What's the state of play in bond markets?
How is it possible that government bonds have been selling off at the same time as riskier assets?
Part of the answer is that central bank reserves are held predominantly in government bonds. Right now, with many of them preparing large liquidity support lines, they have to liquidate bond holdings to realise the cash.
At a more fundamental level, consumption is falling fast, adding a demand shock to the existing supply shock due to the shut down of Chinese factories. If we think about retailers, most keep three months’ worth of operating cash flow on hand. If this crisis, and reduced consumption, lasts longer than that, many will be liable to go bankrupt.
Interest rate cuts are relatively ineffectual in addressing such challenges. So we have a large amount of fiscal spending in the pipeline and more direct, micro level measures to support companies, such as government loan guarantees, which allow companies to run big overdrafts.
Ultimately some of these overdrafts may have to be forgiven. These losses will go on to government balance sheets resulting in a large increase in national debt in many countries, perhaps as much as 5-10 percentage points. The increase in government yields is also a reflection of this.
These cross currents appear to explain why government yields have been rising at times when they would normally be going down.
Why was the Federal Reserve policy rate cut not well received?
In a normal economic cycle, cutting rates is the usual medicine for a negative shock, but current circumstances are far from normal. Cutting rates now achieves little other than providing liquidity to banks, which they already have plenty of. Banks are in good shape: well capitalised, good asset quality, less leverage and large liquidity coverage. So there is no impediment to lending. If we look at credit markets, spreads have widened a lot to price in a bigger risk premium and higher defaults, so the market is telling you that lower rates are not the answer.
Is there a risk of a solvency issue in the financials sector?
We think this is unlikely. Companies have started to call in credit lines, Boeing for instance has just drawn on $14 billion from its banks. This raises the prospect of a big drain on bank liquidity, but that’s why central banks will provide support. Banks are also in the best shape they have been for many years.
It’s more likely we see an issue with asset quality. There are $1.4 trillion of leveraged loans globally, mostly to private equity-sponsored companies. Some of these are highly levered, 5-7x ebitda, so any slowdown or stoppage in those businesses is very damaging to credit quality.
Are there opportunities emerging in fixed income?
Indiscriminate selling is resulting in some extreme pricing. There’s been a lot of selling of short dated bank bonds for instance, purely because this is a liquid part of the market, and there are instances of 1 or 2-year bonds in this area trading at 5-7% yields. That’s remarkable value and in fact these are some of the best assets to hold in these circumstances.
There is going to be a short and sharp recession. We think disruption will last 3-6 months after which we could start to see recovery. If that happens, you could argue the market does indeed appear broadly cheap now. But it is important to be selective and cautious. Especially if the recession lasts longer, then it won’t matter how cheap some companies are now, because they will ultimately be zero and for others recovery rates will be very low.
As we get more clarity on the extent of government support, we will be able to gain a better idea of where the greatest risks lie and where the best opportunities are.
Where is the best place to be in fixed income?
Governments aren’t going to default and it’s likely central banks will monetise government debt so short-dated government bonds will still provide capital preservation, but with low returns. There will be a temptation to load up on higher yielding bonds, but it requires a circumspect approach, and a focus on selection to separate the ongoing risks from the opportunities. Default rates are going higher and there will be downgrades from investment grade to high yield. Some companies will take the right actions to strengthen balance sheets, others will need to restructure.
The scale of the market re-pricing, even outside of the energy sector, means that opportunities have arisen. However, it would be difficult to say here and now that there is unequivocal value in the market as a whole, and investors should be wary of the “lazy carry” of passive exposure to the high yield market. The opportunities that have arisen are certainly best approached from the bottom-up.
How is securitised credit looking?
We remain of the view that the US consumer is in a better position than the corporate sector. Some sectors will become more vulnerable as unemployment goes up. If shops close, workers get furloughed or made redundant and incomes fall. That said, all the abuses of the mortgage market are gone and assets are of much better quality. We are still inclined to think this is a better place than the highly leveraged high yield energy sector.
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