From liquidity crisis to solvency crisis
The worst of the health impacts may be behind us, but it seems likely that the full economic fallout from COVID-19 is yet to come. Now that rapid government intervention has overcome the immediate liquidity crunch, highly indebted corporates will need to find a pathway to deleveraging, while markets continue to under-price risk. Experience suggests that those who stay patient will be rewarded as default risks rise.
It would appear the worst of the health crisis is behind us, although the human toll has been and continues to be substantial. The growth rate of the virus globally has been slowing and the worst-case scenario and possible overwhelming of medical systems appear to have been averted.
Different countries are clearly at different stages. Those that locked down early appear to have had the most success in slowing the growth rate, while those who were late to the lockdown or had less stringent rules would appear to have been less successful. While the growth rate has slowed, the virus has not been eradicated and until a vaccine is delivered, it would appear to be an ever-present threat. New outbreaks are possible as social distancing rules are relaxed and people move back to some level of “normal” life.
Picking winners as default risks rise
While the picture around the health aspect of the crisis is somewhat clearer, the economic outlook remains clouded. The depth of the recession and its duration is uncertain. Predicting the shape of the recovery, be it a “V” “W” or a “Nike swoosh”, is difficult. The massive stimulus has provided a large sugar hit to the economy and the liquidity crisis that led to dislocations across credit rates and equity markets have been calmed, at least for now.
However, our concern is that we move from a liquidity crisis to a solvency crisis and that markets are under-pricing risk. Corporates went into this crisis with elevated levels of debt. Leverage was high as a result of an extended period of cheap and freely available debt funding, which meant that corporate balance sheets were susceptible to a change in circumstances. Leverage is not an issue when earnings and margins are elevated, however it quickly becomes a challenge when earnings reverse and, in some cases, go negative. The focus moves from the ability of a company to service its debts to the level of asset coverage that lenders have. Companies with insufficient asset coverage may not be able to roll existing debt or raise more capital and hence will begin on the path to default.
Injecting liquidity into the system does not remove the solvency issues, and in some cases may exacerbate them as companies take on more debt. Injecting liquidity does not pay down debt and repair balance sheets. Profit and cash flow are required for deleveraging to occur and, given the uncertainty around earnings, the process by which this will occur appears unclear. In short, there will be winners and losers. Companies that cannot generate enough cash flows will have to default. It is our job to avoid the losers and pick the winners.
The investment challenge
The investment challenge for income investors persists and if anything has become more complicated. Some Australian banks have deferred their dividends, which will further hit investors that rely on a dividend income stream. Combine this with cash rates close to zero as well as low government bond yields, and the ability to earn income is further challenged.
The temptation to move out along the risk curve is strong, which we believe remains a dangerous strategy at this point. While markets appear to have stabilised and credit risk premiums are higher, we do not think that we are in the clear and believe we are in for a challenging phase of markets going forward. Our experience during the global financial crisis (GFC) highlights to us the importance of being patient and finding value, particularly as we are still at a relatively early stage in this recession.
Our portfolio position
Our portfolio posture remains defensive and liquid. Cash remains elevated and despite its low level of yield it is capital stable and provides “option” value in that we can quickly and easily deploy cash and reposition the portfolio as opportunities present.
In credit markets, spreads have retraced some of the widening and given the outlook on earnings we are concerned that the market is failing to price in sufficient risks around the path of potential defaults and downgrades. In high yield, the challenges in the energy sector are at least partially priced, however outside energy they are still not yet at extreme levels as occurred in the GFC. The high yield market also has the potential challenge of having to absorb downgrades from the US investment grade market, which given the size differences could also cause digestion issues. We retain our short position.
The US investment grade credit market has also seen spreads retrace some of the widening and arguably is not pricing in ratings migration risk as the true extent of balance sheet damage becomes clear. The Fed stepping in to buy corporate bonds as part of its quantitative easing (QE) program to ensure the flow of funding to companies may be partially responsible for this return to a more orderly market. However, the market has not yet had a shock from defaults, and we think it may move to price this in the near term and push spreads wider. At this stage, we are holding our position.
The Australian investment grade credit market has also regained its composure and trading has become more orderly. The RBA has not included corporates as part of QE at this stage, however the broader response from the Government has been large and reasonably swift. We expect stress in the broader company landscape, though we view the corporate bond market as being sufficiently robust in terms of balance sheet strength to work through the difficult landscape ahead. We have retained our position after increasing its size last month.
The Australian hybrid market has steadied, and yields are off their highs as stress in the banking system is being addressed through capital raisings and deferring dividends. Hybrids are still reasonable value, although liquidity can be challenging.
Our exposure to AAA residential mortgage-backed securities (RMBS) as a source of high-quality yield continues to serve its purpose. Holding senior positions in the capital structure, these bankruptcy remote structures, in our view, currently have a very low risk of capital loss based on our punitive stress tests on the housing market. We have retained our position and at this stage are allowing it to amortise to a lower level.
We have retained our Emerging Market Debt Absolute Return exposures, which continue to provide both diversification and risk-managed exposure to emerging markets. We also retain our US securitised credit exposures which provide diversification from corporate credit. The pressures coming through this market appear to have eased, however we will continue to monitor the flow-through effect of the fiscal stimulus in the US.
On the currency side, our key positions are long USD and Yen versus the AUD. Over the month we did reduce our USD position by 1% to 5.25% in the portfolio and added a 2% position to the Yen. We believe the AUD can go lower on risk asset weakness, although a stabilisation in the environment could see the AUD move higher. As such we have altered the composition of the position.
Our duration position remains at 1.7 years. With the RBA entering into QE then arguably the short end of the curve remains somewhat tethered. We continue to see duration in Australia as less useful as either a source of yield or for risk management. As such, we are looking to reduce overall duration and position further out the curve where there is more potential for yield compression in risk-off phases. In the US, our duration position is also unchanged at month end, although we are also looking to position further out the US curve given higher yields and greater risk management capability.
Overall, we remain defensive, liquid and diversified. The active approach, broad opportunity set and our global capability provide us with the tools to access a diverse range of assets that will allow us to set up for the next phase of the cycle. As the balance between risk and reward continues to shift in favour of the buyers of risk premium, we will look to more constructively position the portfolio.
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