Following a near-ideal year for asset returns across the fixed income spectrum in 2019, we entered 2020 with expectations of substantially lower, but positive beta returns. But as the coronavirus took hold and benign economic expectations gave way to severe disruptions, the market experienced tremendous volatility in the first half, initially to the downside and then followed by a sharp rebound.
March saw an unprecedented downturn in credit markets as the Covid-19 outbreak intensified in the US and Europe. Spreads widened dramatically across fixed income asset classes as governments imposed extreme containment measures and shut down nonessential businesses.
Central banks responded with dramatic steps to combat the economic and liquidity shocks, with massive government-sponsored fiscal stimulus on its heels. The Federal Reserve cut rates 150 basis points (bps) in two moves in March, bringing the federal funds target range to 0%-0.25%. More importantly, it also rolled out numerous initiatives to restore liquidity to financial markets, including the investment grade (IG) credit markets and even the high yield (HY) universe. On top of these actions, the Fed stated it “will continue to use its full range of tools to support the flow of credit to households and businesses.”
The “fast and furious” central bank and fiscal actions halted the dramatic March downturn in credit markets and were sufficient to renew liquidity and investor confidence. They established the foundation for the ongoing credit market recovery as various markets enter the reopening phase of economic activity. The result has been a move from liquidity-focused markets driven by panic and systemic risk concerns to more rational conditions, with investors once again focusing on fundamental risk scenarios. Spreads across most fixed income asset classes tightened rapidly in the second quarter, and may settle into a trading range for the remainder of the year in which subsequent movements are more gradual, reflecting shifts in fundamental economic and earnings expectations. But the overall technical trend is expected to be toward tighter spreads in the second half of the year and into 2021 as markets normalize.
A few key actions have driven recent performance. For corporate credit, the Fed’s 23 March decision to include investment grade corporate bonds in its asset purchases eliminated fears of downside systemic tail risk and encouraged buying back into assets perceived to be oversold. And on 9 April, the Fed expanded its bond buying program to include fallen angels as well as high-yield exchange-traded funds (ETFs), with an aim to ensure credit markets are able to support businesses that are otherwise fundamentally sound.
The immediate impact was a deluge of new issuance by investment grade corporates as they sought to bolster their liquidity positions to weather plunging economic conditions. Despite the massive volatility, March saw record-high IG issuance that continued into another record in April, along with a surge in issuance of HY bonds, though substantially in senior-secured format. The European Central Bank (ECB) also announced that it would begin purchasing fallen angels, likely with an aim to support Italian government bonds, which may face downgrades. However, it may include corporates as well. The deluge of supply temporarily abated the spread tightening in May, but when new-issue supply slows down, spreads will grind tighter, as markets are forward-looking and sentiment is shifting decidedly more positive.
Looking at longer-term implications for fixed income assets, even with a strong economic recovery, we’re likely facing a period of ultra-low, near-zero interest rates for several years. This means we could expect:
Steepening of the yield curve. This has already started to play out in recent weeks, and overall rates will likely remain at extremely low absolute levels for three to five years.
Ballooning central bank balance sheets. In March, the G7 purchased $1.7 trillion of assets, and the expected pace of purchases would expand central bank balance sheets by $10 trillion over the next 12 months. With massive US debt-to-GDP ratios projected to hit WWII levels, as well as rising deficits across many parts of the world, government debt loads will weigh on future fiscal flexibility. And this overhang doesn’t consider municipal budgets at local levels, which could result in severe challenges.
This raises the downside risk of a future stagflation-type recessionary scenario (though our base case is for low growth and low inflation) with long-lasting imbalances. But combined with ultra-low interest rates, in a trend that appears particularly acute in Europe and in Japan, the outlook for longer-term fixed income and government bond returns may become much less appealing.
While investor confidence has improved, risk concerns remain elevated amid record unemployment, uncertainty over the strength of an economic rebound, deteriorating US-China relations, and political risks emanating from the US presidential election, the broadening movement against racial injustice, Brexit concerns, and a fracturing of the European Union over recovery stimulus funds. Yet such setbacks are likely to delay the timeline and pace of eventual recovery, rather than imperiling it. Against this backdrop, we believe a cautious approach remains prudent at prevailing spread levels, though we continue to look for selective risk opportunities that have lagged the recovery.
We see such opportunities in emerging market (EM) debt, where valuations remain attractive, especially when considering the resilient fundamental picture and technicals that have improved on a reversal of outflows and the reopening of the new-issue market. Given our expectation that fallen angel risk will be relatively well contained this year and driven primarily by sovereign risk (rather than systemic deterioration of credit metrics), we see an attractive opportunity to add exposure within the EM investment grade corporate market.
While we find both high yield and bank loan markets attractive on an intermediate-term basis, we continue to marginally prefer high yield, which stands to benefit from more favorable technical demand due to retail inflows, direct Fed support, and fallen-angel issuers entering the market and trading at attractive levels; loan demand is challenged by retail outflows and reduction in new collateralized loan obligation (CLO) formation. With increased dispersion, we are seeing idiosyncratic security selection opportunities.
In investment grade credit, we see a greater probability for fairly positive return outcomes over the next six months, given central bank support. We favor the US over Europe; buying demand is likely stronger in the US, and more importantly, we think the US is better positioned for the economic recovery when it comes. Moreover, hedging costs are coming down for foreign buyers of US credit, which will create technical demand for US investments. Explicit support for fallen angels has provided a liquidity backstop and made it easier for lower-rated credits to access the market.
We are more cautious on certain segments, such as commercial real estate and mortgage-backed securities. We believe spreads should continue to grind in slowly given Fed intervention, and while the ruling about forbearance resolutions was welcomed by the market, it could be overutilized by borrowers if the economy experiences a second wave of shutdowns.
All told, while being mindful of ongoing areas of caution and the potential for further setbacks in economies and markets, we continue to seek attractive opportunities to add risk as investors regain confidence and markets begin to look forward. However, the rebound is decidedly migrating from beta opportunities to alpha opportunities.
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As of 31 March 2020