COVID-19 crisis: a fixed-income perspective
In an open forum, we gather the thoughts of Luc Mathys, Head of Fixed Income, on the unfolding fundamentals and potential opportunities in the world of fixed-income investment.
How has the COVID-19 impacted financial markets?
The global economy has been ravaged by a demand and supply shock, which is expected to result in substantially negative growth rates in the second quarter. Consequently, financial markets have moved dramatically over preceding weeks, drawing comparisons with the global financial crisis. As was the case in 2008, market liquidity is very poor, with dysfunctionality stretching to the upper end of the quality spectrum, including government bonds and even foreign exchange markets.
Have you seen turbulence on this scale before?
Moves in interest rate markets have been dramatic with US 10-year treasury yields shifting over 100 basis points (bps) intraday and the entire German bund curve moving into negative territory. Meanwhile, indiscriminate selling across all sectors of the credit markets has also resulted in pronounced fluctuations for credit spreads. The speed of the correction has been significantly greater than that witnessed in the global financial crisis, with the level of the US high-grade credit spread spiking to its second highest of all time. We have seen seven major recessions in the last 50 years and, judging by the magnitude of the repricing, this current episode would rank as the third largest of these.
The situation will ultimately improve and we are already moving in the right direction in some respects.
Which areas of the market have been most affected?
While spreads on high-grade indices have widened up over 250 bps on average since beginning of the year, high-yield spreads have spiked more than 1000 bps at the peak. In general, the lower the quality, the bigger the spread change and the hardest-hit sectors have been energy, gaming, lodging, utilities and basic industries.
Can you describe the impact on the primary market?
New issuance initially came to a complete standstill. Conversely, in the week ending March 27, we saw in the US the highest weekly volume of the year with USD 100 bn of issues coming to the market. However, these arrived with large pricing concessions and a degree of urgency due to the non-functionality of commercial paper markets.
How soon are markets likely to become less volatile?
Due to the ongoing market distortions and low visibility on economic and financial data, volatility appears set to stay with us for some time. Normally, financial market crises comprise multiple legs and do not move uniformly, with policy responses leading to temporary and significant rebounds, while counter-trend rallies also become evident from time to time as prices bounce from oversold levels. The situation will ultimately improve and we are already moving in the right direction in some respects, but certain conditions have to be met before we see volatility retreat to more subdued levels.
We believe that active management and an appreciation of liquidity provisions is crucial, in addition to the usual bottom-up analysis, to surviving these unusual, if not unprecedented, and constantly evolving market conditions.
What are the likely catalysts for a market recovery?
The key is to reach a peak in Covid-19 infection rates, which would provide better visibility on the economic and financial outlook. We also need to see recession-like valuations to accommodate grim news flows. In this respect, it is worth noting that most fixed-income markets are already pricing in a worse scenario than a technical recession. The third condition is a continuation of strong policy support at both the central bank and government levels. Central banks have responded quickly and decisively but lack the power to directly influence small businesses and consumers. Consequently, the actions of governments in stepping up with, for example, direct credit facilities is a positive sign. Finally, from a supply and demand perspective, we need to see a reversal of the outflows in the different components of the fixed income markets. These reached successive weekly records during March.
Can you describe your approach to portfolio positioning?
We believe that active management and an appreciation of liquidity provisions is crucial, in addition to the usual bottom-up analysis, to surviving these unusual, if not unprecedented, and constantly evolving market conditions. Portfolios have to remain liquid in order to react to the changing market environment. It is also essential to remain wary of avoiding vulnerable issuers, of which there are many in various sectors.
And what about diversification?
There is a tendency in the asset management industry to laud diversification, but it becomes especially important in an environment in which we could see a spike in defaults. Typically, investment funds hold between 60 to 200 positions, which protect investors well from single-issuer defaults. This makes them structurally safer than single-line holdings in client custody. We would advocate starting to enter the fixed-income space with a diversified approach over an extended period. No-one is going to time the bottom perfectly, but many dynamics mentioned earlier are moving into the right direction. Meanwhile, current entry points are providing attractive levels to lock in yields over the coming years when interest rates will be at record low levels.