Somehow the word “unprecedented” just doesn’t seem to cut it anymore when describing the economic devastation and financial market pain being wrought by the coronavirus. In the short span of a few weeks, the Fed has gone from trying to cushion an economic slowdown with a 50 basis points cut to reintroducing nearly all of the alphabet-soup of programs used during the financial crisis, including quantitative easing. And yet, for all the Fed’s support it has seemingly not been enough to improve fixed income liquidity, alleviate dollar funding pressure, or reduce volatility in the markets that are supposed to be the most stable. Throughout the week, the Fed has needed to repeatedly increase the size of their daily purchases of Treasuries and expand their lending of dollars to foreign central banks. Only on Friday, does it appear that these measures are beginning to really have an effect, but it could be too soon to say. Unfortunately, it is difficult to imagine that anything the Fed is doing will really improve risk-taking sentiment until the news around the virus improves.
In the meantime, investment grade credit markets have become highly dysfunctional. Market makers are extremely hesitant to take risk given the extreme volatility, ongoing client selling to meet redemptions, and the simultaneous surge in issuance by highly rated companies. To be frank, it seems unfair to blame dealers for not using their balance sheet when high-quality companies use any temporary stability in the equity market to issue corporate bonds at levels 50-100 basis points wide to existing bonds. It’s also seems unfair to blame companies like UPS, Disney, Verizon, CocaCola, Pepsi, Northrup Grumman, and other high-quality bellwethers for wanting to increase liquidity even at seemingly punitive levels given the uncertainty around the virus. Nevertheless, the issuance-repricing dynamic has weighed on secondary liquidity to such an extent that bid-offer for IG long bonds can be 5 points or more.
The one-way nature of the selloff in credit markets has been unprecedented, even relative to 2008/09. The speed of spread widening has simply been ferocious. Indeed, the spread widening seen over the past two weeks in the IG and HY markets has occurred at a pace that is roughly 6-10 times quicker than anything seen before. In other words, it’s only taken 5-10 days for credit spreads to widen to levels that took 60 days in 2005, 2007, 2008 and 2018. This is likely reflective of the unique nature of the Covid-19 shock to the global economy and the rush to source liquidity as some businesses effectively shut down for an unknown period of time. In addition, it is likely that some of the market moves have been exacerbated by the unwinding of certain strategies. Risk-parity strategies have not been faring well during the past two weeks with equities declining and Treasury yields sometime rising in a very uncorrelated way. We believe many of the funds following these strategies are being forced to delever and that some of their sales are in credit product.
From a technical perspective, an encouraging sign is that foreigners (particularly Asia) have been buyers of credit over the past week in reasonably large size. If dollar funding conditions continue to improve as the Fed’s various programs work their way through the global economy, it is likely these investors will continue to invest in U.S. fixed income as the amount of sovereign debt trading with negative yields is once again at a peak. However, these buyers are not so large that they can offset the outflows coming from mutual funds and ETFs. According to Lipper, investment grade funds experienced an outflow of roughly $35 billion for the Wednesday-to-Wednesday period ending on March 18. That is a massive number and roughly 5 times larger than the previous largest outflow, which occurred the week before. If mutual fund outflows continue at a similar pace, no amount of foreign buying is likely able to stabilize the credit markets.
Beyond these technical considerations, credit investors will be closely watching the progress of the proposed $1-plus trillion fiscal stimulus package in Congress over the weekend. Market volatility and the speed with which small businesses are shuttering seems to have focused minds in Washington DC and a deal is now expected by the end of Monday. Yet the ultimate size is still a question and as more States and local governments institute shelter-in-place instructions, it is likely that the stimulus package will need to grow well beyond $1 trillion. Partisan politics could yet lead to disappointment. We are also watching closely for any signs that the Fed is looking to address the dislocations in the credit markets. The Fed would need Congressional authority to follow the ECB’s lead and buy corporate debt. It is difficult to handicap the odds that Congress will grant that authority or that the Fed will ask for it, but it is possible that the Fed launches another financial-crisis era facility extending leverage to investors that want to buy distressed assets—i.e. TALF, the troubled asset lending facility.
Regardless of the size of the fiscal stimulus package or new actions taken by the Fed, credit markets will likely stay volatile until the virus appears contained. That being said, we believe at current valuations the investment grade credit markets look attractive over a 6-12-month horizon. As such, we have increased our short-term and long-term score for investment grade credit to +1 (on our -3 to +3 scale). The performance of the long duration strategies continues to be reasonable, but admittedly difficult to calculate precisely given how poorly the benchmark index is being marked and the fact that only select liquid bonds are being traded by market makers. With the change in our short-term and long-term outlook scores, we began adding risk to the portfolios on Tuesday, March 17, primarily through new issuance from A-rated companies. We continue to look for opportunities to take advantage of the volatility and position our client’s portfolios to outperform as the economy recovers.
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