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Zombie revival, improving fundamentals and monetary policy

The outlook for high yield in 2021

The biggest driver of the high-yield market in 2021 will be coronavirus cases versus vaccines.

Although the next few months will be hard, when a mass rollout of one or more covid-19 vaccines finally begins, it could bring some of the much talked about ‘zombie’ companies back to life, writes Kevin Mathews, high yield credit portfolio manager at Aviva Investors.

The high-yield market is currently see-sawing based on the news flow around the vaccines, their effectiveness and possible mass rollout dates in different regions, set against the trends on daily case counts.

The next year should see a gradual decline in these bouts of volatility as the picture becomes clearer for high-yield companies.

Travel and leisure firms that have been hit hardest by the coronavirus will be able to resume operations once a big enough proportion of the population is vaccinated.

In 2020, many became ‘zombie’ companies as they issued massive amounts of debt to stay afloat until they could restart business activity.

After possibly an entire year with little or no revenues, they will gradually be able to begin going back to normal; a number of zombies could be revived.

Resuming operations

The turnaround in company fundamentals will also shape the high-yield market.

At some point in 2021, the market will see a peak in default rates and leverage as a direct by-product of the pickup in earnings growth.

The return to earnings growth as high-yield companies can finally resume operations will allow some to avoid defaulting, and default rates should peak once the picture becomes clearer.

Similarly, companies will be able to start decreasing their levels of leverage as they wean themselves off the debt that has ensured their survival in 2020.

Some of those hardest hit bonds could bounce back strongly if the issuing companies can survive long enough to start making money again.

Major central bank attitude

In light of the Federal Reserve’s revised inflation targeting, but also lessons learned from the global financial crisis, central banks are likely to keep rates down and continue buying bonds for some time.

This should lead to high levels of refinancing once again in 2021.

The Federal Reserve changed its inflation targets in its 2020 framework review and will allow inflation to overshoot the 2% target temporarily.

The European Central Bank is widely expected to adopt a similar viewpoint when it publishes its own review in 2021.

In addition, these central banks have acknowledged the dangers of tightening policy too early, as demonstrated in the wake of the global financial crisis.

This change in attitude by major central banks should conspire to keep monetary policy loose even if the employment situation improves and we see signs of inflation picking up.

With rates remaining low, the high-yield market will likely see another year of elevated supply as companies take advantage of supportive conditions for refinancing.

Current conditions are very favourable for companies to go back to the market and take out additional debt – either shorter-term or higher-cost debt or both.

Kevin Mathews

Yields on the asset class are at historic lows but credit spreads are not; spreads look to have room to compress.

With one or more vaccines and ongoing easy monetary policy widely expected in 2021, the high-yield market should also see a broad turnaround in company fundamentals, all of which would be supportive for the asset class.

Names that have been particularly impacted by the pandemic that manage to stay afloat stand to gain significantly when normal activity resumes.

Selectivity will remain key, however, as companies have not all been able to raise enough liquidity to see them through the full crisis.

It will be important to avoid issuers that do not have the runway to survive until their businesses get back off the ground.

This article was written for Expert Investor by Kevin Mathews, high yield credit portfolio manager at Aviva Investors.

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