June 10, 2020
In March, markets began to crack under economic pressure still prevalent months later. Record bond issuance and a deep freeze of credit markets took hold as uncertainty made liquidity a priority for all. Today, fiscal pain is felt by both government and corporations—further amplifying the importance of adapting to the new world.
Compared to only a few months ago, today’s fixed income markets are different. Covid-19 and its associated blowback have changed companies, sectors, markets and economies in such a way, a new playbook is warranted.
This is the view of Gautam Khanna, senior portfolio manager of the BNY Mellon’s Core Plus strategy:
“Certain economic sectors are arguably less exposed to Covid-19 and might even be benefiting. We aim to be overweight in those areas,” he says. “Likewise, we want to be careful of anything directly impacted by Covid-19. Whether it’s airlines, gaming or anything leisure oriented—the bar to owning any of that is higher than in normal times. However, when we do find names in those areas, balance sheet strength and better quality issuers with strong liquidity is preferred.”
So, how did we get here? It may help to start from the beginning, says Khanna.
According to Khanna, the pandemic, as well as subsequent lockdowns, drove up market volatility as bond holders sought to liquidate assets in response to economic uncertainty. This affected US Treasury-based products – everything from nominal bonds to Treasury inflation-protected securities (TIPS) – as sell-side participants attempted to delever in an environment where buy-side demand had virtually evaporated.
The result was a liquidity freeze as illustrated in Figure 1. Here, we see how the number of bid/ask participants for 10-year treasuries remained fairly stable until March – at which point liquidity plummeted as buyers left the scene.
“Balance sheets were restricted as a result of regulations introduced post-2008,” observes Jamie Anderson, head of trading at investment firm Insight. “While some dealers and traders were unable to buy more bonds because of balance sheet constraints, others had duration limits that a least slowed the street’s ability to continue to add bonds. Because there was no one on the buy-side to step in and no one on the sell-side who could continue to intermediate the risk transfer, there was really only one solution to the problem, and that solution was the arrival of the Federal Reserve (the Fed).”
On March 15, the Fed announced its intent to purchase Treasuries and agency mortgage-backed securities (MBS). A few days later, it expanded the program to purchase as many assets as required to maintain stability in Treasury markets, according to Anderson. Similar measures were taken in both investment grade (IG) corporate and high-yield (HY) markets as the Fed launched a total of nine different facilities.
“That finally allowed the buy-side to return with confidence that liquidity would be restored,” Anderson says.
In the event, March became a record month for investment grade corporate bond issuance, topping out at US$262bn. In fact, total issuance has skyrocketed this year, ending the week of May 15 at US$921bn [Figure 2].
According to David Hamilton, US head of credit analysis at Insight, both the liquidity freeze and subsequent record corporate bond issuance both have one thing in common: The need for cash.
Many high-quality companies issued debt at the onset of Covid-19 in order to boost liquidity during rising uncertainty, he says, and analysts project IG issuance could total anywhere from US$1.3-1.7trn by the end of 2020. A similar story is playing out in HY markets, which is on pace for US$350bn.
Fall from grace
On the flipside of the coin, however, March was also a precursor to a record period for downgrades. Before Covid-19, there had been a spur of mergers and acquisitions, as well as leveraged transactions to pay-out shareholder returns, notes Hamilton. “Rating agencies gave these companies a lot of leniency,” he says. “So, really, downgrades today represent how over-levered some of these companies were prior to the pandemic.”
The result was a vicious cycle of downgrades. As high-quality companies issued more debt, bonds on the riskier side of IG were pushed into BB – or ‘fallen angel’ – territory, and of course, those with lower ratings in HY ended up defaulting due to lack of liquidity to survive the economic lockdown.
Since then, the fallen angel universe has ballooned to US$130bn [Figure 3] while default projections for the end of 2020 far exceed those ahead of Covid-19
This is a time for active management to shine, according to Hamilton. However, in order to unearth real gems and avoid landmines, he stresses the importance of issuer-byissuer analysis rather than making broad bets based on ratings.
For Hamilton, the prevalence of downgrades means investors need to be more alert than ever.
“Through March and early April, the credit curves were relatively flat. This presented an opportunity as long tenure bonds in high-quality credits really outperformed the rest of the market, allowing us to invest in high quality companies at a discount,” he says. “However, income statements are relatively unknown right now. So we’re making decisions on assumptions for prolonged business disruption.”
“If you think it’s going to be three months or six months, stress it out for nine months or a year. Most importantly, stress the credit for a liquidity shortfall.”
A closer look at the playbook
Khanna echoes this sentiment, noting that even if a deal poses an attractive entry point, companies must meet a set of criteria before he will consider their bonds. These include balance sheet strength, liquidity, staying power and the ability to navigate this unprecedented time.
“Sector selection and security selection are also playing a big role,” he adds. “It could be that a BB issuer in the cable space is better equipped to deal with this crisis. We’re all working from home, using our broadband connections, and the cable companies have good visibility in terms of revenues, earnings and cash flows—perhaps a lot better than many investment grade issuers in the leisure space, or perhaps in the commodity complex.”
While Khanna’s primary goals of precision and diversification still remain as important as they were prior to the pandemic, he acknowledges the market has changed. Secular trends, which were slowly brewing before the economy shut down, sped up at the onset of the pandemic. The momentum of online retail and cloud computing trends have only accelerated, for instance, while those businesses that have been unable to operate remotely have borne the brunt of the disruption. This created a clear distinction of risks in corporate bond markets..
“To the extent we’re quarantined, all of the businesses that help us with our ability to continue to communicate will do quite well. But we want be picky and bottom-up oriented when it comes to identifying those issuers that check the boxes,” Khanna says.
Beyond the horizon
Looking to the future, Anderson says the biggest challenge for fixed income markets will be adapting to the Fed as a new market participant. He believes the central bank will continue buying a large variation of bonds for a quite some time, and—over the long term, what will really matter is how it exits markets and reduces its balance sheet. He also doubles down on the importance of liquidity.
“People will need to understand the liquidity of all different instruments slightly better than they did going into this,” he says. “Understanding the liquidity of your position and stress-testing it in illiquid markets will be key.”
Hamilton agrees: “It basically comes back to stressing these credits for a prolonged and impactful decline in earnings ability. Will they have the liquidity to sustain themselves until some sort normalcy comes back?” he says. “As limitations loosen up, how the new normal looks—as well as when it will come—will hopefully become clearer.”
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Bonds are subject to interest rate, credit, liquidity, call and market risks, to varying degrees. Generally, all other factors being equal, bond prices are inversely related to interest-rate changes and rate increases can cause price declines. Mortgage-backed securities: Ginnie Maes and other securities backed by the full faith and credit of the United States are guaranteed only as to the timely payment of interest and principal when held to maturity. The market prices for such securities are not guaranteed and will fluctuate. Privately issued mortgage related securities also are subject to credit risks associated with the underlying mortgage properties. These securities may be more volatile and less liquid than more traditional, government backed debt securities.
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