Outlook 2021: Expect boring start to junk secondary after turbulent year; returns to be negligible

By Abigail W. Adams

Portland, Me., Dec. 31 – Negligible returns, a narrow range for credit spreads, slowing downgrades, moderating defaults and a return to predictability are the expectations for the domestic high-yield secondary bond market in 2021.

As market players close the books on a historic year that holds the record for the quickest disintegration and snap-back recovery of risk assets, sources were in agreement the road ahead would be smoother with market conditions easier to predict and navigate.

While there are risks that may not be fully recognized or priced in yet, no source expects a repeat of 2020’s violent market swings.

Credit spreads are expected to stay in a narrow range around their current level, both in scenarios where they tighten and widen.

Returns will be negligible with optimistic and pessimistic forecasts both falling in the low single digits.

However, while the year ahead will be tough, there are still opportunities in the market, sources said.

And market players are bracing themselves for the race to find those pockets of opportunity.

A year to remember

Books are closing on a historic year for the domestic high-yield secondary market.

The list of records that were broken was long, said Oleg Melentyev, BofA credit strategist and co-author of the report “High Yield Strategy: 2021 – The Year Ahead.”

From the speed of the market sell-off and the disintegration of credit spreads, the amount of fallen angels, the extent of government intervention, the volume of new issuance, and the rapid recovery, 2020 “was an absolutely wild ride,” Melentyev said.

The market was tight heading into February with trade talks and interest rates the primary drivers of macro-related market volatility.

While there were signs of weakness in mid-February as the severity of the Covid-19 outbreak began to register, its toll on the economy took capital markets by surprise.

“Nobody saw it coming,” a source said.

The high-yield market was trading with a credit spread of 403 basis points on Jan. 31, according to BofA data.

By March 23, credit spreads had blown out to 1,087 bps with the entire high-yield market in distressed territory.

In the last week of February, the ICE BofAML US High Yield index turned negative.

The downgrades were fast and furious with the market averaging $125 billion per month March through June.

A record number of fallen angels entered the high-yield index – approximately $170 billion as of the end of November – including Ford Motor Co.

And then the Federal Reserve stepped in.

For the first time, the Federal Reserve became a purchaser of corporate bonds with the establishment of its Primary and Secondary Market Corporate Credit Facilities.

The facilities enabled the Federal Reserve to purchase high-yield ETFs and the individual bonds of fallen angels that lost their investment-grade status after March 22.

It was the inflection point for the market’s rebound.

“The Fed bid up the whole market,” a source said.

Credit spreads snapped back, hitting the 500 bps range by July.

The ICE BofAML US High Yield index returned to positive territory in August.

Issuers sold debt at record levels with pricing growing increasingly tighter.

Ball taps market

The high-yield market saw its first ever issue on a 2-handle with Ball Corp. pricing a $1.3 billion issue of 10-year senior notes at par to yield 2 7/8% (Ba1/BB+) on Aug. 10.

Despite the tight pricing, the majority of new paper traded up in the secondary space.

While volatility again reared its head in October amid earnings reports, pre-election stimulus negotiations, and the looming U.S. presidential election, the secondary space caught fire following the election results.

With a Biden administration in the White House and a divided congress one of the best-case scenarios for capital markets, investors stampeded back to risk assets, sources said.

The fire was accelerated by news of a Covid-19 vaccine. The secondary market roared into the final weeks of the year.

Credit spreads hit their tightest levels since February in December, closing out the Dec. 4 week at 410 bps.

However, the record-setting year did not produce record-setting returns.

The ICE BofAML US High Yield index posted a year-to-date return of 5.3% at market close Dec. 14.

While a significant improvement from the trough of 2020, it was meager in comparison to 2019’s double digit returns of more than 13%.

Returns are expected to remain spartan in the coming year with credit spreads range bound and few surprises on the horizon.

While returns will be meager, volatility will be low with the wild ride of 2020 coming to an end.

“We look forward to a more subtle, sane and hopefully even boring year in 2021,” Melentyev wrote in the BofA Global Research report.

The risks

The domestic high-yield secondary space is expected to wield few surprises in 2021.

With a Biden administration in the White House and a divided Congress, macro risk is low.

“We’re not going to see dramatic changes,” a market source said.

Higher interest rates are pegged as the No. 1 risk for the high-yield market heading into 2021, according to the BofA report.

“The market is putting an extremely low chance on interest rates jumping from all-time record low yields while taking on all-time record high interest rate risk,” the BofA Global Research report stated. “This is not a good combination.”

Low interest rates have caused investors to turn to the higher-rated credit tiers of junkbondland.

If Treasuries become more attractive, the scenario could reverse, causing rate sensitive names to crater.

Other sources pointed to the termination of the Federal Reserve’s secondary corporate market credit facility as a risk that will drag down the market.

Without the “Fed’s bid,” some sources saw a scenario where the market would lose some of its froth.

However, the secondary market corporate credit facility has not been an active purchaser of bonds, operating at only a fraction of its capacity.

The facilities were created with a capacity of $750 billion.

However, as of Nov. 30, only $13.6 billion of available funds had been used to purchase bonds, according to the Federal Reserve’s periodic report on its outstanding lending facilities.

The market was aware the facility was set to terminate on Dec. 31 and has already priced it in, a source said.

However, the impact of the credit facilities was psychological, and that psychological impact is expected to continue even after the facilities close.

The market now has the expectation that if something happens, “the Fed will not let this market fail,” a source said.

However, whether the level of support the market now expects will continue once the era of government-imposed shutdowns is over remains to be seen.

Investors are also starting to rethink leveraged loans, which has become a more attractive asset class heading into the final months of the year, a source said.

Issuers are starting to again migrate to leveraged loans as opposed to pricing secured debt.

If investors follow suit, the outflows from the high-yield market will weaken the space, a source said.

However, with returns expected to be in the low single digits in the year to come, any risks the market faces may end up providing opportunities for active investors.

The returns

The year ahead is expected to be uneventful with defaults low, credit spreads range bound, and returns negligible.

Some anticipate a widening of credit spreads from their current levels; others see a scenario where they continue to tighten.

However, the difference between the two estimates is narrow.

BofA analysts are predicting credit spreads in the range of 400 bps to 550 bps in 2021.

Returns are expected between 0.3% and 4.6%.

The default rate is expected to drop double digits in 2021 – to about 5% from its peak of 12% in the second half of 2020.

Recovery rates are also expected to increase, especially for unsecured debt.

With the pace of defaults expected to slow, the fundamentals of companies expected to improve and an accommodative Federal Reserve, others see a continued tightening of the market with credit spreads returning to the 300s.

Credit spreads are expected to tighten to the 350 bps to 375 bps range in 2021, according to the Barclays report “US High Yield: valuations to continue climbing despite constraints.”

Returns are estimated to fall between 3.5% to 4.5%, according to the report.

With Treasuries so unattractive, investors will continue to turn to BB and B credits “to pick up some juice,” which will continue to drive the market tighter, a source said.

The expected slow-down in the pace of new issuance will also support tighter spreads.

A large portion of the new paper expected in 2021 will be refis with companies taking out their current issues for new paper with tighter spreads.

The process will turn into a “vicious cycle,” that will keep the market grinding tighter, a source said.

Whether credit spreads tighten or widen from their current levels, sources were in agreement – returns will be negligible.

However, there are still pockets of opportunities in the market, sources said.

But it will be a race to find them.

The opportunities

With the high-yield secondary market tight and many expecting it to grind tighter, the hunt for yield will grow increasingly fierce.

“It’s going to be a real tight race,” a source said.

Cyclical sectors that have only begun to benefit from an economic recovery will be on the radar of market players zeroing in on the opportunities that still exist.

Small cap companies and media, transportation, gaming and autos are all areas that still provide good value, according to the BofA report.

Retail will also be one to watch, a source said.

“It’ll be interesting to see what happens,” a source said.

Will consumers return to brick-and-mortar retailers or will the migration into the digital space continue?

Outside of sectors, M&A activity may offer the best opportunities for gains with capital structures getting taken out at a premium.

There will also be a bump in the capital structures of junk bond issuers that turn to equity markets and price IPOs, a source said.

The IPO bump was recently seen in Golden Nugget Inc.’s capital structure.

More adventurous market players are already turning to CCC energy credits in an effort to boost returns.

“There’s a real yield grab in distressed energy right now,” a source said.

With a rebound in crude oil futures, energy names that were trading in the 30s at the height of the market sell-off a few short months ago were trading in the mid-70s in December.

The move in crude oil futures is encouraging.

However, the distressed energy space remains the most volatile and high-risk in the market.

While overall defaults are expected to moderate to 5%, defaults in the energy sector are expected to remain elevated at 11.3%, accounting for one-third of total defaults in the market, according to the BofA report.

While some market players are making a killing in the space, it is also the space where market players may get killed.

“When it gets frothy like this, it usually ends in tears,” a source said.

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