Following the unprecedented issuance totals in 2020, the marketplace for high-yield bonds is poised for another hectic year, as refinancing efforts continue apace, while M&A and leveraged buyout activity accelerates, according to a range of market participants.
To recap, high-yield issuance came to a dead stop last March as the pandemic shuttered broad swaths of the global economy, triggering waves of downgrades and exploding risk premiums. The Federal Reserve in April expanded its corporate safety net to catch recent fallen angels, spurring liquidity-strapped issuers from the sidelines and comforting skittish investors. Issuance totals were at or near record levels for the monthly periods from May onward, and 2020 concluded with nearly $435 billion in volume, the most for any calendar year, according to LCD.
The breakneck pace for bond issuance also reflected a slower recovery in the leveraged loan market, as investors and borrowers alike gravitated to fixed-rate paper and as bond spreads compressed through year-end.
"Spreads widened out in March to unbelievable levels," says Kirk Mentzer, senior vice president and director of fixed income at Huntington Wealth & Investment Management. "If investors were able to buy sometime in March or April they were amply rewarded for taking this risk and taking a leap of faith that the market would return to normal."
Volume: Levels to retreat, but remain healthy
Street consensus estimates show strategists eyeballing $300 billion-$375 billion of high yield bond supply in 2021, down from 2020's year-end figure, with a $275 billion-$350 billion forecast for leveraged loans. For reference, loan issuance of $393 billion in 2020 was down 20% from 2019.
"In particular we are forecasting 2021 high yield bond issuance of $375 billion gross and $125 billion net of refinancing," write credit strategists at J.P. Morgan. "This forecast assumes a 15% decline in gross HY volumes off of 2020's record level (vs. ~$425 billion in FY20) and also a 10%-15% decline in net volumes (vs. ~$150 billion in FY20). That said, 2021 would still be among the heaviest gross volumes since 2012-2014's stretch (avg. $374 billion) and assumes a second consecutive record year of heavy refinancing activity ($250 billion)."
Use of proceeds: Refis to run rampant, M&A/LBO activity to pick up
Debt paydown activity, which accounted for nearly 68% of volume in 2020, is expected to be the main impetus of supply again this year given that borrowing costs have remained at attractive levels and the Fed has signaled a lower-for-longer policy in regard to interest rates. Within this carve-out, bond-for-loan takeout issuance is estimated to decline year-over-year after exceeding $90 billion (up 28% from 2019's sum) in 2020 as companies aimed to quickly repay tapped-out revolvers and existing institutional loans.
"Bond-for-loan refinancing will likely decline year over year but remain elevated in a historical context despite a rebound in loan supply, while general corporate purpose/capex funding should fall somewhat from this year's all-time high," say credit strategist at Barclays.
Additionally, with a coronavirus vaccine projected to become more widely available by mid-2021, companies may ease the pace of deals designed to bridge cash flow disruptions and shore up balance-sheet liquidity. Bond issuance with proceeds earmarked for general corporate purposes accounted for 17% of 2020's final total, the most ever for a single year.
As for the potential wild card inputs, forecasts point to an uptick in M&A and leverage buyout bond prints, against a backdrop of private equity firms sitting on dry powder and rates remaining attractive for sponsors and borrowers. The final months of 2020 showed potential for this predicted trend to take shape, as the share of M&A/LBO prints ticked to 3.6% of issuance in the fourth quarter of 2020, from 1.6% in the third quarter.
"High yield issuance will remain robust, in our view, driven by refinancing opportunities as well as accelerating M&A/LBO-related activity," the credit strategy team at Citigroup notes.
Secured issuance: Back to loans
Scaled-down loan volume was a windfall for secured bonds during 2020. Issuers typically drawn to placing floating-rate paper sought alternative means of funding and enticed investors with the allure of holding higher ranking debt in the company's capital structure. The preference was particularly glaring in the second quarter when the volume of secured bond paper totaled $54.8 billion, a record for a single quarter. Full-year 2020 secured bond issuance was $135.9 billion. A pivot is expected in 2021 as the loan market seems primed to rebound, albeit at a slow pace.
"While we have already seen a meaningful degree of normalization in terms of secured ﬁnancings ﬂowing back into the loan market over the past few months, we still remain close to historical peak levels in terms of high yield secured issuance," note BofA Global Research strategists. "Directionally we would expect continued normalization towards more secured ﬁnancings ﬂowing back into the loan market, however as the experience of post-2009 recovery shows, this process could take considerable time."
Ratings, sectors and politics
As the Fed in March and April 2020 tailored its liquidity programs to support high-grade and fallen-angel issuers, the share of double-B rated paper increased. The largest uptick for this segment of the ratings universe occurred in April as the high-yield marketplace reopened. April concluded with double-B rated paper holding a 61% share of total high-yield issuance. For the full year, the carve-out was 36%, the second-most overall for an annual period. Double-B paper also bested the overall high-yield universe in performance terms, returning 9.40% for the year, per the S&P U.S. High Yield Corporate Bond Index.
For the upcoming year, the Barclays team notes, "BBs present the most attractive risk/reward profile given negative convexity facing single-Bs."
On the opposite end, the J.P. Morgan team recommends fund managers "overweight B and CCCs and underweight BBs" due to the historically low yield for higher quality issuers. "While there is plenty of room for BB spreads to compress should interest rates rise, we believe investors will need to move down in quality in order to outperform in 2021," the strategists note.
The White House will soon feature a new administration, though control of the Senate remained uncertain ahead of pivotal runoff elections in Georgia. Prior to the determined outcome, it was difficult to assess how new policies might affect various industries, though predictions are for minimal sector disruptions.
"Obviously, the big ones would be healthcare and energy that we would expect to be most directly impacted, but the way we see the runoff election in Georgia playing out, with split government it would be difficult to have significant widespread regulatory change," says Matt Kennedy, head of corporate credit and senior portfolio manager at Angel Oak Capital Advisors. "We don't think the administration will have a huge impact on any sector in particular. We do invest in energy and the new administration is in favor of clean energy, which could be negative for carbon-based energy issuers at the margin."
Returns: Mixed bag
High yield's initial volatile response to the pandemic triggered spread widening north of 1,000 basis points (bps), with double-digit average yields in the early days of March, pushing returns into negative territory. Observations of the S&P U.S. High Yield Corporate Bond Index during the final session of 2020 reflects the market's rebound with the average option-adjusted spread at T+356, up 36 bps year-to-year, and a four-handle average yield to worst, declining more than 100 bps. The year-to-date return was noted at 6.78%.
Estimates for the asset class's returns by year-end 2021 range from 2.5% to 8%, with spreads ranging 300 bps-450 bps, Street research shows. Citi, among the bears, feels "loans are poised to outperform bonds, but more importantly, also provide rate protection" to return 3% in 2021, and fixed-rate paper, 2.5%. Wells Fargo strategists foresee a 7%-8% return for bonds "as high yield spreads tighten from current levels to 300 bps."
Defaults: Vulnerable to the virus
S&P Global Ratings on Nov. 23 said it expects the U.S. trailing-12-month speculative-grade corporate default rate to rise to 9% by September 2021 from 6.3% in September 2020, with 165 high-yield rated companies predicted to default on debt repayments. Ratings cited the second wave of coronavirus infections and further economic restrictions as remaining risks.
Among the Street predictions, UBS strategists see U.S. speculative-grade default rates "peaking near 10% in Q1, then falling to 4% by end-21 with non-bank liquidity leading bank lending standards."
The team at J.P. Morgan believes a widely distributed vaccine by summer 2021 and less activity in the energy sector could produce a year-over-year decline in default activity next year to 3.5% for both high-yield bonds and leveraged loans.
Similarly, Citi experts foresee a 3.4% rate for bonds and 3.7% for loans; BofA says the rate "should moderate to 5.0%"; Barclays forecasts 5%-6% of high-yield issuers will default in 2021; and Wells Fargo estimates "high yield defaults are likely to end 2021 around 5%" with sectors vulnerable to virus volatility, including transportation and energy, responsible for a greater share of the activity.
At 2020's close, risk-gauging sentiments appeared in line with default predictions. The S&P/LSTA Leveraged Loan Index distressed ratio was noted at 4.35%, down sharply from 31.11% in March and the distressed ratio for S&P U.S. High Yield Corporate Bond Index was observed at 5.13% in December 2020, a retreat from March's 34.94%.