The speed and magnitude of spread widening across investment grade and high yield credit sectors in the past few weeks has been unprecedented. There are three primary drivers: Serious credit concerns related to the deep economic contraction ahead that could lead to downgrades and defaults; Liquidity concerns or a potential lack of financing for otherwise healthy business that could drive them to distress; And sheer forced selling which can distort pricing relative to credit and liquidity concerns. Fortunately, the Federal Reserve has responded to the liquidity challenges by unleashing its powerful arsenal of tools, many of which were developed in the Global Financial Crisis (GFC) of 2008, to stabilize and clear credit markets, and to support new issuance. The initiatives announced earlier this week went beyond the GFC programs to importantly include the direct purchases of investment grade credit instruments, in addition to their massive purchases of U.S. Treasuries and Agency mortgage-backed securities which the Fed has been buying for the past 11 years.
An inventory of Fed actions in the past few weeks is worth note:
- Cut the Fed Funds Rate to 0%-0.25% range
- Purchases of U.S. Treasuries and Agency MBS are unlimited and will proceed as long as needed
- Purchase of Commercial Mortgage-Backed Securities issued by Government Supported Entities
- Relaunch of backstop to Money Market Mutual Funds
- Relaunch of a Commercial Paper Funding Facility (CPFF)
- Relaunch of the Term Asset-Backed Securities (ABS) Lending Facility (TALF)
- Launched two lending facilities to buy high quality corporate bonds and provide 4-year bridge loans – Primary and Secondary Market Corporate Credit Facilities (PMCCF and SMCCF)
- Launched a facility to provide short term loans backed by highly rated municipal debt
It is our view that these actions are bold, decisive and well suited to ease liquidity strains in many parts of the credit market. If not initially sized appropriately to get the intended market reaction, we have no doubt that the Fed will increase the program size until markets ultimately regain equilibrium.
It is our view that the significant widening of credit spreads in short-term, high quality paper is largely the result of sizeable selling – most prominently large sales by investors who need to raise liquidity and are seeking to generate that liquidity from parts of their portfolios which have the smallest discounts to par value. That is happening in short-term credit, even though the discounts have surely widened as selling pressure has intensified.
We do not have broad concerns in the profile of credits we own across our fixed income portfolios, though there will be some sectors that will naturally come under intense economic strain. We underwrite the bonds we own to withstand severe economic stress, and only invest in durable credits which we believe can do well in a range of economic environments. With the Fed providing deep liquidity to support financial institutions and market trading, and with high quality credit investments likely to withstand even a significant economic contraction, we ascribe most of the enormous widening of spreads over the past few weeks to forced selling, which at some point will logically abate.
We know that when aggressive Fed actions were successfully implemented in 2008, the positive impact on credit markets was substantial. As evidence, the 1-3 year ICE Bank of America Investment Grade Index returned -7.84% from August 31, 2008 to October 31, 2008. It was up 5% in the next three months, and from October 31, 2008 to October of 2009, it returned 17.4%. While it is difficult to predict the exact timing in this credit cycle, we are confident that the Fed’s initiatives will successfully ease strains across credit markets, and valuations will eventually improve as a result. We are advising clients with available liquidity to consider acting now. We are already seeing welcome signs of improving liquidity, particularly in the U.S. Treasury and Municipal bond markets. Other credit sectors will likely follow.
Historic context is important and provides support to our view that much of the recent spread widening is related to forced liquidations. Since 1987, the worst year ever for investment grade defaults was in 2008, at 0.42%. One way to interpret this data is that an investment grade Corporate bond investor would need at least 42 basis points1 of spread in order to compensate for the default costs associated with a diversified portfolio in the worst-case scenario experienced to date. Even if defaults are multiples of this worst experience ever, which may very well be the case with GDP expected to contract by 20%-30% in Q2 along with projections of unemployment rising above 10%, we believe that current spread levels represent abundant compensation for a record rise in defaults.
Investment grade Corporate bond spreads remain in an elevated range of approximately 250-400 basis points, with certain sub sectors in the epicenter of the current crisis (Energy, Aviation, etc,) trading at spreads well above this range. Corporate bond spreads steadied this past week, even drifting a bit lower as we go to print. As shown in the corresponding table, our valuation model currently indicates that nearly the entire universe we track is a “buy”. This contrasts with less than 10% meeting our “buy” criteria only a month ago. Liquidity in the Corporate bond market continues to be quite challenged, particularly in the front-end. The Federal Reserve’s action to buy Corporate bond ETFs directly has been constructive and is improving investor demand, particularly for issues eligible for these vehicles. We also continue to be encouraged by strong investor demand for new issuance in longer maturities. Again this week, a number of high-quality issuers came to market with deals that were many times oversubscribed. We participated in several of these issues, and have also been selectively adding exposure in the front-end for clients with liquidity to put to work. We are adding credit exposure at a measured pace, but we are mindful that the Federal Reserve is likely to be successful in improving liquidity in the coming weeks which should be positive for the sector. Coming out of this crisis, investors will be faced with little or no yield in U.S. Treasury securities which will make Corporate bonds at current yields seem very enticing.
Structured Fixed Income
Prices on many of the Asset-Backed Securities (ABS) and Commercial Mortgage-Backed Securities (CMBS) we hold across mandates fell further during the week. Some of this reflects a broadening investor view of weakening credit quality within the sector, but we believe that much of the price decline in high-quality ABS is liquidity driven. While these prices may reflect what a distressed seller would have to accept under very poor liquidity conditions, they do not in our opinion reflect the credit quality of the individual issues. We experienced a similar situation in the GFC. As prices marked down, we searched broadly for available securities and found little if any supply at those levels. And what was the credit performance of ABS through the GFC? ABS, excluding non-Agency residential mortgage-backed securities (RMBS), performed extremely well. For example, of the $800 billion of non-residential ABS outstanding at the end of 2007, only 0.03% experienced impairments over its remaining life, none of which was AAA, AA or A rated.
Given the time-tested asset types, larger issuer equity cushions, and structural protections in the bonds we own across client portfolios, we expect ABS performance through this episode to hold up similarly well. Unfortunately, in this environment as in the GFC, a handful of forced sales will temporarily determine market prices, rather than a reasoned view of the credit risk in the bonds.
Secondary market activity has presented opportunities in ABS, particularly in very short maturities, but we are not seeing broad based selling. The Federal Reserve’s new program to improve liquidity in the securitized markets, TALF, cannot be as quickly implemented as programs targeted at other fixed income sectors, so it may take a little while longer to see meaningful improvements in the liquidity of the ABS sector. We have re-underwritten each of the structured fixed income issues we own over the past several weeks and are not inclined to sell any as the result of a prospective negative trends in the economy.
In recent years, we have maintained virtually no exposure to Agency mortgage-backed securities (MBS) based on their unattractive compensation. This week there appeared to be growing stress in both RMBS and MBS. There is concern that delinquencies will rise as many homeowners across the country are losing their jobs and source of income, at least temporarily. This is occurring in spite of the fact that federal regulators are well on their way to establishing relief for homeowners. Regulators have already committed to mortgage payment holidays of up to one year for mortgages held by the Agencies subject to eligibility requirements. The rest of the mortgage industry is expected to quickly adopt similar policies.
We anticipate that the Federal Reserve purchases will limit the spread widening in Agency MBS (now at option-adjusted spreads of 60 basis points). We are also observing that Credit Risk Transfer (CRT) securities are stressed, and an ongoing lack of demand could pose challenges for future Agency MBS issuance. CRT issuance began in 2013 with the goal of transferring the first loss on mortgages guaranteed by the Agencies to private investors willing to take on that risk for higher yields. We have not invested in these securities, as the yields on offer have generally not been generous enough in our view to take on the risk associated with first loss. We suspect that the Fed understands the issues here as well, and will take whatever steps are necessary to ensure the securitization of Agency mortgages will continue. Under current conditions, CRT debt does not pass our credit requirement for durability and we do not expect to be active.
Buyers returned to the Municipal bond market with a vengeance this week. We noted in last week’s commentary that Muni/Treasury ratios had blown out to 200%-400% across the yield curve. Historically, when this has occurred, the situation often has been short-lived, as it has been again in this instance. Municipal bond rates across the curve are down 125-150 basis points this week, erasing much of the selloff-driven rate increase that began in early March. Selling in the past few weeks was largely driven by mutual fund liquidations to meet shareholder redemptions. Our investment team was active during the selloff, selectively adding over $500 million dollars of high-quality Municipal bonds to our client portfolios. Last week we had little company as we searched for value, but the party became much more crowded this week as Municipal yields topped 3%. We believe banks have been a major buyer as the value proposition for them is obvious. Banks are sure to experience lower net interest margins as rates for mortgages and commercial lending decline and refinancing activity accelerates. Cushioning that blow by investing in high quality Municipal bonds is a logical reaction under the circumstances, and we believe we are seeing that play out now. With money market funds soon to yield 0% or go negative, and with U.S. Treasuries paying less than 1% for all but the longest maturities, current Municipal bond rates at 1.0%-2.0% across the yield curve will likely continue to attract buyers.
Liquidity in the TIPS market since the crisis began had been poor, though it improved significantly this week. The actions taken by the Fed are most easily implemented quickly in U.S. Treasuries, so not surprisingly, we have observed the most improvement in these markets. For the week, real yields have rallied approximately 80 basis points and breakeven inflation rates have risen by 75 basis points. The 10-year breakeven inflation rate has rebounded from 0.50% to 1.10%. Inflation expectations indicated by TIPS remain very low despite what we see as better fundamental support for inflation:
- Oil prices appear to be stabilizing although at very low levels.
- Fiscal and monetary policy stimulus are moving towards unprecedented levels.
- An increased focus on reestablishing U.S.-domiciled links in the overall supply chain is expected even if it comes at a higher cost.
- Supply destruction is accompanying demand destruction potentially leading to shortages as the economy recovers.
Interestingly, investors were reluctant to relinquish TIPS to the Fed given current market levels. As a result, TIPS purchases by the Fed were below target for the week. We are very constructive on TIPS going forward at these valuations for investors who strategically maintain an allocation. For our taxable mandates, we also see value in TIPS versus nominal U.S. Treasury securities; however, much more lucrative opportunities in the credit markets will likely speak for our available reserves.
Senior Vice President
Fixed Income Product Specialist
212-493-8247 | email@example.com
Opinions, forecasts, and discussions about investment strategies represent the author's views as of the date of this commentary and are subject to change without notice. References to specific securities, asset classes, and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations.IM-07742-2020-03-27
1 A unit that is equal to 1/100th of 1% and is used to denote the change in a financial instrument.
2 Standard deviation is a measure that is used to quantify the amount of variation or dispersion of a set of data values.