Most of the global bond market sold off sharply in the first quarter as the coronavirus crisis emerged and intensified. Economic activity halted across much of the world. Credit spreads—yields relative to comparable-maturity government bond yields—ballooned to historical wides at a record pace. And even developed-market government bonds suffered from choked liquidity.
As many investors recall from the Great Recession more than a decade ago, indiscriminate selloffs can generate big potential rewards. Today, nearly every fixed-income sector presents such opportunities, albeit in the context of continued volatility over the near term.
But that doesn’t mean our expectations for every sector are uniform. Below, we provide our outlooks for the major bond sectors globally, beginning with an assessment of a condition plaguing all of them: illiquidity.
Policymakers Pull Out All the Stops
Liquidity seized up in March when markets quickly repriced to reflect a significantly darkened economic scenario and uncertainty about how deep and long the coronavirus-induced recession might be. Many sellers came to market, but they found few buyers willing to hold more risk than they already had on their books. Dealer banks that had acted in the past as market makers, stepping in to buy or sell as needed, no longer play the role of buyer in the years since the Global Financial Crisis.
Without this traditional backstop, prices tumbled and the price of liquidity soared. Deleveraging and forced sales worsened the collapse and accelerated the liquidity spiral. As a result, many investors who sold assets in March paid a great deal to do so. Meanwhile, investors also paid a premium to buy the most liquid securities on the market—US Treasury bills. T-bill yields dipped into negative territory in late March as the flight to liquidity accelerated.
In response to the economic shutdown and resulting liquidity challenges, policymakers have rolled out unprecedented fiscal and monetary support globally. Central banks worldwide dusted off nearly every available tool to restore liquidity to markets and support economic growth. The US Federal Reserve cut rates to zero, resumed quantitative easing and launched numerous facilities to ensure that the plumbing of the financial system will work properly again. Other central banks have taken similar actions to support the flow of credit and the normal functioning of markets.
On the fiscal side, action has been swifter and more robust than in 2009. From China to Spain to the US, governments around the world have rolled out massive fiscal aid to keep their economies afloat. While fiscal packages can’t restart the economy before the public health situation eases, they will make it much easier to restart the economy down the road.
It’s early days yet to know whether this flood of stimulus is working. The picture is mixed. On the one hand is an encouraging surge in new issuance. US$100 billion of US investment-grade corporate issues were priced in the market in the last week of March, possibly heralding the return of buyers to the market at these attractive levels.
On the other hand, liquidity remains constrained, albeit mildly improved versus weeks ago. And bid-ask spreads are still very elevated across global bond markets, even for government bonds. On March 31, the bid-ask spread on the 10-year US Treasury was about three times pre-crisis levels.
Most importantly, most countries have not yet seen a peak in COVID-19 cases. Until the pandemic is under control, uncertainty, volatility and trading challenges will persist. Under these conditions, liquidity management remains imperative.
Corporate Bonds: Fallen Angels, Expected Defaults and Compelling Yields
Indiscriminate repricing of the corporate bond market reflects major economic uncertainty as the world slides abruptly into recession. The longer the economic shutdown persists, the deeper and more lasting the damage. We’re likely to see this take the form of a spike in downgrades and defaults.
We currently expect a sharp economic contraction in the first half of 2020 to be followed by a moderate rebound in the second half. In this scenario, the global economy would return to its previous trend rate of growth—thanks to the massive stimulus efforts noted above—but at a lower level than would otherwise be the case.
Even so, the result would be a meaningful increase in the number of fallen angels—securities downgraded from BBB, the lowest tier of the investment-grade market, to below investment-grade ratings.
Not surprisingly, the sectors most at risk for a blizzard of fallen angels are those most negatively affected by the coronavirus pandemic and lower oil prices, as well as issuers who had levered up for mergers and acquisitions. Sectors at risk include consumer cyclicals (autos, gaming, home construction and retail), consumer noncyclicals (primarily leveraged food & beverage credits) and energy.
The 8.5% share of the market that we expect to be downgraded below investment grade over the next three years is similar to the share we saw similarly downgraded following the recession of 2002–2003 (10%) and the Great Recession (8%). However, because the investment-grade corporate market is now about four times bigger than it was in 2008, the value of downgraded debt will be far larger than in prior crises.
For investors who can hold below-investment-grade debt, fallen angels can present buying opportunities because their prices tend to bounce back quickly after downgrade, as the securities find new buyers among high-yield investors.
But what is the impact on the high-yield market of a slew of fallen angels? Historically, the surge in supply in a comparatively small market at first creates technical pressure. But over time, the high-yield market digests the volume.
Today, global high-yield spreads are more than 10%—well above their long-term averages of about 5.5%. In fact, on a risk-adjusted basis, high-yield underperformed equities in the first quarter. Typically, high-yield drawdowns measure about half as much as equity drawdowns; but year to date, high yield fell about two-thirds as much as stocks.
At these levels, high-yield corporates appear to be attractively priced, but it’s important to be aware of the much higher potential for defaults today than just three months ago. We’re expecting a spike in defaults of around 8%–12%, depending on the length and depth of the downturn. Ample yields already compensate investors for significantly higher defaults ahead. And remember, a high-yield portfolio’s starting yield has been an excellent proxy for return over the next five years.
The takeaways for credit investors?
First, it may be time to begin adding credit risk. It’s impossible to call a bottom to the recent rout, but given the dire expectations already priced into most corporate securities, yields are compelling. In the investment-grade market, new issues are coming to market at an especially attractive yield premium. That said, be selective; fundamentals matter.
Second, be selective in BBB-rated debt. This is the quality tier from which most fallen angels plummet, and investors need to make sure they’re being compensated for the risk that a given security will be downgraded.
Third, high-yield investors should consider adding to positions in debt rated BB and B. Look for companies with strong liquidity positions that can weather the current storm.
Fourth, be cautious within the energy sector. As oil prices decline, default risk increases. Energy issuers with more diversified and higher-quality assets, more experienced management teams and lower production costs than their peers are better positioned to weather the oil-price plunge.
Finally, consider the subordinated (AT1) debt of European banks, whose capital is at an all-time high and whose nonperforming loans are at historical lows. Stronger national champion issuers and AT1 structures are especially attractive today, in our view.
Emerging-Market Debt: Oil Shock Creates Opportunities
Investors might also consider diversifying into emerging-market debt (EMD), where a combination of liquidity challenges and an oil shock have resulted in severe price dislocations—and opportunities.
The oil shock began in March, as global demand fell off due to the coronavirus pandemic. When OPEC+* failed to agree on an extension of output cuts, Russia and Saudi Arabia ramped up production in a battle for market share.
Collectively, these conditions caused the price of oil to plunge to unprecedented lows. West Texas Intermediate (WTI) crude oil fell from its January high of US$63.27 per barrel to just US$20.83 on March 18. Prices have since recovered a bit, but they’re 60% lower than three months ago.
Oil-exporting countries, which comprise 40% of the hard-currency EMD market, suffer when oil prices are low. Oil-importing countries, in contrast, benefit from cheaper oil. But these benefits have been offset by the broader effects of the coronavirus crisis and general risk-off sentiment.
The US Fed recently promised new swap lines to nine countries to ensure they get access to US dollars, which are in high demand. The World Bank and International Monetary Fund also made funds available to the developing world. These actions have helped improve investor sentiment.
Yet EMD spreads remain far wider than their January levels, and price dislocations persist. In our view, this represents a good opportunity to incrementally increase exposure to EMD, both broadly in investment-grade countries and selectively in high-yield sovereigns whose prices have reached attractive levels from a fundamental perspective.
Securitized Assets: A Disconnect from Fundamentals
The liquidity spiral helped drive a massive sell-off in US credit risk transfer (CRT) securities—residential mortgage-backed bonds issued by US government-sponsored enterprises. This sector felt the impact of leverage being unwound: forced liquidations, margin calls and cancelled repo lines.
Why? Investors had used them as leverage precisely because of their high quality. In other words, the pressure that CRTs experienced in the first quarter wasn’t entirely driven by fundamentals, even if some concerns stemmed from prospects for forbearance and uncertainty around payoff profiles. Indeed, the fundamental picture looks meaningfully better today than in the runup to the Great Recession. (CRTs didn’t exist at that time; they were created in 2013 to get US taxpayers off the hook for losses like those racked up on mortgage loans in 2008 and 2009.)
To begin, the underwriting standards for residential mortgages are much stricter now. Most borrowers have FICO scores—measures of an individual’s credit risk—above 750, indicating an excellent credit history. Home prices have also appreciated significantly since 2008. And today’s mortgage bonds have much less risk layering than years ago, a practice that led to high credit losses during the US housing crisis. CRTs typically don’t layer high-risk metrics such as poor loan-to-value (LTV) ratios plus low FICO scores plus high debt-to-income ratios.
Fundamentals for commercial mortgage-backed securities (CMBS) are also significantly better today than in 2008. Then, the average LTV at origination was nearly 70%. Today, LTVs average a healthier 62%, given multiple years of deleveraging as well as a significant increase in prices across property types.
Equity cushions, service coverage and internal cash flows are all higher today. Tighter underwriting standards for recent vintages have helped too. Lastly, the banking system shut down in 2008, making real estate transactions impossible to conclude. In contrast, today’s commercial real estate transactions are continuing, and lenders are still willing to provide capital.
Much of the pressure on CRTs and CMBS has instead stemmed from liquidity challenges and negative headlines around retail in a world wrestling with COVID-19. But in our view, current valuations more than adequately compensate investors for any potential negative factors and expected losses.
The Sun Will Shine Again for Bond Markets
Even though the storm continues to rage, we’ve begun to feel cautiously optimistic. No investor or manager knows precisely when the bond markets will rebound, but we know they will.
Trillions of dollars of fiscal stimulus and rock-bottom interest rates can help economies restart quickly from their government-imposed deep freeze. Indeed, with a record amount of cash sitting on the sidelines today, credit markets are more likely to snap back than to tentatively return to normalcy.
In the meantime, investors who are prepared to ride out near-term volatility might consider leaning into opportunities to get an edge over broad investment sentiment—and the inevitable rainbows.