Sector selection and the V-shaped rebound


We like sector “Leaders” that exhibit characteristics of defensive cash flows and balance sheets.
Chief Investment Office01 Jul 2020
Photo credit: AFP Photo


Time to seek alpha. We had opined that a low rates environment would drive yield compression (please see “Credit: Yield compression inevitable in a world of low rates”, 18 May 2020), with the strategic preponderance on Investment Grade (IG) credit as the benefactor of flows in the face of unpredictability. Since then, IG returns have surged back into positive territory for the year; in quick validation of the strategy. With absolute yields in IG now trading much closer to their all-time lows, the magnitude of a beta-driven rally on lower-risk assets is unlikely to be as significant as before.

Opportunities, however, remain in the High Yield (HY) markets given a more cautious recovery – despite cash still lingering on the sidelines (Figure 1). For these higher risk markets, the challenging task of sector selection will remain key in the balancing act of positioning defensively while also angling to capture higher yields.

Never let a good crisis go to waste. Fortunately, the steep fall, followed by the subsequent sharp rebound in corporate bond prices, has provided us insights to sectors that are attractive in the HY markets – those that outperformed through the volatility.

We define the steep fall as the period between 1 January 2020 to 23 March 2020, when the markets had formed a bottom. The sharp rebound is defined as the period between 23 March 2020 to 19 June 2020, around the period when risk assets recouped most of their losses for the year. The sector performances are then classified into four quadrants:

  • Cyclicals: Sectors that underperformed during the selloff but outperformed in the rebound.

  • Defensives: Sectors that outperformed during the selloff but underperformed in the rebound.

  • Leaders: Sectors that outperformed in both the selloff and the rebound.

  • Laggards: Sectors that underperformed in both the selloff and the rebound.

We believe that investing in a diversified credit portfolio of sectoral “Leaders” is the most defensive way to position for HY exposure. Rather than guessing the alphabetical shape which would best describe the recovery, and in so doing try to time the markets, investors should stay engaged with HY credit for respectable income generation as we enter into a protracted period of rates near the zero-bound.

Figure 1: Fund flows into HY credit are cautious, but optimistic

Source: EPFR Global, DBS

Putting names to faces. In addition to the sector analysis, we also tabulated the top 10 issuers by notional amount outstanding in the “Leaders” category with ratings in the BBB/BB bucket – our preferred ratings segment – to have a sense of the issuers driving the performances in these sectors. This is not a recommendation list per se, but more an effort to gain an understanding of the businesses behind the sectors that have outperformed to better analyse their performance drivers.

The results for US, European, and Asia HY markets are detailed below.

US High Yield

For the analysis of US HY, we have excluded the Energy sector given that it exhibited huge volatility – underperforming the index by 20% during the selloff and outperforming by 37% during the recovery – placing it firmly in the “Cyclicals” category but heavily distorting the results as a consequence.

Figure 2: Sector-level relative performance of US HY (ex-Energy)

* Bubble size represents relative weight of the sector in the Index.
Source: Bloomberg, DBS

Table 1: Top 10 issuers among US HY “Leaders” in the BBB/BB segment

* DBS does not have a house view on some of these issuers
Source: Bloomberg, DBS

US HY “Leaders” driven mainly by sectors with insulation against/benefit from viral shutdowns. Enforcement of stay-home notices have reiterated the necessity of high quality broadband for consumers, which renders demand for higher speed tiers greater price inelasticity over time. This explains the dominance of Cable & Satellite industry groups among the top 10 names, alongside other benefactors of stay home demand such as Netflix. Kraft-Heinz also benefited from rising consumption of branded packed/frozen foods such as pasta, processed meats, and cheeses vis-à-vis restaurant dining during the lockdown. Drivers for the Wireless Telco sector were less virus-related; the sector performed largely following the approval of the Sprint/T-Mobile merger.

European High Yield

The European HY market has shown relatively wider differentiation in sector-level excess returns, we think in part due to the lack of explicit European Central Bank (ECB) support for European HY corporate credit, unlike that of the Federal Reserve’s intervention in US HY exchange-traded funds (ETFs) and Fallen Angels.

Figure 3: Sector-level relative performance of European HY

* Bubble size represents relative weight of the sector in the Index.
Source: Bloomberg, DBS

Table 2: Top 10 issuers among European HY “Leaders” in the BBB/BB segment (ex-US)

* DBS does not have a house view on some of these issuers
Source: Bloomberg, DBS

European HY “Leaders” driven by sectors akin to those in US HY. The sectors that have led both the US and European HY are synchronously the Communications, Consumer Staples, Materials, and Health Care sectors. This could be attributable to (a) similar drivers to sector preferences in US HY and (b) the same US issuers raising sizeable debt in EUR markets. Nonetheless we excluded US issuers from the top 10 list to ascertain the profile of the more region specific European issuers. Here the Telco industry features prominently, due to largely defensive characteristics of the business model, as well as its continued emphasis on deleveraging.

We excluded Financials from the “Leaders” category due to our specific preference for AT1s of the larger IG banks (please see “Credit: Reiterating the value in AT1s”, 3 Apr 2020), and consider that credit quality considerations are vital for exposure to Financials as growth in the region remains lacklustre.

Asia High Yield

The Asia HY market has vastly different performance characteristics compared to its Developed Markets counterparts in the US and Europe. This is largely due to the outsized 42% of the index comprising of issuers in the Real Estate industry. The laggard performance of the “Government” sector is attributable to the downgrade of Sri Lanka by Fitch and Moody’s in April and May this year, respectively, due to its stressed external liquidity position.

Figure 4: Sector-level relative performance of Asia HY

* Bubble size represents relative weight of the sector in the Index.
Source: Bloomberg, DBS

Table 3: Top 10 issuers among Asia HY “Leaders” in the BBB/BB segment

* DBS does not have a house view on some of these issuers
Source: Bloomberg, DBS

Asia HY “Leaders” driven by Real Estate, Consumer Discretionary, Utilities, and Communications sectors. We previously presented our preferences for the China Real Estate, Macau Gaming, and Indonesian Utilities among Asia HY names in the thick of the volatility March and April (please see “Credit: Unconventionally defensive opportunities “ on 9 Mar 2020 and “Credit: Evaluating credit risks amid a brief recovery” on 17 Apr 2020), and see the analysis above as validation that these remain the preferred sectors from a risk-reward perspective. China Real Estate in particular, saw contracted sales and prices remain resilient due to strong population inflow from relaxed hukou rules, declining mortgage rates, and rising land costs, demonstrating that domestic demand for property was deferred, and not destroyed by the lockdown.

To sum up commonalities, sectoral “Leaders” in the various markets have exhibited a strong ability to retain cashflows through the crisis and possess defensive balance sheets. We continue to advocate that investors stay engaged with HY credit, as the asset class will continue to benefit while rates remain persistently low. Sector “Leaders” in HY include Communications, Health Care, and Consumer Staples companies in the US and Europe; as well as Real Estate, Gaming, and Utilities sectors within the Asia HY market.

Nonetheless, regarding concerns of a viral second wave, the epicentre of the outbreak appears to be shifting towards LatAm with the region contributing to c.42% of new deaths globally (Figure 5). We continue to see Asia as the region better insulated, as a lower reservoir of the virus among the local population (Figure 6) significantly reduces the risk of a secondary breakout that would require the reinstatement of disruptive social restrictions that hamper economic recovery.

Figure 5: Epicentre of the outbreak has shifted to LatAm

Source: Bloomberg, DBS

Figure 6: Asia appears better insulated against a viral second wave

Source: ourworldindata.org, DBS

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