High-yield market default scenario ‘too pessimistic’
4 October 2020
Michael Scott, portfolio manager at Man GLG, believes high-yield markets are pricing in a default scenario that is too pessimistic, but may offer opportunities for yield-hungry investors.
The trailing 12-month default rate currently sits around 5.6% according to Fitch Ratings, as markets react to the Covid-19 pandemic, but while Scott expects this figure to climb to 10% in this cycle he says the market has moved too far.
Scott says: “In my opinion, defaults may rise from here and peak at around 10%, mainly concentrated in consumer-facing sectors, as well as energy. However, such a scenario seems more than priced in. We therefore think valuations are compensating for a worse default outcome than the one we actually end up with.”
While the pandemic has had a pronounced impact on the global economy, causing sharp volatility in the financial markets, Scott argues that the economic backdrop was far more positive than many accept.
Scott explains: “Of course there are some clear risks on the horizon, but I believe they are not big enough to derail the economy. While this has been one of the worst recessions on record, it is also one of the shortest, and while spreads on high yield blew out initially, central bank actions coupled with fiscal easing seems to have bought stability.”
High yield debt has rebounded strongly from the lows seen when lockdowns were implemented earlier this year, with the IA Sterling High Yield universe returning some 3% over the past three months.
However, Scott cautions that risk remains in certain sectors, particularly the US shale industry where he anticipates a potential default rate of 20% this year.
Scott adds: “In some of the worst impacted sectors, I believe there remain some striking individual opportunities, especially with yields still trading at spreads of 500bps on average across the high yield universe.
“Airline debt as a sector is down 29.8% year-to-date, while entertainment is off 25.6%, but these COVID-disrupted sectors may offer some of the best opportunities, in my view.”
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