Our Fixed Income Experts Assess Opportunities in Multi-Sector Bonds

A review of factors influencing the market in the wake of recent volatility—and the sectors that may potentially benefit from a gradual reopening of the U.S. economy

Read time: 5 minutes

On April 29, Lord Abbett Managing Director and Portfolio Manager Christopher Gizzo, Investment Strategist Andrew Fox, and Director of Product Strategy Stephen Hillebrecht held a webinar for professional investors focused on multi-sector fixed income strategies. Here, we summarize our experts’ views through their answers to investor questions.

What is the investment team’s high-level view on the macro environment?

Christopher Gizzo: We are broadly constructive at this point generally on risk in the near-term, especially as we get closer to a reopening of the U.S. economy. And the May timeframe to gradually begin that reopening has been in line with the base case that we have had. So as long as we continue on this path, we will maintain this view.

We do not think currently that we will experience a retest of the bond-market lows that we saw in March. To us, the main reasons are the sizable amount of support from the U.S. Federal Reserve (Fed) and U.S. government for the economy and markets; and the fact that consumer and corporate balance sheets were broadly strong coming into this crisis.

Tell us a bit more about those Fed programs and how they have affected the fixed-income markets.

Andrew Fox: There's a laundry list of them (see Figure 1).
 

U.S. Federal Reserve Lending Facilities: What's Behind the $2.3 Trillion in Support
Recently announced Fed lending facilities and related actions

Source: U.S. Federal Reserve, Federal Reserve Bank of New York, and Lord Abbett. Information as of April 28, 2020. Implied leverage=Stated capacity divided by U.S. Treasury investment in the lending program. Issuers that were investment grade as at March 22, 2020, but were subsequently downgraded to no worse than BB- remain eligible.
¹Federal Reserve indicates capacity for both programs on a combined basis.

I would break them into two categories. The ones at the top of the table—the primary corporate credit facility and the secondary market facility—were designed for the longer-term support of the markets. While their ultimate success remains to be seen, they certainly have been helpful, in our view. The lower section represents what we consider a largely successful effort to ameliorate the short-term funding issues the markets saw back in March. Those conditions have largely receded in importance as those markets have improved, though they have not fully healed.

While these programs are certainly supportive, they are not a panacea. We believe there will still be a sorting of winners and losers by the capital markets as we go forward. But the fact that the market knows that the Fed is ready and willing to act has already helped greatly, in our opinion.

Please give us your views on high yield.

Hillebrecht: If you look at the 10 biggest one-day moves in high-yield bond spreads, five of them happened in March 2020, based on Bloomberg data. High-yield spreads were north of 300 basis points (bps) earlier in 2020; they widened out to 1,100 bps in late March before moving back to the 800 bps neighborhood. So we had a lot of volatility.

What might that mean for investors? Taking a historical view, this table shows that huge spread movements may potentially represent good entry points for those with investment horizons of 12 months or longer.

Figure 2. Periods of Elevated Spreads Historically Have Been Attractive Entry Points in U.S. High Yield
Performance of the ICE BofAML U.S. High Yield Index and S&P 500 in the periods following the initial month that the high yield index spread exceeded 800 basis points

Source: ICE BofAML and S&P Dow Jones Indices. Data as of April 28, 2020.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

Gizzo: We think that the high yield market at this point is still pricing in a default rate that is higher than what we are probably going to actually experience. At a spread of around 800 bps, we believe it is pricing in a high single-digit default rate. In our view, that is based on an average recovery estimate that is rather low for those companies that are actually going to default.

It's typical of high yield investors to overestimate the amount of the defaults during these crises. It's happened in each of the past episodes of elevated volatility. In 2008, for example, at one point the market was pricing in at a default rate that was in the high teens. The actual default rate in 2009 was 10%, based on data from J.P. Morgan.

Figure 3. Based on Elevated U.S. High Yield Spreads, Investors Appear to Have Priced In a Severe Default Outcome in 2020

Source: Moody’s and Lord Abbett. Data as of December 31, 2019.  Chart depicts implied cumulative default of a hypothetical credit portfolio of five-year maturity, assuming 30% recovery, at credit spreads of +600 basis points (bps), +800 bps, and +1000 bps, utilizing statistical cohorts from periods of rising defaults in the high yield market: January 2000, January 2007 and January 2014.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

While prices appear to reflect a high single-digit default, our estimate is closer to the mid-single-digits. Why is our expectation lower than the market’s? There are two reasons, in our view. As mentioned earlier, corporate balance sheets were generally in fairly solid condition coming into this. Corporate liquidity is strong, in our view. Our analysts have been digging in on all the companies that we own, and they have been running stress cases that include an economic shutdown through the end of the third quarter. And even in that downside case, we still see that the vast majority of the higher-quality companies that we have in high yield are potentially positioned to see this through to the other side. Government support of credit markets is also a significant positive, in our view, as is the likelihood of bondholder and general creditor support for individual issuers.

Lastly, the healthy operation of the financial markets has been a big positive in terms of bridging these companies through. So far in April 2020, we have seen around $40 billion of issuance in high-yield bonds, based on Bloomberg data. In investment-grade, we are on pace for a potential record month of issuance.

Speaking of investment-grade, please share your thoughts on that segment of the market.

Hillebrecht: If you look at investment-grade, you saw similar volatility to high yield in March. Seven of the biggest one-day moves in investment-grade corporate spreads happened during that month. Spreads have come back down, but recently remained at levels that are about as high as they’ve been in the past decade.

Gizzo: We do see some room for tightening. And we think that in investment-grade, there are opportunities in the lower tiers—‘BBB’-rated issuers. Some of the new issues that are coming out to further bolster corporate liquidity are attractively priced, in our view. And we have taken advantage of a couple of those.

But broadly in the sectors that are working, if you look at some of the winners in health care or telecomm, there are still some opportunities there. Among the issuers that would benefit from a gradual reopening of the economy, there are actually pockets of healthcare worth considering, in our view, as well as some names on the industrial side. We are also looking at commodities in the investment-grade space—all sectors that could potentially benefit as the global economy gets back up and running.

Could you give us a few words on structured products?

Fox: For asset-backed securities (ABS), a sector dependent on the U.S. consumer, the CARES Act has provided meaningful assistance for people's paychecks, a development that we think has been very helpful, and supportive of the asset class. As for commercial mortgage-backed securities (CMBS), we think it makes sense  to stress cash flows given the current challenges to retail and other represented businesses in the sector. [For additional insights on these asset classes, read Andy’s recent commentaries on ABS and CMBS.]

How is the investment team thinking about current positioning?

Gizzo: We have continued to shift our emphasis to higher-quality credit from developed-market nations. We have been focusing there on investment-grade; we also see a significant opportunity in the higher-quality areas of high-yield.

How should clients think about a multi-sector strategy in their fixed-income portfolio?

Fox: If you want a place to be while the equity and broader fixed-income markets strengthen, or if you're looking for a way to participate in the early stages of a U.S. economic recovery, we believe a multi-sector approach could be worth considering. We think it represents an attractive way to diversify portfolios given its inherent flexibility and ability to participate in various areas of the fixed income market.

Hillebrecht: The multi-sector approach can offer some idiosyncratic opportunities for managers. With a flexible strategy that can move across multiple asset classes, there can always be pockets of opportunity in each of those individual asset classes, in our view.

Any closing thoughts?

Gizzo: We think it's important to remember what the long-term returns look like when you normally have these episodes of spread widening in credit markets. It’s also important to remember that the markets typically overshoot when selling pressure increases; we think they overshot again during March. We think there are a number of reasons why we likely won’t see a retest of the widest spreads in March. If you are looking to the long term, we believe there is a high likelihood that you are going to have a positive experience putting money to work in the credit markets today.