The coronavirus is raging again. Whole states are at risk of closure, November payroll growth was anemic and solvency risk is bubbling back up. That stocks could rally amid such a backdrop should probably, by now, surprise nobody. That it’s happening on the back of firms with the worst balance sheets might.
Companies with shakier finances rallied 4.3% over the past five days, beating their sturdier counterparts for a fourth week, the longest streak in 13 months, data compiled by Goldman Sachs Group Inc. and Bloomberg show. Up 25% since the start of October, the weak-credit group is poised for its best quarter of relative performance since the last bull market began in 2009.
While the reasons are well known — progress on vaccines and stimulus — the trade remains laden with risk, as animal spirits roar back alongside deteriorating business fundamentals for virus-stricken firms like Delta Air Lines Inc. and Royal Caribbean Cruises Ltd. In the latest quarter, the number of junk-rated corporations borrowing in U.S. dollars that lost money before interest and other required expenses reached 47, according to a Bloomberg Intelligence analysis. That’s almost double the previous three months.
“Clearly, leverage pays off in upcycles,” said John Porter, head of equities at Mellon Investments. “It pays to trade down in quality if you’re right that there is going to be a rising tide.”
The resurgence is a turnaround from the early part of the year, when despite all the strength at the top of the market, shares of credit-impaired companies remained distantly behind. The cohort trailed the S&P 500 by 11 percentage points in the first six months after the bear-market trough on March 23. They were on top over the last five days, beating the index’s 1.7% gain.
As year-end approaches, with bankruptcy courts increasingly clogged, investors are pouring money into the market’s riskiest corners. They’re brushing aside insolvency risk and piling into zombies companies whose businesses are losing money even before servicing their debt. Their shares have surged 53% on average this quarter, about 10 times the S&P 500.
To be sure, gains aren’t confined to the stock market’s weakest links. On Friday, all four major indexes closed at record highs for the first time since January 2018. To David Sowerby, portfolio manager at Ancora Advisors, it’s not surprising that leveraged companies would lure investors at a time like now, since they’re the ones whose fortunes would improve fastest should a recovery take hold.
“It’s more the acknowledgment that the cyclicals which can be associated with an eventual re-emergence of the economy are faring better,” he said. “I’m still very cognizant of the balance sheet when I’m adding to cyclicals. I’m not abandoning the strength of the balance sheet, how much debt they have, how much free cash flow they are generating.”
Even so, the exuberance is on display across asset classes. In the corporate credit market, yields on junk-rated debt sank to a record low this week of just 4.45%. Within high-yield, the average yield on CCC rated securities — the bonds most at risk of default — dropped to the lowest level since September 2014.
“The bullishness is rampant,” said David Rosenberg, founder of Rosenberg Research & Associates Inc. “Life has been good for risk assets this year, once governments and central banks primed the pump like never before,” he added. “This is how asset bubbles are formed and we are in one now and could well be in one for years to come.”