Domestically, several tax and spending initiatives were introduced to support businesses, including property tax holidays, direct grants and loan schemes.
Presence of covenant-lite (“cov-lite”) loans
- A cov-lite loan is a loan that does not require the borrower to comply with financial maintenance covenants during the loan’s tenor, eg interest coverage ratio.
- Cov-lite structures account for around 85%6 of the institutional loan market and provide borrowers with greater flexibility during periods of distress. As a result, while defaults may be deferred in the short term, their presence is expected to result in a longer and more elevated default cycle given the credit deterioration that can take place over this period.
Good and bad defaults
Defaults are not something to be avoided at all costs. Instead, to some extent, defaults are part of a healthy economy. Other high-profile defaults in 2020 include retailers like JC Penney, J Crew and Macy’s, and many would argue those firms have been structurally challenged for years. Equally, many would argue that protecting fundamentally sound firms that have suffered through Covid-19 makes sense. The line between the two can get awfully fuzzy though.
As an investor the aim is not to avoid defaults at all costs, the trick is to ensure that, on average, your portfolio is earning enough yield to compensate you for any defaults that may occur. However, as yields have fallen and fallen, the buffer has become incredibly thin.
What’s the outlook for credit markets from here? Are we set on an explosion of defaults over the coming years?
Credit spreads have narrowed from the attractive levels reached in the spring of 2020. Given the level of central bank support and the ongoing demand for yield, we believe the risk of material re-widening will remain low – limited to those sectors most vulnerable to Covid-19.
While default risk is negligible in investment grade markets, it remains elevated in high yield credit, particularly within the US.7 With leverage at record highs and interest coverage ratios at all-time lows, default risk is likely to be a dominant theme throughout 2021.
Accommodative monetary and fiscal policy has helped sustain highly indebted and loss-making “zombie” companies, who would have otherwise entered administration or liquidation under more normal circumstances. These companies pose a significant risk for investors and have implications for the broader economy.
What does this mean for your portfolio?
Few investors managed to make the most of the fantastic entry-point to credit markets in spring 2020, and now many rightly worry about tight spreads and defaults.
There are a range of credit strategies we think are still worth consideration in this environment. As mentioned earlier, we like active management in high yield credit, and some of our clients are adding higher-returning multi-asset credit strategies to their portfolio or allocating to asset-backed securities or opportunistic credit funds. Get in touch to find out more.
1 Credit downgrades and fallen angels, Blackrock
4 Global corporate defaults surged to 11-year high in 2020, S&P Global
7 Schroders Credit Lens, Schroders