Long-term value opening up in leveraged credit markets

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      By Jeffrey D. MuellerCo-Director of High Yield Bonds, Portfolio Manager, Eaton Vance Advisers International Ltd. and Will ReardonInstitutional Portfolio Manager, High Yield

      London - Pandemic fears and subsequent outflows from high yield and leveraged loan funds since the latter part of February 2020 has, in our view, given rise to potentially attractive investment opportunities for long-term investors willing to look past the likelihood of continued volatility in the near term.

      Right now, we are starting to see opportunities to add risk to higher quality, defensive parts of the market (higher quality, more liquid names have underperformed in the selloff). We calculate that, with US high yield spreads, as represented by the ICE BofA US High Yield Index as of 18 March 2020 in excess of 900 basis points (a rare phenomenon), long-term investors in this asset class could enjoy double-digit gains over the next five years.

      Clearly, we still face a number of unknowns, among them:

      • The extent of the negative global economic impact of the coronavirus pandemic;
      • The efficacy and speed-of-impact of substantial stimulus measures announced by governments and central banks to date;
      • Perceptions of the evolution of the virus and how soon these become less negative; and
      • Fundamental impacts: the ability of some companies facing severely weaker demand to survive over the next 18 months to two years.

      While we seek to get a clearer picture of these factors and how it is priced into markets, we are not inclined to jump into the deep end of the risk spectrum right now. That said, we clearly do see opportunities opening up for the long term. Some positives to take away:

      • Many higher quality issuers and big, liquid capital structures across sectors have experienced more than their fair share of the pain in this sell off and we believe that the valuations on offer in this part of the market now look attractive.
      • In US high yield, for example, the current credit spread ratio between CCC/BB has tightened to 2.5 (the five-year average is 3.5). As this ratio reverts back to the average, higher quality should outperform.
      • Among collateralised loan obligation (CLO) structures, we retain high conviction in the fundamental strength of some of these capital structures, all the way down to the BB-rated tranches.
      • The leveraged loan market, as represented by the S&P/LSTA Leveraged Loan Index, is trading at deeply discounted prices and implying a brutal default path, even if we assume lower than historically average recovery rates (average price of US$81.4 on 18 March 2020), despite having limited exposure to some hard-hit sectors like energy.
      • The up-in-quality trade in energy has been challenging at times. Some quality names in the energy sector (struggling with both weak demand and increased supply from Saudi Arabia) have faced additional technical pressure due to higher trading volume relative to their lower quality, less liquid peers. Understanding financial liquidity among energy issuers will be key to identifying likely survivors, despite depressed oil prices. We believe that the higher quality issuers that have unexpectedly underperformed so far will become outperformers in the future.
      • Select parts of the technology sector are beneficiaries of increased demand for PCs and IT-related equipment as more people work from home.
      • European high yield has often seen bigger price falls than US high yield because we typically see lower coupons than in the US. We expect a reversal of this once markets stabilise.

      Bottom line: Although market liquidity is fluctuating, we believe active managers will continue to be able to take advantage of attractive opportunities across credit markets.