Counting the cost as risk premiums rise
The COVID-19 global health pandemic is inflicting substantial human cost and has resulted in a significant global economic shock. The situation is different to a normal cyclical recession, given it is the result of a rapid shutdown of many businesses and altered societal norms in an effort to combat the spread of the virus. This has directly led to a cratering of economic activity. The massive government stimulus packages are designed to prevent the private sector from irreparable damage so when the virus is sufficiently contained the shutdowns can be lifted and economic life can resume.
It seems clear to us a recession is unavoidable. The depth of the recession and the length of time for which it lasts is now the central focus. We are in an unprecedented environment which has seen a significant repricing of markets, as risk assets have sold off heavily and continue to experience large intra-day moves. Volatility remains elevated and arguably the worst of the health and economic news is still to come.
It is worth remembering that leading into the crisis there were tentative signs of a global reflation. Markets, however, were priced for perfection, with no room for error. Arguably, if it wasn’t the virus that was the catalyst for market repricing it would have been something else. At the time, low interest rates and compressed risk premiums made it challenging to generate reasonable levels of income. The search for yield pushed many investors further along the risk curve, into assets that have subsequently been shown to be high risk, highly correlated to equities and in many cases illiquid. Similarly, private assets which were witnessing strong demand and are typically less liquid are now slowly being repriced to reflect the changing environment.
Rebuilding risk premiums
This phase of a rebuilding of risk premiums is invariably painful. Even high-quality assets suffer at least some form of negative mark-to-market. The positive news, however, is that opportunities are emerging. While the term premium remains non-existent, credit and liquidity risk premium are building. High levels of yield are now available and, in some cases, have more than doubled from before the crisis. As such, the ability to deliver income going forward could in one sense, be easier. However, given the ongoing uncertainty and the range of potential outcomes, managing capital volatility is more challenging.
While the risk premium has been partially rebuilt, it remains unclear at this stage whether they have changed enough to compensate investors for current risks – particularly around defaults, which have yet to rise significantly. Global corporate updates continue to be dominated by the coronavirus outbreak. Companies continue to withdraw full-year guidance, draw down credit lines, cut costs, suspend capital return programs and (particularly in the case of retail) furlough workers. Buyback suspensions and dividend cuts are becoming the norm, which will assist credit investors but not resolve the stress and fragility of many corporates.
The impact on earnings is largely unknown. Some market commentators are reducing 2020 earnings estimates by 30%, which clearly has implications for the path of defaults and ratings migrations. In a way, governments have sought to flatten the curve for the corporate sector, as well as for the virus, using massive stimulus and intervention to help corporates manage the crisis and come out the other side, hopefully without entering bankruptcy. Banks continue to provide liquidity and financing to corporates, helping to contain the rate of defaults, at least for a time. It is essentially a corporate race against the clock to get the virus contained so the world can be reopened. At some point in time, though, defaults will rise as bankruptcies become unavoidable. Then we will see the winners and losers emerge.
Our portfolio position
So, what are the key positions in the portfolio? Firstly, cash remains elevated. We see cash as capital stable in a sense – and despite its low level of yield, it provides the option to quickly and easily deploy it to reposition the portfolio as opportunities present.
While we have seen a repricing in credit markets, given the outlook on earnings, we are concerned that spreads can go wider. In high yield, the challenges in the energy sector are well priced in with spreads over 19%, signalling imminent defaults as a result of the low oil price. However, outside energy, spreads are closer to 8% – cheap but not yet at the fire sale prices we saw in the global financial crisis (GFC), where spreads were double current levels. The high yield market also has the potential challenge of having to absorb downgrades from the US investment grade market, which could cause digestion issues. We retain our short position but will look to take profits on spread widening.
The US investment grade credit market has also repriced and looks better value, but again is not at fire sale prices , with ratings migration risk arguably not priced in. The Fed stepping in to buy corporate bonds as part of its quantitative easing (QE) program and ensure the flow of funding to companies may be partially responsible for this. That said, 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 been volatile as bid–offer spreads remain wide. The RBA has not included corporates as part of QE at this stage, which may be contributing to this dynamic. That said, valuations have improved, and we have added 2.5% exposure through lifting some of the credit default swap (CDX) protection we were carrying into the crisis. The response from the government has been large and reasonably swift, so while we expect stress in the broader company landscape, we believe the corporates we are exposed to have sufficient balance sheet strength to work through the difficult landscape ahead.
The Australian hybrid market is on many measures looking cheap. With yields up to 9% this market is pricing in significant stress in the banking system. We see this point of the capital structure to be reasonable value, although liquidity can be challenging. Also, our exposure to AAA RMBS as a source of high-quality yield continues to serve its purpose. The Australian Office of Financial Management (AOFM) is intervening in this market as it did in the GFC, providing stability and reducing volatility. Holding senior positions in the capital structure, these bankruptcy remote structures, in our view, have a very low risk of capital loss based on our punitive stress tests on the housing market.
We have retained our emerging market debt (EMD) 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. We have seen some pressure come through this market and will continue to monitor the flow-through effect of the fiscal stimulus in the US.
On the currency side, our key position remains long USD versus the AUD. Over the quarter we took profits and reduced our position by 2% to 6.25% in the portfolio. At the current level, we believe the AUD can go lower although the future path looks to be more symmetrical, in that a stabilisation in the environment could see it retrace some of its recent gains.
Our duration position remains at 1.7 years. With the RBA entering into QE, arguably the short end of the curve remains somewhat tethered. This is likely to also put downward pressure further out the interest rate curve. Overall, we 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 on the curve, where there is more potential for yield compression in risk-off phases. In the US, our duration position is also unchanged at quarter end, although we are looking to position further out along the US curve, given higher yields and greater risk management capability.
Overall, we have made some adjustments to portfolio positioning, but at this stage have not substantially altered what is a defensive, liquid and diversified portfolio. 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. The active approach, broad opportunity set and our global capability provide us with the tools to access a diverse range of assets, allowing us to position ourselves for the next phase of the cycle.
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