Having started the year with low yields and tight spreads, fixed income markets had the most brutal month I can recall in March and have been repriced in the most aggressive manner imaginable. The dust does appear to have settled and a more balanced market without ‘fire sale’ pressure has returned, so we thought it was worth recapping where we are today and sharing some thoughts for the journey ahead.
1. Firstly, we are now in a deep recession which will most likely last until the second quarter of 2021, but it could take quite a while after that until we return to the productivity levels of Q4 2019. Recession for bond investors typically means a sharp pick-up in the default rate and a huge bias towards downgrades over upgrades. We would not be surprised to see a 10% default rate in 2020, and would expect at least 10 downgrades for each upgrade. CCC rated bonds typically account for around 95% of defaults, with single B taking nearly all of the remainder, but given the nature and cause of this recession, we should also be mindful of some higher rated companies jumping to default before their downgrades happen. There will be a time to buy lower rated companies, but it is not yet, so we will be sticking with higher quality names for now.
2. Government bonds have done their job, but it’s questionable what their role will be in the future now that base rates have hit policymakers’ lower bounds and curves are so flat. With huge supply ahead to fund enormous fiscal expansion, along with the risk of inflation that this brings, we can see central banks’ next policy aim being yield curve targeting. It could well be the case that central banks own the long end while portfolio managers own the front end, as ‘risk-free’ bonds become return-free too.
3. Credit spreads ballooned out in March and have bounced back in early April to a more orderly level, but at still elevated yields reflecting the economic backdrop. The Crossover index, a commonly used hedge for fixed income participants, was at 210bp in February, peaked at over 700bp in March and now is trading at around 530bp. High yield indices have basically doubled in yield with GBP HY at 10.01%, USD HY at 9.84% and EUR HY at 6.80%, but again all off the peaks of two weeks ago. This seems justified. It is worth noting that on a risk-adjusted basis (allowing for ratings, maturity and currency basis differences), the US looks materially more expensive than both sterling and euros. This has been driven largely by liquidity as sterling and euros overshot more in March’s trading vacuum.
4. Bond funds saw their biggest ever monthly outflows in March, but these have since stabilised and the dash for cash – which created many of the distortions in March – has for now at least become more balanced. We have the beginning of a more normal, albeit recessionary, market order.
5. New issue markets were frozen for much of March but have reopened with huge amounts of investment grade issuance in particular. New issues are rightly coming with substantial new issue premiums to attract buyers to part with their expensively hoarded cash. The lack of liquidity in secondary markets means new issues can be a good source of liquidity, and investors can affect portfolio change by taking part. Most deals have performed very well.
6. We expect credit markets will lead the recovery (leaving equities behind), as investors will have a lot more confidence about solvency and coupon stability than the future of dividend payments and corporate earnings streams as the second order effects of the virus and the economic shutdown are felt. Investors switching to equity based on the price drop there does not make sense to us.
7. Visability on credit metrics has perhaps never been more difficult, so we believe it’s important to focus on the most stable revenue streams possible.
8. A lot of bad news was priced into bond markets very quickly during the sell-off, with prices moving quicker than investors could trade, materially quicker than rating agencies could downgrade, and of course much quicker than companies could respond. Consequently we should expect the bad news flow to continue, but also reflect on what is already priced in, which is a lot. Because we anticipate further volatility, investors should not be expecting a straight line recovery in spreads, even for what they view as the strongest credits. However, the income from these bonds can still generate attractive returns, even in the absence of a recovery, so locking in higher yields that will protect against more volatility should prove a good strategy in the medium term.
9. When markets were priced almost to perfection earlier this year, there were very few anomalies or special situations for investors to dig into as firms had plenty of time and capital to iron them out. Today’s market is the polar opposite; investors have had their hands full with much bigger problems and dealers have developed lower risk appetite amid such high volatility. In my view one of the very few positives, apart from cheaper valuations, is that today’s market does have a lot of opportunities for all different risk appetites.
10. This is stating the obvious, but the type of portfolio for today’s market is different from the one that we entered 2020 in. Change will be essential to navigate the rest of 2020.
