Uncovering bond value in a stormy environment

The unprecedented scenario brought about by the pandemic has forced many investment professionals to prioritise the way analysis is done. As with other asset classes, a sub-segment within the fixed income space, high yield (HY) debt, was highly sensitive to the market moves we’ve experienced in March this year.

Understandably, the woes surrounding the global economy, pushed HY towards a nose dive trend, in terms of pricing. As expected the moves were remarkably amplified by the lack of liquidity which hindered further the asset’s performance.

At the peak of the pandemic, US HY traded with a spread over the benchmark of circa 1,049 bps (10.49%), whereas European HY spiked to 865 bps (8.65%). Levels which were last seen for the former way back in 2009, while the latter experienced similar levels in the European crisis way back in 2011.

As we have experienced over the years, exchangeable traded funds (ETFs) did their bit in amplifying downside moves. Generally ETFs, given their passive management, do not hold any cash levels, and in order to fulfill their redemption orders, they have no other option but to hit the bid levels being put forward within an already illiquid market. In turn, this will have a strong impact on specific names.

Thus, many might argue that in terms of liquidity one would be better-off holding an ETF than a specific name in times of volatility. Technically speaking it is the case, however, the levels of returns would be lower, given the lower specific risk and liquidity risk from holding an ETF.

That said, we believe that in such a low yielding environment, taking a more active approach, as opposed to a passive approach, can still fulfill ones objectives, with possibly relatively similar risk-adjusted returns. As pointed out in the introductory part, prioritizing in terms of analysis is crucial at this juncture to manage higher returns versus the posed risks.

Given these uncertain times, internally we tweaked slightly our bottom-up analysis by giving more weight to selective elements within our analysis and mainly prioritizing through a ladder labelled the ‘The ladder of priority’. We strongly believe that in such uncertain times, predominately brought about by the pandemic, such an approach uncovered significant value when the risk-off mode bells start flashing.

The ladder of priority focuses on three pillars, survival, corporate liquidity and market liquidity, with the highest weighting being given in their respective order. We believe that in times of distress, analysis of a company’s survival should be given priority. Thus analyzing the current liquidity levels and the cash being generated from operating activities is crucial for a company to continue to service its debt obligations.

Secondly, corporate liquidity analysis focuses on the accessibility of a company to raise capital through equity or debt in times where the entire market is under stress.

In this regard, strong relationship with banks and the support of shareholders is imperative. Indeed at the peak of the crisis we’ve seen companies going down the restructuring route given no support from lenders and/or shareholders, while others thrived as they managed to get the necessary support to sail through these uncertain times.

Thirdly, analysis on market liquidity is also crucial in terms of companies tapping the primary market to re-financing or to raise new capital. Such analysis mainly focuses on the easing moves being taken by major central banks which emerged as imperative in transmitting confidence within financial markets.

Indeed, the moves taken by the Federal Reserve in April in injecting liquidity by buying also selective sub-investment grade bonds was a bold move in transmitting confidence both in the primary and secondary market. The former commenced seeing strong activity following an inexistent March, while the latter experienced a narrowing in spreads, as markets cheered the monetary efforts.

Such an approach helped us to uncover value in credit stories which were harshly impacted by both market and sector risk. Indeed, many buying opportunities were presented in a diversity of sectors with the telecoms, industrials, shipping, meat producers and gaming, amongst those industries which were offering value in a distress market. On the contrary, others continued to predominately suffer the sector and liquidity strains to which we have shied away given the surrounding uncertainty.

In all fairness from the peak of the pandemic, bond prices have increased remarkably, and thus buying opportunities are now more casual. That said, we still strongly believe that our approach will continue to possibly uncover value, but mainly identify credit stories which can withstand possible operational disruptions and thus sustain and service their obligations.

As the saying goes ‘cash is king’ and in uncertain times it is the only certainty for a company’s survival. 

Disclaimer: This article was written by Jordan Portelli, Head of Fixed Income at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd and is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.
For more information visit https://cc.com.mt/. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.