Morgan Stanley
  • Thoughts on the Market
  • Dec 17, 2020

Corporate Credit 2021: A Shift to High Yield

Andrew Sheets and Vishy Tirupattur


Sheets: Welcome to Thoughts in the Market, I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley.

Tirupattur: Hi, I'm Vishy Tirapattur, Head of Fixed Income Research at Morgan Stanley.

Sheets: And on this special edition of the podcast, we'll be discussing the 2021 outlook for global credit markets and how investors can view corporate credit amid a synchronized global economic recovery. It's Thursday, December 17th, at 1:00 p.m. in New York.

Sheets: So Vishy, How are you thinking about the global fixed income markets from a broad view as we head into next year?

Tirupattur: Higher rates and steeper curves is the basic message we have for our outlook for 2021.

Tirupattur: What do we mean by higher rates? So we expect that the front end of the curve to be anchored to the central bank policy, no change there. We expect the 10-yr part of the curve and the 30-yr a part of the curve to go higher. So the 10-yr we expect will end up at 1.45% by the end of 2021, higher about 50 basis points from where we are today.

Sheets: So Vishy, I think when investors kind of think about the interaction between interest rates and other types of bonds in the market, I really find there are kind of two schools of thought. There's a group of investors who think that higher interest rates like the rise that we're forecasting, is pretty bad for corporate credit. It's bad for emerging markets because those higher interest rates suggest kind of less accommodative policy, higher borrowing costs, et cetera. And there's another school of thought that says no, actually, you know, if rates are rising because the economy is getting better and that's kind of very much our forecast, than that should be fine for those markets. So you know as you think about that dynamic, which one of those two cases do you think ultimately ends up playing out?

Tirupattur: I am firmly in the second school of thought that you describe, Andrew. That means rates are going to be higher on the backside of the Treasury curve. So that means the 10-yr bond to be higher, but the front end actually remains fairly anchored to where we are. So that is the background that is constructive, broadly speaking, for credit assets. Risk assets broadly, credit assets in particular.

Sheets: I want to talk a bit more about the corporate credit markets and how you're viewing that from a global perspective. And again, you know, we've we have a big debate there between I think, investors who say spreads have already narrowed pretty considerably. Kind of all the juice has been squeezed at the corporate credit market in others who are more optimistic. So, you know, what sort of returns are you expecting in corporate credit? And then, you know, Where on the credit quality spectrum do you see the best risk reward?

Tirupattur: So when I think about this, I think where we are today in the credit market, the best opportunity is lower in the credit quality. So what we would call better expected returns in the high yield space and then the higher quality investment grade space. So what we are calling for is a convergence street between higher quality to lower quality. And the best opportunity in my mind is between the high yield space. And what we think here is that over the course of next year, returns to credit investing are going to be about our long term averages from an excess return perspective, but more profoundly so in the high yield space compared to investment grade space.

Sheets: So Vishy one of the biggest concerns I get from investors around our preference or high yield is around default rates. You know, we've just been through an incredibly severe recession. And so I think a lot of investors looking out to next year are concerned that weaker companies of which kind of high yield tends to be populated will be more vulnerable to that continued disruption in the economy. And you'll see more defaults and that will lead to worse credit returns. So how are you thinking about that risk and what are your expectations on the default side?

Tirupattur: To look at that, we need to step back and think about what happened this year. One most notable thing is the opportunity set that the policymakers have created for access to capital markets. So companies have used that access to the capital markets and have issued a lot of debt. now, if you look at cash as a percentage of debt, it is pretty close to all time highs. So a lot of the cash that's been raised during the course of this year is actually still sitting on companies’ balance sheets. And this gives them the opportunity to cover their financing needs going forward. That's the first point.

Tirupattur: The second point is that as we saw a very severe recession come through, we did see defaults pick up. And we think the good news here is that the defaults, we think, will peak around the second quarter of next year. And from then onwards, we expect the default rates to trend down over the course of the remaining part of the year. So in some ways, the worst of defaults has already happened. And companies we think are better prepared to handle the challenges that come with this market as we come out of the recession and then pickup into a strong economic growth.

Sheets: I think that's a great point you raise Vishy on the high cash to debt levels because you know something that's always a tension when you're a corporate bond investor is that you don't get to devote. The equity holders, the equity holders vote on the direction the company takes. And so, you know, by that turn, companies often take more risk, do more things that are geared towards higher growth, higher future returns, things that will help the equity holders. But by taking those risks, you are not necessarily helping the bondholders sleep better at night. And so it can be a narrow window. The economic cycle where company management is a lot more conservative is very focused on the bondholder, you know, making sure that the balance sheet of the company is beyond reproach. And I you know, I think, as you mentioned, we're still in that kind of relatively rare window where companies have raised a lot of cash. They've kept that cash on the balance sheet. They're trying to kind of prepare for any eventuality. And obviously that won't last forever. But for the moment, It does seem like a better than average backdrop from the perspective of how kind of financially conservative company managements are.

Tirupattur: That's a very good point, Andrew. we think that incentives are very much in line today for companies to engage in balance sheet repair. So we do it is clear that leverage levels as a consequence of the recession we are going through, certainly have gone up pretty high. And over the course of next year, we expect two things to happen. We expect the earnings to pick up and at the same time we expect some balance sheet repair also occur. So the combination of both of these things would mean leverage over the course of the year will gradually begin to start coming down. And that is good news for credit investors.

Sheets: Vishy, how worried are you about ratings downgrades and are there kind of particular areas of the market where we think this might have a greater or lesser effect?

Tirupattur: Rating agencies over the course of this year recognize one thing. They recognize that this disruption that we have seen in company behavior is really an exogenous event. So having recognized that this as an exogenous event, they have really given a lot of rope for companies to manage through this crisis. So we think what would really happen is that rating agencies would watch if companies are following up on the balance sheet repair point that I mentioned earlier. So if rating agencies see behavior that is inconsistent with that, we expect to see downgrades to follow rather quickly. On the other hand, if companies, as they are incentivized to do so, continue their balance sheet repair, see their earnings pickup and their leverage, the debt to EBITDA levels come down gradually, we think rating agencies are going to be pretty accommodative of that.

Sheets: So Vishy one of the kind of unprecedented actions that happened this year, was that the Federal Reserve stepped into the corporate bond market in a way that it hadn't done before. And then much more recently, there are signs that due to some changes in Treasury Department policy, some of that support might go away. So could you quickly kind of summarize how important do you think those dynamics are and do and do some of these recent announcements change the story?

Tirupattur: The policymakers did a lot of new things in this course of this year. The most notable in some ways, the policymaker’s response has been is developing into it, creating credit support facilities. And they did that by creating a facility where the Treasury Department puts in what we call an equity tranche money. And the Fed will lend it to that facility, the debt component. And then the facility is then used to buy corporate bonds. And that facility was not tremendously used. But I think the idea that the facility like that exists, effectively for constituted a put option from the policymakers to the credit market.

Tirupattur: Some of these facilities are going to go away end of this year. And this is how I think about this. The policymakers have introduced a new toolkit for them to manage challenges in the credit market. If there is a substantial dislocation, they have now a tool that they could deploy that was not available until this year. So even if it goes away, in some ways it can be redeployed. And there are funds available that could be deployed to reconstitute these facilities that do not necessarily require explicit, additional incremental congressional approval. So I think the way to think about this is that the policymakers have created a put it was a somewhat out of the money put option to the credit markets. The strike place of that put option has moved somewhat lower, but the put option is very much there.

Sheets: That's great. OK, final final question. So, Vishy, you know, as we've discussed on this program today, we're optimistic on credit markets. We think they're still well positioned in an environment of better growth next year and quite a bit of liquidity support. But if you think ahead and you think about, you know, bear case scenarios, you know, things that could go wrong, what would be the risk that you're most worried about affecting our otherwise optimistic story?

Tirupattur: The thing I would be worried about most is that our expectations of growth do not materialize, virus lingers longer, and company profit profitability that we expect to pick up through higher earnings over the course of the year do not materialize. And companies don't follow up on the balance sheet repair that they are at the moment very much incentivized to do. If that happens, we would expect rating agency downgrades and a pickup in default prospects going forward, and that is the scenario that I would be most worried about.

Sheets: Vishy. Thanks for taking the time to talk.

Tirupattur: Thanks for hanging with me.

Sheets: As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show. 

Vishy Tirupattur, Head of Fixed Income Research, talks with Andrew Sheets about why corporate credit investors could see better returns in the high yield space in 2021.

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