Credit rally masks market fragility

As we move past the halfway point for the calendar year, it appears we may be at the beginning of a potential second wave of the COVID-19 virus. In the absence of a vaccine, flare-ups are expected, as attempts to supress the virus are ongoing. The World Health Organisation has recently warned the worst of the coronavirus pandemic is still to come.

The current flare-up appears worst in parts of the US. Some areas are taking steps to scale back reopening, with Arizona closing bars and New Jersey halting plans for indoor dining. Even Australia, which has arguably fared reasonably well, is also returning to selective lockdowns, with 10 postcodes in Victoria subject to severe restrictions. The situation remains fluid and uncertain.

While we may not return to the days of full lockdown, it is worth considering that coming out of lockdown is arguably more challenging than going in. The spike in cases may see a further delay in the return to some form of reopening and normal functioning in the economy. It remains unclear what the new normal looks like, and the degree of the true economic impact is to some extent masked by the large government stimulus packages which appear to be here to stay, at least in the short term.

Despite continued uncertainty around the health aspects of the pandemic, poor economic data and ongoing geopolitical issues, risk assets have enjoyed a strong liquidity-induced rally. The S&P 500 Index finished the quarter up 20% at 3,100, its biggest percentage quarterly gain since the fourth quarter of 1998. Global high yield credit spreads have almost halved from the peak and have tightened over 500 basis points. Meanwhile, sovereign bonds remain relatively subdued and largely range-bound, given widespread yield curve control cross many markets.

Credit market rally gathers speed

The rally in credit markets has been quick, with liquidity provided by central banks having buoyed risk assets. This is most prevalent in the US, where the Federal Reserve, among other initiatives, has been buying direct corporate bonds in the primary and secondary markets, and has also been actively buying bond ETFs. Some may argue that this is at least a partial nationalisation of some segments of the credit markets. The Fed appears to be a non-price-sensitive market participant, which stymies true price discovery.

Furthermore, the abundant liquidity has calmed investors, who seem to believe it will be positive on two counts. First, the primary market facilities mean the availability of financing for a range of corporates has improved, hence removing (at least partially) the risks of default that arise from an inability to roll debt as it matures. Second, the secondary markets facility has apparently seduced corporate bond holders into believing they can transact corporate bonds in an orderly market and meet redemptions or implement portfolio changes as and when they wish. This is a very different mindset to the early days of the pandemic, and is possibly overly optimistic.

Liquidity alone is not enough

Our central view remains that liquidity is important in flattening the default curve, but at the end of the day liquidity does not remove solvency risks. Higher operating and financial leverage for many corporates has made them vulnerable to even a mild shock. Clearly, we are in the middle of a significant shock as profits and cash flows fall precipitously for many companies and leverage is increasing. Abundant short-term liquidity and cheap costs of funding are delaying the default cycle, but in our view not removing the tail risk. In order to strengthen and repair balance sheets, companies need to generate revenues and cashflows to service debt. They can of course raise equity to deleverage, but not all will be able to do so or choose to do so. The key source of balance sheet repair is to generate cashflows to service and pay down debt, which is clearly challenging across many segments of the credit markets at present.

As such, we are concerned that credit markets are somewhat complacent, overpricing the positive effect of the liquidity injection and under-pricing the solvency risk and additional risk premium required to compensate for uncertainty. The challenge from a portfolio perspective is to balance the risks and rewards. The existence of abundant liquidity suggests that credit assets can continue to provide carry. However, we also believe that markets remain vulnerable to a shock and can still experience significant downside price moves. Hence we remain defensive and liquid.

Our portfolio position

Earlier in the quarter we were deploying cash into credit assets, given the extent of the spread widening. We allocated 5% from cash into investment grade credit – mainly into Australian investment grade, which had been slower to tighten and is shorter in tenor and higher in quality than other markets. We also reduced part of our short global high yield position, given the extent of the move. That said, we did not take a long position, as we believed the spread moves at the index level were largely driven by the significant widening in the energy sector, rather than a broader repricing.

We also adjusted the mix of our credit allocations. We trimmed our exposure to global corporate bonds, given the extent of the liquidity-induced rally that outstripped many other markets. We also trimmed our exposure to Australian higher yielding credit to take some profit on the partial retracement of spreads. In early June we allocated 2% into the Schroder ISF Asian Credit Opportunities Fund. The rationale is to improve diversification and access additional yield via the higher term structure in these markets.

We retain our emerging market debt absolute return exposures. This continues to provide risk-managed exposure to emerging markets and has performed relativity well in the crisis, given the focus on downside risk and managing portfolio volatility. We retain our US securitised credit exposures, which provide diversification from corporate credit. The holdings were biased to higher quality segments going into the crisis, and despite some pressures coming through this market, the allocation has fared reasonably well. The stimulus coming through to the consumer has assisted this segment, however we continue to monitor the flow-through effect on the US consumer. 

Our exposure to AAA-rated residential mortgage backed securities is a source of high-quality yield. Some stress is evident in the housing market, as shown by the number of borrowers in the hardship category; however, even with potential stress, these securities have held up well and continue to amortise in this low rate environment.

On the currency side, our key positions are long USD and Yen versus the AUD. We reduced our allocation to 3% from a high of 5.5% earlier in the year, which has partially insulated the portfolio from strength in the AUD versus the USD. The Yen position is stable at close to 2%. We believe the AUD could go lower from here on risk asset weakness, which supports its role as a downside risk hedge.

Our duration position remains moderate at 1.8 years. With central banks implementing various forms of yield curve control, we continue to see duration as less useful as either a source of yield or for risk management. That said, some duration is important and will benefit the portfolio should we get another downdraft in risk, or in the less likely event that the market starts to price in negative rates in Australia, the US or both.

Cash remains elevated at 22%, ensuring we maintain liquidity and can easily deploy more cash into opportunities as they arise.

Looking forward, we are conscious that risk assets have enjoyed a solid rally. The size and speed of the move leads us to be cautious, together with the fact that a challenging economic environment and fragile market are being masked by central bank liquidity. A major event – whether a significant corporate failure, geopolitical issues, the impending US election, or something else – could force the market to begin pricing in greater uncertainty. As such, we are aware of the potential downside risk and the importance of protecting capital, which is reflected in our portfolio positioning.