Amid buoyant markets, structural default risks rise

Q2 saw the largest quarterly rally in risky assets in over 20 years, as markets bounced hard off the widespread wreckage of March. The contrast between the Wall Street rebound and the Main Street economic pain is stark. However, markets are forward-looking and sensitive to new news, and on most indicators economies bottomed in April or perhaps early May and have been progressively lifting since. Medical containment of the virus in developed economies, hopes for a vaccine, the breadth and speed of the economic policy response, a sharper than expected rebound in economic activity from the low point, and underweight risk positioning all contributed to the market rally.

We have all learnt a lot very quickly – for example, how to socially isolate and work from home effectively. However, in deciding how to respond to the crisis, economic policymakers had the benefit of the GFC experience to guide them. Although the nature of the problem is different – this time it’s individuals and businesses facing loss of income through shutdowns that require support, as opposed to banks needing bailouts – the key lesson learnt was the need to act quickly and at scale.

Income support measures do appear to have been very effective in supporting household spending, and market support measures implemented by central banks have obviously allowed wealth levels to rebound after the initial shock. Having positioned our portfolios to capture this rebound (with hindsight, not as aggressively as we would have liked!), we have been surprised by its speed. However, a central question now relates to persistence: in the absence of a vaccine and with the high probability that ‘second waves’ of the virus will trigger at least renewed localised lockdowns, will policy support persist for long enough? Because without it, the fundamental picture is gloomy – unemployment is high, earnings are down, defaults are rising, and for many industries the damage won’t be repaired for years.

Default risk structural as well as cyclical

For fixed income investors, the likelihood of borrower default is high cyclically, but there’s also a chance it becomes high structurally. Short-term income support or repayment holidays for individuals, and credit facility and market liquidity support measures for corporates, removes some of the immediate risk. However, the underlying problem remains, to be addressed another day: serviceability of high debt levels. While over time the cost of debt has come down as base rates have dropped to almost zero, and more recently financing conditions have loosened a little, serviceability ultimately requires income. Pragmatically, policymakers appear keen to do whatever it takes to minimise business and job destruction; however, while this may allow companies to survive, it may leave them carrying high debt levels in a weakened income position for years.

There are many layers of uncertainty, over both short-term and long-term time horizons. In the short term, while visibility on both the medical and economic situation has improved dramatically via the capture and dissemination of real time data (for example, via Google’s mobility tracker), it’s hard to estimate whether there will be a more material re-escalation of the medical situation involving a return to widespread economic shutdown, and many companies are still withholding earnings guidance because of this uncertainty. We are closely monitoring the progression of the medical situation, the unfolding data, policy developments, and the response of corporates to their predicaments. Over longer time horizons, a key uncertainty is whether the pandemic triggers a more meaningful retreat from the globalised free-market model of capitalism to a more inward looking and interventionist version.

Our portfolio position

Back in March, with cash rates at zero and credit spreads at their widest, we identified that the best opportunity in fixed income was in credit. This was reinforced by the actions of central banks. By moving to control the yield curve, central banks limited the active opportunity in rates, while at the same time the provision of liquidity support and direct market purchases reduced downside potential in credit. As a result, we deallocated from government and quasi-government bonds and allocated to credit across a spectrum of assets. This meaningfully shifted our active risk away from rates and towards credit. It also appreciably improved the portfolio’s income-generating potential and arguably its diversification (at least with respect to the sovereign-dominated benchmark).

The recent sharp narrowing of credit spreads makes us more circumspect on the credit opportunity from here, as we question whether spreads now compensate for the COVID-19 induced deterioration in fundamentals as earnings decline, balance sheets become further stretched and ultimately some defaults materialise. For example, Australian bank and residential mortgage-backed securities (RMBS) spreads have retraced fully to pre-COVID-19 levels, yet the risks on their loan books are materially higher. As a result, we have trimmed our RMBS exposure, and within our Australian corporate allocation have been rotating from financials to industries which remain more fairly priced for the risk, including transport and utilities. More generally, we’ve been looking for opportunities to trim exposures in places that have recovered the most and to add them where better value remains. In our global exposures, for example, we’ve rotated from global high yield to Asian credit. The latter we think is better positioned (versus the US) with respect to the medical emergency, has a strong tailwind of likely further bank easing, and is more attractively priced. Overall our preference remains for Australian credit, though we are looking to diversify in areas that provide a different exposure to traditional developed market corporate exposure. The trimming and rotation has left our credit allocation at about 70% through its range.

In rates, our core view is that yields are likely to stay anchored at low levels, courtesy of both weak economies and ongoing dovish policy implementation by central bankers. We remain a little long duration in both Australia and the US, with a preference for 10 year over both shorter and longer tenors. While we think rates volatility, and hence opportunity, is likely to be low, we’re looking to maximise the opportunity by researching in detail the new demand–supply environment to identify opportunities between and along curves. More recently we’ve been encouraged by policy developments in Europe, including both the steps towards debt mutualisation with the Eurozone, and the commitment by Germany to (finally) expand fiscal policy meaningfully, and have taken small short duration positions there. We’re also mindful both of the reduced hedging ability of government bonds at lower yield levels, and of alternatives to our low yield, low volatility central outlook.

Overall, the portfolio is well positioned to both capture the opportunities and navigate the risks ahead, and to continue to provide low-risk income and diversification potential for broader portfolios.

Learn more about the Schroder Fixed Income Fund.