Junk bond market tail risk and the companies to be hit hardest

During the first of our fortnightly portfolio and market updates, focussing on the investment implications of the spread of COVID-19, Jacob Mitchell explains that unlike the GFC, banks have approached the COVID-19 economic downturn with sound balance sheets. Much of the tail risk in the junk bond market now lies in institutional and retail balance sheets.

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Episode 1 Part 2 – Transcript:

Jacob Mitchell:

We think ultimately central banks will be forced to buy junk bonds and leveraged loans, and a lot of that risk – different to 2009 – the banks have generally gone into this with well capitalised balance sheets. 

A lot of the tail risk in the junk bond market really lies directly on institutional and retail balance sheets and that’s something the Fed will be very aware of. 

So why is that the case? Well when you look at the major participant in the leverage loan market, 65% of all leveraged loans are extended to private equity. As you know, private equity is typically an institutional asset class. We have been discussing just how much pressure many of the companies (outside of the large tech companies) that have experienced an expansion in margins, tend to dominate their sectors, putting disruptive pressure on many of the traditional incumbents. The yellow there on the left hand side of the chart (slide 5 – US Non-Financials EBITDA Margin) shows what has happened with margins even before COVID-19. Those margins outside of the tech sector in the US were already under pressure. 

Those companies have tended to buy back stock, they tend to be the companies that private equity own and their cash flows are already under pressure and now the recession that we’re looking at is going to put them under more pressure. 

So, when you look at the behaviour of markets, the initial response – investors have used the liquidity of the equity markets to basically fund losses in other parts of their portfolio. So, volatility in equities and correlation in equities has exploded. 

Equities are moving, increasingly they are moving in a highly correlated and volatile manner that’s the worst environment for investing. But the real pressure that we see has actually happened in credit. 

The cost of insuring a portfolio of junk bonds in the US – that cost has exploded by about 300 basis points. Now that really highlights that when you’re looking at tail risk protection the most important thing is to buy it when it’s cheap. You don’t know when these left-field events are going to happen. So when it’s cheap buy it, and in terms of our shorts, our credit protection in the portfolio has given us some downside protection through this period of extreme volatility. 

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29 March 2020
Antipodes