US High-Yield (HY) Corporate Bond Views—Q1 2021

    Franklin Templeton Fixed Income

    In the near term, we expect volatility to remain elevated in the US high-yield corporate bond market as investors grapple with the promise of successful vaccines on the horizon, paired with a recent spike in COVID-19 cases that could lead to further economic disruption over the winter months. With $17 trillion of negative-yielding debt across the globe, we still think high yield will attract the interest of investors able to withstand the volatility. The record amount of new issuance this year has enabled companies to bolster liquidity and extend debt maturities, which has resulted in a default rate that has been much lower than thought possible last spring. So even with nominal yields near historic lows, we still think HY investors are more than compensated for expected default losses. We still see potential for spread tightening over the course of the next year and believe that the relative yield pickup, along with the lower duration exposure to a potential rise in interest rates, should make US high yield an attractive asset class in the continued low global-rate environment we expect going forward. We also believe that individual security selection is now more important than ever.

    The size and composition of the US high yield market has changed notably this year. A record amount of fallen angels and net new issuance has increased the size of the market by more than 20% year to date (YTD), despite defaults of close to 7%. An elevated level of ratings downgrades of existing issuers, driven by the pandemic, further contributed to a shift in the ratings profile of the market and the indexes, though the net effect of all of the preceding was a material improvement in quality for the asset class.

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    Visit Global Fixed Income Macroeconomic & Sector Views: Q1 2021 to learn more about our outlook for each sector.

    Issuance has remained quite active, driven by bond and loan refinancings as well as funding for acquisitions, share repurchases, and—in a handful of cases—dividends. Issuance in August and September was at a pace near the monthly all-time record, with October issuance trailing off, though still 50% above the average volume for the month. In early November, issuance slowed during election week, but picked up again in the following weeks. Issuance is up 80% over the comparable period last year. We have generally found new-issue concessions to be an attractive way to pick up yield and spread.

    This year has also seen a record amount of fallen-angel volume. While the pace has slowed from earlier in the year, rating agencies continue to take action as the duration and magnitude of profitability declines becomes clearer. We believe $100 billion or so remains at risk for downgrade to HY over the next 12 months. With exchange-traded funds (ETFs) having a disproportionate impact on the market, the valuation differential between larger ETF-eligible names and smaller, less liquid capital structures has widened. While we believe the overall market is fairly valued, we are finding pockets of value among these smaller issuers as well as select larger names.

    The default outlook is relatively benign. We believe it may tick up modestly by year end, but otherwise is likely to have peaked. Based on our analysts’ bottom-up assessment, we project a default rate including distressed exchanges of 2.5%-3.0% over the next 12 months.

    Looking toward a Biden presidency with a split or nearly split Congress, we anticipate a relatively manageable impact to the overall US HY market. An increase in the corporate tax rate is a lower probability, and even if it does come to pass, we do not anticipate it to be hugely impactful to most high-yield issuers. There are likely to be regulatory and executive actions that impact specific industries, but most make up smaller portions of the HY indexes, with the exceptions being energy and health care.

    Within energy, a Biden administration and Republican majority Senate is a net negative for the oil & gas industry, though less so than the “blue wave” scenario could have been. In our view, a Democratic sweep of the two Georgia Senate runoffs is unlikely to meaningfully change the outlook, as there seems to be enough opposition from moderate Democrats to eliminating the filibuster and from Democratic senators from hydrocarbon states to stifle some of the more extreme legislation targeting energy. Therefore, sweeping legislation such as a “Green New Deal” or a nationwide fracking ban is effectively off the table, though we think the latter was unlikely in any event. Another consequence of the Senate composition is a higher probability confirmed heads of federal agencies such as the Environmental Protection Agency are more politically moderate.

    President-elect Biden has stated support for banning new permitting on federal lands and waters, which accounts for approximately 22% of US oil production and 12% of US natural gas production. While existing production will not be shut in and companies would likely shift drilling to non-federal lands, this could result in a lower growth trajectory for US oil production. Ultimately, we anticipate the oil & gas industry could face incremental regulatory burdens and costs such as tighter controls on emissions, regulations on water management and difficulty in permitting new pipelines. In isolation and under an assumption of US shale as the global swing producer of oil, higher operating costs due to regulatory burdens should increase the marginal cost of supply.

    On the foreign policy front, Biden is likely to have the US rejoin the Iran nuclear deal, which ultimately could lift sanctions on Iranian oil and over time, result in incremental oil supply. As well, Biden plans to also rejoin the Paris Agreement on climate, though it remains unclear what his view is on the billions of dollars the United States would transfer to developing countries under the agreement. Biden’s platform also includes specific emissions reduction goals, which will require massive investment and subsidy of non-carbon emitting power sources. Ostensibly, rolling back the Trump administration’s tax cuts would fund these initiatives. Broadly, compared to Trump’s policies, Biden’s proposed policies are more likely to incrementally bring forward peak oil demand, though arguably this is still approximately 10 years out. Unknowns include changes to international relations with Saudi Arabia, Russia and China, among others.

    We believe Biden’s administration ultimately will result in a higher cost of doing business for US oil and gas companies, which is a near-term net negative. However, the perceived need to gain scale to offset higher costs could sustain or accelerate the recent trend of credit-friendly exploration & production mergers.

    Within health care and pharmaceuticals, Biden’s victory with a split Congress has mixed implications but provides the sectors with relief that the most aggressive policies possible under a “blue wave” are off the table. Some of the initial focus could be COVID-19 relief, vaccines and stimulus, which would have modestly positive implications for these sectors. Thereafter, it is likely the Biden administration could begin to push its health care agenda through administrative actions and Medicare demonstration projects, which is a way to try out a new policy and get feedback before applying it to a broader population without needing Congressional approval. However, a split Congress would likely limit implementation of a lot of the more aggressive changes.

    Policy changes are very likely for the pharma sector. Under Biden and a split Congress, some level of drug price reform is possible, but would likely be influenced by the industry and might focus on reforms to Medicare Part B or D. These reforms would be moderate headwinds for certain companies but would be largely manageable. Vice President-elect Harris has supported more aggressive policies such as march-in rights, but these might be more controversial with a split Congress. The most significant drug price and industry reforms under a “blue wave” are off the table.

    For the health care sector, efforts to build upon the Affordable Care Act and expand insurance coverage are likely and would be modest positives for meaningful parts of the sector, like hospitals. The biggest potential risk would be bipartisan agreement on surprise balance billing legislation, but another risk that has moderated in recent days is that large parts of the Affordable Care Act could be deemed unconstitutional. The Supreme Court is currently reviewing the law. The worst outcome for the sector would be if the individual mandate was deemed unconstitutional and the mandate is inseverable from the rest of the law such that the entirety of the law, or much of it, would be struck down. The Court has concluded oral arguments and it was quite clear that several justices are supportive of allowing the rest of the law to survive even if the mandate is unconstitutional. A decision could occur anytime between December and next June.


    WHAT ARE THE RISKS?

    All investments involve risks, including possible loss of principal. Municipal bonds are sensitive to interest rate movements, a municipal bond portfolio’s yield and value will fluctuate with market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. The price and yield of a MBS will be affected by interest rate movements and mortgage prepayments. During periods of declining interest rates, principal prepayments tend to increase as borrowers refinance their mortgages at lower rates; therefore MBS investors may be forced to reinvest returned principal at lower interest rates, reducing income. A MBS may be affected by borrowers that fail to make interest payments and repay principal when due. Changes in the financial strength of a MBS or in a MBS’s credit rating may affect its value. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in emerging markets involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size and lesser liquidity. Investments in fast-growing industries like the technology sector (which historically has been volatile) could result in increased price fluctuation, especially over the short term, due to the rapid pace of product change and development and changes in government regulation of companies emphasizing scientific or technological advancement. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. High yields reflect the higher credit risks associated with certain lower-rated securities held in the portfolio. Floating-rate loans and high-yield corporate bonds are rated below investment grade and are subject to greater risk of default, which could result in loss of principal—a risk that may be heightened in a slowing economy.

    Any companies and/or case studies referenced herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio.