How Does the Current Market Volatility Compare to Past Periods of Stress in 2011, 2015/2016, and Q4 2018?

High yield spreads in the current market environment have widened more quickly than the previous three environments. Broad high yield spreads have widened about 370 bps from 380 to 749 bps in just over two weeks. In 2011, it took five months (April to September 2011) for spreads to widen from ~450 to 750 bps; eight months for spreads to widen out from 450 to 750 bps in 2015/2016 (May 2015 to January 2016). In 2018 Q4, spreads leveled off at approximately 534 bps.1

Overall, the market environment is most reminiscent of 2015/2016 in that the energy sector (and other coronavirus impacted bonds) has experienced extreme weakness, while non-energy bonds have performed relatively better.

Unlike 2011, 2015/2016 or 4Q 2018, this sell off has more unknowns. The sudden stop of economic activity in China, combined with a potential sharp slowdown in world activity as a whole makes judging likelihoods more difficult.

Overall, the market remains relatively orderly. We do not see much in forced selling in the market and have seen buyers for the higher quality segment of the market from long-term strategic institutional investors.

Do You See Material Financial Stress/Dislocations Outside of the Energy Sector?

We do not see material financial distress outside of the Energy sector and select names in more cyclical or tourism related sectors such as airlines, transportation (shipping, cruise lines), leisure/casinos, and autos.

Since the beginning of the selloff on February 21 through March 12, Energy has been a significant underperformer in relation to all other sectors as seen in Figure 1 below.

Outside of Energy, select airline names are down $15 to 20 during this period and certain shipping, cruise lines and casinos down $25 to 30.

Spreads on the ICE BofA US High Yield Index ended at 749 bps on March 12, which implies a default rate of approximately 7% for the market. Spreads ex-Energy at 649 bps, implies a default rate for the rest of the market at 5% (assuming a 40% recovery rate).

Although the probability of defaults and out-of-bankruptcy restructurings within the Energy sector and other select idiosyncratic credits is now higher, a market default rate of 7% would imply that about half of all CCCs will default. With Energy spreads at approximately 1,700 bps, this implies an energy default rate of close to 25%.

We believe that actual default rates will be lower given that

- the US economy is faring better than the rest of the world and

- the bulk of the US high yield market is domestically focused, with the biggest issuers in the market generating revenue in the US

- BB-rated companies now make up 47% of the market, up from 36% at the end of 2008 (% par value) 2

Do You Expect an Increase in Fallen Angels Entering the Market?

Outside of Energy, we do not anticipate a general trend of downgrades/fallen angels to the US high yield market. Most BBB issuers have the underlying strength and financial flexibility. If faced with a potential speculative grade credit rating, most BBB issuers could focus on deleveraging.

Should major exploration and petroleum investment grade companies be downgraded to high yield we would estimate the amount to be approximately $55 bn or 4% of the overall high yield market.

We expect downgrades/fallen angels this year to be more company specific.

So far this year, only $34 bn of debt has been downgraded to the US High Yield market according to BofA (or just over 2.5% of the total market). The new supply has been welcomed as issuance this year has been mainly for refinancing purposes and we continue to see demand for high quality high yield bonds from global investors.

The high yield market has significant capacity for growth. Despite strong demand for credit in general, the size of the high yield market has essentially remained flat since 2013 (by contrast, the investment grade and leveraged loan markets have grown over 40% and 50%, respectively).3

Generally, the trend has been more rising stars (bonds upgraded from high yield to investment grade) over the past few years. Since 2017, $148 bn of bonds have been upgraded to investment grade compared to $117 bn of fallen angels. Note, of the $117 bn, volume has been concentrated to two issuers: Kraft Heinz ($25 bn) and Teva Pharmaceuticals ($19 bn).4

1 ICE BofA US High Yield Index

2 Source: ICE BofA US High Yield Index

3 Source: Bank of America and JP Morgan

4 Source: Bank of America. Issuers cited do not represent portfolio positions of MacKay Shields, nor does the firm express any views, positive or negative, on such issuers.

ICE BOFA US HIGH YIELD INDEX The ICE BofA US High Yield Index tracks the performance of U.S. dollar denominated below investment grade corporate debt publicly issued in the U.S. domestic market. Qualifying securities must have a below investment grade rating (based on an average of Moody’s, S&P and Fitch) and an investment grade rated country of risk (based on an average of Moody’s, S&P and Fitch foreign currency long term sovereign debt ratings). In addition, qualifying securities must have at least one year remaining term to final maturity, a fixed coupon schedule and a minimum amount outstanding of $100 million. Original issue zero coupon bonds, "global" securities (debt issued simultaneously in the eurobond and U. S. domestic bond markets), 144a securities and pay-in-kind securities, including toggle notes, qualify for inclusion in the Index. Callable perpetual securities qualify provided they are at least one year from the first call date. Fixed-to-floating rate securities also qualify provided they are callable within the fixed rate period and are at least one year from the last call prior to the date the bond transitions from a fixed to a floating rate security. DRD-eligible and defaulted securities are excluded from the Index. Source: ICE BofA, used with permission. ICE BOFA IS LICENSING THE ICE BOFA INDICES AND RELATED DATA "AS IS," MAKES NO WARRANTIES REGARDING SAME, DOES NOT GUARANTEE THE SUITABILITY, QUALITY, ACCURACY, TIMELINESS, AND/OR COMPLETENESS OF THE ICE BOFA INDICES OR DATA INCLUDED IN, RELATED TO, OR DERIVED THEREFROM, ASSUMES NO LIABILITY IN CONNNECTION WITH THEIR USE, AND DOES NOT SPONSOR, ENDORSE, OR RECOMMEND MACKAY SHIELDS LLC, OR ANY OF ITS PRODUCTS OR SERVICES.