MARKET COMMENTARY

Fixed Income Update: The Good, the Bad, and the Ugly

03.23.2020 - Jeffrey S. MacDonald, CFA

Last week financial markets both in the US and overseas were extremely volatile.  The spread of COVID-19 and the announced policy responses across our three levers of containment, monetary, fiscal and healthcare, led to wild swings in global financial assets.  The outlook for economic activity in the US looking especially bleak for the foreseeable future. With positive tests spiking and social distancing taking a meaningful toll on big and small businesses, investors’ views and expectations are evolving quickly as capital flows across asset classes respond to those changes.

Fixed income markets have not been spared.  Last week was particularly volatile with sub-sectors across the asset class struggling to find stability. This morning’s announcement by the Fed of additional measures to assist corporate debt markets was a welcome addition to its ongoing support of market activities.  

Below are a few of our observations.

The Good

Money Markets

Money market funds typically allocate the bulk of their invested assets to short-term funding markets.  Borrowers use this market, generally through the issuance of commercial paper to fund their daily operations.  A breakdown in these funding markets can cause serious liquidity problems for borrowers and “run-on-the-bank” moves by investors can cause  these markets to seize up.  Dusting off part of the playbook from the Global Financial Crisis (GFC), the Fed established a facility that allows banks and money markets to pledge short-term, high-quality collateral at the Fed in return for short-term loans needed to fund investors demand for cash.  Initially not included in the original draft, a day later the Fed revised the program to allow it to accept short-term, high-quality municipal collateral as well as providing welcome liquidity backstops across the majority of the vehicles active in the oversight of the approximately $4 trillion in assets in this market.

New Issue/Primary Markets      

One of the leading indicators of bond market health is the primary side where issuers bring new bonds to market to either expand their credit or refinance maturing debt.  This market has largely been closed the last few weeks but for several days the market felt strong enough to open up for several investment grade taxable issuers to bring deals to market. As expected, most of the issuers were high-quality, large borrowers who are normally active participants. While issuers were forced to offer higher interest rates, it was encouraging to see large deals being successfully placed. Continued new issue activity is one indicator that we will be watching closely this week for signs that the primary market is beginning to thaw out.

Municipal Markets         

The tax-exempt municipal market struggled with large sellers all of last week seeking to raise cash to meet redemptions.  The muni market has always been prone to bouts of illiquidity from time to time.  This one, however, could be particularly problematic given the potential impact of this economic slowdown on state and local governments’ ability to provide services and an inability to access the bond market to fund those services could exacerbate an already challenging outlook.  In an encouraging development on Friday, the Senate introduced a bill called the “Municipal Bond Emergency Relief Act” which would expand the Fed’s ability under the Federal Reserve Act to purchase bonds in all maturities to support credit flow to states and local governments.  Currently, the Act only allows for the purchase of very short-dated maturities.

The Bad

Investor Redemptions

Fund flows were decidedly negative across most major sectors of the bond markets.  Investment grade corporates, high yield, and tax-exempt municipals all posted record fund outflows last week going back to when this data first began being collected.  With redemption requests of this magnitude, fund and ETF sponsors will need to sell bonds in the market to raise the necessary cash.  However, with so much cash leaving these subsectors of the market, last week’s outflows have created the kind of imbalance between buyers and sellers that can lead to disorderly markets.  A key market dynamic to watch this week will be the pace of these outflows and if there is an improvement in investor appetite for credit that slows or reverses these unprecedented outflows.

Secondary Markets        

Last week’s secondary market liquidity was in many respects a by-product of the unprecedented fund outflows that the market witnessed.  With the broker-dealer community less engaged than usual in the face of these volatile markets, it was left to other investors to provide yield and spread levels that they were willing to buy bonds at.  With a much smaller buyer base than is typical in well-balanced markets, selling bonds was challenging last week to say the least.  If there is a bright spot here, sellers were able to successfully find buyers in most cases, unlike during the GFC when the secondary market for bonds froze up, albeit at punitive spreads relative to levels in late 2019.

The Ugly

Energy 

The impact from the coronavirus has hit the broader economy hard and will continue to be a drag for likely a quarter or so.  Within the overarching concern about the economy there are specific industries that investors have penalized/punished particularly hard in which the efforts to contain the outbreak have impacted the outlook disproportionately. Sectors such as Travel, Leisure and Restaurants all qualify but Energy stands out given the “double-whammy” that the coronavirus outbreak and the Saudi Arabia-Russia production spat have delivered to the industry.  In the US high yield market, which has a considerable allocation to the Energy sector, March’s month to date return ex-energy is a disappointing -14.5% while the high yield energy sector was down -37.5% over the same time period.

Credit Downgrades        

If Paul Revere were still around in today’s “gig” economy, I’m sure he could find a few busy shifts riding up and down Wall Street warning “The downgrades are coming…!!!”.   Both Moody’s and Standard & Poor’s have announced they are reviewing global credit ratings in response to the economic and earnings impact of the coronavirus response.  Moody’s struck early last Friday with a downgrade of Occidental Petroleum from an investment grade rating of Baa3 to a below investment grade rating of Ba1.  This will not be the last of these downgrades we are likely to see and expect this week to introduce a few more.  Many bonds are already trading at levels suggestive of some negative rating action.  While these downgrades will likely still allow for many issuers to access the market, the cost of the debt will be higher even in the face of much lower base rates in the Treasury market.

“Fallen Angel” Impact   

Fallen angels, meaning those investment grade issuers downgraded to high yield, were a hot topic back in 2018 when the Fed was tightening and markets became volatile.  The same level of concern occurred in 2005 when auto companies were on the verge of, and then ultimately were, downgraded, leaving the much smaller high yield market there to support their bond prices and future market access.  Ultimately, spreads widened and an investor base developed to clear the market for Ford and GM.  Fast forward to today and the BBB segment of the market (one rating above high yield) is much larger as a percentage of the investment grade market at roughly 50%.  Now not every BBB rated company is going to be downgraded but if last week’s price action was any indication, expectations are that the downgrades in that space are coming and investors are starting to demand compensation for that risk.

This Week…

There is still a lot of risk out there heading into this week that bears watching.  There are a few factors that should start to improve the liquidity picture but improvement in the functioning of the market will likely take some time and investors seem braced, and in most ways charging a premium, for that.  Wider spreads and a repricing of credit seem appropriate in our view given the fast deterioration in the market outlook.  This week, with the Fed having provided more support for fixed income investors, we will hope to see more progress in the primary market and more balanced two-way markets in the secondary market even at these wider spreads.  We would view that as a small step in the right direction as we work to navigate these volatile times.




The information provided is intended solely to provide general information. The information and opinions stated may change without notice. The information and opinions do not represent a complete analysis of every material fact regarding any market, industry, sector or security. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy, or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

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