Jenna Barnard and John Pattullo, Co-Heads of Strategic Fixed Income, join Adam Hetts, Global Head of Portfolio Construction and Strategy, to discuss all things corporate bonds. Topics include philosophy, making the right calls during the COVID-19 crisis, chances for an aggressive recovery, the prospects of higher interest rates and whether 2021 offers a sweet spot for credit investing.

Tune in to Global Perspectives, a series where our investment leaders discuss the biggest market trends and implications for investors.

Key Takeaways

• COVID‑19 had a very different impact on credit markets than the last two economic downturns. This was a three-week market liquidity crisis, not a traditional solvency crisis with accompanying defaults. Markets remained open and willing to lend to COVID‑impacted names, albeit at a price.
• The crisis could be followed by a surprising recovery, with the potential for a sharp rebound by next spring or summer. In such a scenario, could 10-year government bond yields be on the rise?
• Recent vaccine and other market-friendly news, the market’s resilience, and signs that companies are seeking to reduce leverage and improve balance sheets support a positive outlook for credit as we move into 2021.

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Adam Hetts: Today on Global Perspectives, we welcome back fan favorites John Pattullo and Jenna Barnard. John and Jenna are Co‑Heads of Strategic Fixed Income here at Janus Henderson. The three of us had just recorded an episode together in August. If you haven’t listened to that, I suggest you check it out. But this year, the months are going by like dog years, so there’s plenty more to catch up on already. We’ll talk about the election, the vaccine, the surge and more. So, John and Jenna, welcome back.

Let’s start on something you’ve written about extensively, but I’ll call it a COVID confusion in credit markets. Specifically, when COVID hit, there was a ton of fear about a major solvency crisis in credit markets, and everything has mostly been OK after that initial shock. So, can you start by catching us up on how you’re looking at credit and with so much economic uncertainty still out there? Also, explain how it makes sense that the markets seem to be functioning so well.

Jenna Barnard: Yeah, well, I think the nature of this shock has had a very different impact on the credit markets than the last two economic downturns. And the way we’re thinking about it and explaining it, is that this was a liquidity crisis, but it wasn’t a solvency crisis for the credit market. And by that, we mean that there aren’t huge numbers of companies expected to go bust and default. We always felt that the default rate would be at a much lower level than we saw in ’08, ’09 or kind of 2001, 2002.

So, why do we think that? Firstly, there hasn’t been a kind of binge of bad lending in the high-yield market and actually credit markets overall have been relatively disciplined. So, credit is not the villain of the piece here, as it was in the past two cycles. It didn’t cause the downturn. It didn’t exacerbate the downturn.

And obviously, the policy response from governments and central banks has been incredible. And really, the only companies that are going bust are in the really obvious problem sectors, which is energy, you know, in the U.S. high-yield market, and traditional retail and high-yield default rate in Europe is running in kind of mid 3s [%]; in the U.S., outside of those two problem sectors, it’s 2.5% default for the high-yield market. I mean, this is nothing; this [would be a] kind of typical good year for defaults.

So, when did we kind of think about this as a liquidity rather than a solvency event? I think it’s kind of by the second week of April; that was becoming clear to us. And it was becoming clear because you just saw a whole host of COVID-impacted names issuing bonds; high-yield bonds, in particular. You saw cruise lines, airlines, aircraft manufacturers, cinemas. I mean, the market was wide open to provide liquidity to basically bridge these companies for 12 or 18 months, and that was the assumption the market was working with.

So, I think that, you know, companies have reasons to exist, that deliver for capital markets in good times or, you know, typical years. I think there was a huge willingness to provide liquidity to get companies through the crisis and stop them going bust. And that’s really been the theme of the last eight months. So, yes, I think you’ve got to diagnose it right. If you think about, it is a liquidity crisis rather than the solvency crisis, and avoid those few problem credits that the market won’t bridge.

And this has just been an idyllic environment for corporate bond investors since the fourth week of March. It’s been just an incredible opportunity to lock in, you know, decent yields from sensible companies. So, yeah, I think it’s the nature of the shock, you know, credits come out of it very well. Other asset classes like commercial property, obviously being disproportionately impacted. And, you know, it’s the same as the impact of COVID on the economy as a whole. You know, it’s not fair. It’s not equitable. Certain areas have been impacted much worse than others. And any asset class we invest in, it’s been quite an easy cycle and crisis to navigate.

Hetts: Yeah, easy in hindsight. I think it’s interesting, the distinction between liquidity and a solvency crisis, and you mentioned it was more clear it was a liquidity crisis by April. But at first, they have pretty similar symptoms and then maybe it’s different sectors. You mentioned energy and traditional retail, more of a longer‑term solvency issue there. But for the balance of the economy, it’s mostly just liquidity, which has been remedied by a lot of the stimulus and, in hindsight, a relatively benign credit environment. I’m curious, looking forward through this winter, whatever it holds with this surge or second wave, whatever you want to call it, what indicators are you two looking at to maybe get an earlier read on whether the liquidity type crises could actually go into a broader solvency type crisis?

Barnard: I mean, I think with the vaccine news, the chances of that are now minuscule. You know, if you’ve made it this far, then with the positive vaccine news, I think the markets will be even more willing to bridge you for the final six months until we get some sort of herd immunity through vaccine rollout over the summer. And actually, what we saw the day after the Pfizer news, was equity issuance from some of these leisure/travel names. So they actually used the, I think, the certainty or the light at the end of the tunnel that the vaccine gave, to issue equity and start deleveraging.

So I think actually it opens up more potential to repair balance sheets and actually for most companies, if you got this far, I don’t think it’s going to be difficult to navigate through the next six months. Difficult for society, in what’s going to be a very tough winter. But from a market perspective, I think the virus is kind of done and we’re living in a post‑COVID world in terms of markets.

John Pattullo: Yeah, I’d certainly agree there. I think it’s a virtuous circle; because unlike the Great Financial Crisis where the high-yield market was actually shut, where businesses couldn’t get refinanced, right through this crisis, as Jen said, you know, some of these stressed names could refinance and they used bonds, secured bonds, unsecured bonds, preference shares and convertibles and equity. But the market was open at a price. And actually, just to give you some math, I mean, Carnival Cruise Lines, who we all know, last October they issued 10-year bonds at 1% unsecured bonds, and they had to issue at nearly 11%, for I think it was three-year money, which [was] actually secured on their cruise ships.

But the point was they could get financing and they got financing and then AMC Cinemas got it and then someone else got financing. And then if you think about it, it’s just like, it’s virtuous because then the credit spreads come in, and then the next slightly more marginal credit can get financing and then they get financed, and default rate expectations fall, and then volatility falls, and then someone else gets refinanced and so on and so on, so on.

I think we’ve been through that spike, which is actually, massively encouraging. And if you remember, I think, we talked about the death zone, the mountaineering/engineering, last time, whereby you know, that last stretch of when you’re climbing Everest, the last stretch, you want to go up, but you’ve got to make sure you want to come down again as well. The yields were very high for a while but given the extraordinary monetary and fiscal stimulus by the authorities, credit spreads actually raced back in, especially in investment grade and high yield as well.

And hence, you know, the absolute cost of funding wasn’t actually that high. So, it all built remarkably well. The extent of the stimulus, we always sort of see it as a bit like, it’s a war on the virus, you know, and the fiscal response was a fiscal size response to this war, combined with a monetary response, I mean, just off the scale. But it was justified because, you know, we were fighting this war. It just happened to be a war on the virus.

So, yeah, we were pretty positive and constructive on credit going forwards. And, you know, we describe it as the sweet spot. It’s the right time to be in corporate bonds. As Jen said, some companies are raising equity and raising debt, but generally they want to de-lever. They’re not going on silly acquisition binges or misbehaving or buying back shares, you know, broadly trying to make their balance sheets more conservative within credit healing. And that’s a great time to be in corporate bonds.

Hetts: Yeah, I agree, there’s plenty of appetite for risk out there, it’s not just you two. I think after the U.S. election news came out, you have some visibility there. And then, like you mentioned, of course, the vaccine news is huge and it’s been sort of this rising tide that floats all boats, maybe even Carnival Cruise Lines, if you don’t mind that. So I’m curious where you still expect to see the dispersion then? I mean, I think people always talk about style for the equity managers, but it’s just as important for bond managers. So it’d be great to hear where your heads are at, even in this environment where there’s so much pro-risk appetite across the board, it seems. Like what are you looking at for security selection and asset allocation?

Pattullo: Yeah, sure, I’ll have a go at that. Because I think it’s quite important that we actually expect a lot less dispersion because you are right, a rising tide floats all boats. I mean, frankly, some bad businesses can get refinanced here. And, you know, Jenna and I think we’ve got to keep true to our style and our philosophy. We like to lend to quality businesses, which have got a reason to exist. They might have quite a bit of debt on their balance sheet, but they generate cash flow. You know, they look after their customers and their clients and they’re pretty focused on what they’re doing.

We tend to avoid the nasty, heavy cyclicals. [They] tend to destroy value – the shipping, the airlines, the steel, the energy and so on. And then you say, well, hang on, maybe you won’t have enough beta, if all the cyclicals rally back, would be the obvious question. And I think the point is everything tends to rally back. And that was true in 2008‑09. I remember one of our credit analyst was telling me what a great job he’d done because he’d picked a really hairy credit and it rallied back. But I remember looking at the universe and every single credit had rallied in that quarter.

Hetts: Yeah, that makes plenty of sense and definitely see the optimism on credit and think you mentioned sort of the sweet spot right now being in corporate bonds. And, I guess the flipside of that is, is this speaking from the portfolio consultations that my team is doing with our clients is, I think, that optimism on credit and taking a little bit more risk and the fixed income, has been the right trade this year; obviously, as you even called it, going back to March.

But the other side is that, credit is still credit and it’s not always the right tool for capital preservation and flight to quality in a strategy. And I think that’s where our, you know, financial adviser, wealth management clients are scratching their heads, because that flight to quality is usually the role of global sovereigns. So with rates this low and global sovereigns, where are you going for that high quality, flight to quality, sort of ‘sleep well’ portion of the allocation? Or is that still credit because you’re so optimistic on one directional returns there?

Barnard: Yeah, I think it’s important to just distinguish between the cyclical and the structural bear case for government bonds because the premise of the question that government bonds won’t hedge your portfolio and they’re no good as a diversifier, I would disagree with that structurally. You know, bond yields are drifting higher at the moment because the rate of change of economic data is accelerating or has accelerated. And obviously, we’ve had good vaccine news. But structurally, if government bonds… sorry, if there was a deflationary shock, another deflationary shock, there’s no reason why 10‑year government bond yields, even in the U.S., couldn’t go zero or negative, if the yield curve inverted.

There’s no reason that that wouldn’t happen, so I think in that kind of scenario, yeah government bonds will provide diversification within a portfolio and actually, obviously, the experience of low interest rate and low yield countries, even for 10‑year government bonds has been very good because you have the positive convexity with yields decline, duration increases, you can still make very decent money in low-yielding government bond markets.

So cyclically, John and I are cautious about duration. We have been since March, but would be very happy to go back into that if our, back into government bonds, if our outlook changed or, you know, we thought there was going to be some sort of major shock, negative shock.

So, we don’t think we’re at the end of the run for government bonds in terms of providing diversification or hedges, is just cyclically it’s tough sledding from here.

Pattullo: And there’s two things there as well, because we actually find, more [of] our American clients are actually more focused on the downside risk in the funds, and that’s something that Jenna and I have probably focused more on [in] the last five years than we probably did in the previous ten, to make sure that, sure, you know, if it’s a credit event, the credit book will sell off a bit.

And I guess, I mean, you could just say, well, in some ways, high yield which is actually quite a respectable asset class, is kind of like lower-beta equity. So, if I hold just high yield as bonds, I’m really getting half a bond and half an equity and that’s not going to be a hedge at all.

And then the final point on Jen’s sort of cyclical versus structural thing, is we are still of the view that we are living in a world of low growth and low inflation, in a secular stagnating economy. Currently, it’s kind of Slowly‑locks or even Goldilocks for corporate bond people. But we’re going into this reflation trade – which we’re in – post-election, post the vaccine news, which is fine, but come the spring or the summer even, you know, sovereign yields could be quite a lot higher here. And then some people, I think we spoke last time, they may be confusing a cyclical breakout of inflation due to bottlenecks in, you know, lumber and copper and various other things, might confuse that bottleneck inflation with a breakout in structural inflation. And, you know, as managers, we got to make sure that we and the market doesn’t confuse that with some sort of secular, you know, escape velocity, higher growth, higher inflation world, permanently, to which I think we remain fairly skeptical of.

We just have to manage the cyclical reflation, for a while. So I think there could be opportunities actually, Adam, going again in sovereigns; not today, but maybe next summer, they could be at higher yields and could offer protection, especially if, as you know, another shock or something coming along, you just don’t know. But we’re trying to remain really flexible and always looking at sort of cyclical versus structural view of the world.

Hetts: You mentioned that sovereign bonds aren’t dead as risk managers, even though rates are seemingly insanely low. It’s all relative and they could go lower. But the U.S. 10‑year [Treasury] at around, today, which is November 19th, around 85bp (basis points), besides the potential shock and the ability for rates to go even lower, what about the flipside? What do you two see as a potential range for a rise in rates in the U.S.?

Barnard: Well, I think in terms of how high interest rates and yields could go on government bonds. I think it’s the question to ask for next year because central banks are saying, you know, we’re not going to hike rates for, I don’t know, five years. Unemployment has to get back to the lows and inflation has to get above target, and then we’ll think about hiking rates. And there’s a lot of talk about scarring on the economy and the long‑term negative consequences of this crisis.

But the fact is, this is a unique crisis, it is an exogenous shock to the economy. It wasn’t caused by some endogenous problem. And governments have stepped in to bridge households and corporations, you know, to a huge extent. So, it’s quite possible that this recovery will be one of the fastest in living memory. It could be a very, very sharp recovery with people actually willing to spend, wanting to spend and having saved. So, I don’t, we don’t think anybody really knows when rates might rise. We know the barrier to raising rates is higher than in the past because central banks want to see actual inflation, not their consistently wrong forecast of inflation.

Yeah. So that’s, you know, that’s a given. But the shape of this recovery, I think, is the debate of 2021. There is the potential that this could be an incredibly aggressive and sharp rebound come spring/summertime. So the only, you know, central banker who is really talking about that is, I think, Andy Haldane, who’s the chief economist at the Bank of England. You know, the other central banks tend to bleat on about scarring and how long it will take to recover and things like that; the rates market is very much reflecting that consensus view from central banks.

But in the way that this year was the year of the credit market, next year could really put the central banks in play, who say that they’re not monetizing the government debt. Well, the test of that will come if we have a very strong recovery. Then they’ll have to prove that they’re independent. So, yeah, it’s interesting, I think it’s much more of a live debate and probably an earlier debate than perhaps the market’s pricing in.

And in that scenario, you know, 10‑year yields could easily rise back to where they were at the beginning of this year. So kind of mid ones [1%s], if anything, potentially could push to 2[%], but obviously, you know, it depends on the vaccine rollout and how quickly we can reach herd immunity. But I would just say that I don’t think central banks have got an edge really in judging that.

Hetts: OK, well, this has been a great update. And maybe the last question, it’s looking backwards now on this crazy year of 2020. Of course, back in March, you called the credit market outcome pretty well. But what has surprised you both the most about 2020?

Pattullo: Yeah, I mean, for me, I think it’s the policy response has been, frankly, fantastic and appropriate. And, you know, I guess it’s good to see the authorities working, the fiscal policy working with the monetary, I mean, it was just kind of crazy that we had a fiscal expansion in the [United] States, which the Fed [Federal Reserve] essentially had snuffed out by being too aggressive on the monetary side. So, I think that’s the first thing.

I think, you know, that’s hugely encouraging. And I guess they’ve done the right thing. Suppose the other surprise was how fast credit spreads just snapped back. It was, you know, the ratchet back, was almost more scary than when they sold off. So that was extraordinary as well. And, you know, I think last year, corporate bond spreads, are frankly now a policy tool of central banks, which I guess we’re not complaining, but it’s an unusual environment. I mean, it’s good for us as bond managers, but it just is what it is and we need to manage it as best we can for our clients.

I mean, it’s been an extraordinary year for all of us really. Everyone is pretty tired. I would hope for a slightly duller environment into next year. But as ever, as strategic bond managers, we just have to do our best for our clients, remain flexible in our thinking and take the opportunities when they’re there and when the opportunities aren’t there, just, you know, pare it back a bit and be a little bit more conservative. But certainly an extraordinary year Adam, I must say.

Barnard: Yeah, bonkers, absolutely bonkers. I mean, what’s the surprise? I mean, it’s impossible to answer, isn’t it? Just everything, even though, you know, the U.S. election, the lead-up to that and Trump getting COVID; Supreme Court. I’d say what the surprise is that the basic precepts that we use about this cycle worked even in this crisis.

So, John talks about like the death zone for credit spreads, once high-yield credit spreads get above nine hundred basis points [9%], you have to hold your nose and buy high yield. If you’re an investor and you’ve got a, you know, six- to 12-month timeline, it always works. Not very useful as a trader for the next month, but it always works as an investor.

And then the equity market did exactly what it has done in previous downturns, that when the rate of change of the economic data was at its worst – so jobless claims, week on week, were increasing at the fastest rate – once that peaked and started to slow down, the equity market bottomed, which was at the end of March, so I suppose, you know, the news flow was just overwhelming.

The emotion was overwhelming in March, but those basic precepts that we use served us very well, even in a really truncated, really aggressive economic and market downturn. And we just kind of clung to those and headed in. And that helped set the direction of travel, which was wonderful. So, yeah, I guess that would be, the surprise was that, you know, our trusty rules of thumb worked. Just the whole crisis was much faster than anything we’ve ever managed through on previous occasions.

Pattullo: Actually, one thing I might add is I think it’s important not to confuse Main Street with Wall Street. You know, we lend to massive large‑cap American or global businesses, which have defined capital structures. They’ve got access to the bond markets. They’ve got bank finance, they’ve got equity finance. You know, they’ve got bonds out there. You know, so many big companies now finance via the bond market, via the disintermediation of the credit markets, in the last 20 years.

That isn’t to be confused with, you know, the restaurant or the dry cleaners at the end of all our roads and our neighborhoods, which obviously are finding life very hard. I mean, they would probably even be lucky if they had a banking line. They don’t issue bonds, obviously. And I think, you know, sometimes people, I think, understandably confuse what we invest in with kind of what they see, you know, out in the economy. And, you know, we are only investing in the biggest companies, which issue bonds, obviously, and that’s very different from the businesses you see, if you just walk down your shopping mall or your high street or whatever, and hopefully that you just got to kind of put that in perspective because we completely understand there’s a lot of stress and strain out there with unemployment and businesses on their knees, we completely get that and we sympathize. But it’s just most of those businesses don’t have bonds out there for what we invest in.

Hetts: Yeah, well said, John and Jenna. Your answer about surprises, when I was phrasing that question and trying to think about surprises, I had forgotten about Trump getting COVID and the Supreme Court; it’s just so much to keep track of.

Barnard: That was, we were all living in a Netflix series at that point. Yeah, it was wild. Well, I think [Michel] Barnier, who’s doing the Brexit negotiations, this is the crucial week, he’s just got COVID-19 but he’s just come through as well, just in the final days of the Brexit standoff. That’s just, that’s another one.

Hetts: Thanks for all your comments. I always learn a lot and appreciate having you both on. And as always, for the listeners, the views of Janus Henderson’s investment teams and thought leaders are all freely available within the insights section of our websites. We look forward to bringing you more conversations in the near future.

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