STA Weekly Report – A Fixed Income Playbook for Today
Written by Luke Patterson | Friday, March 27th, 2020
INSIDE THIS EDITION: A Fixed Income Playbook for Today KHOU Interview – “How to protect investments amid coronavirus uncertainty on Wall Street“ Weekly Global Asset Class Performance STA Wealth Recession Survival Guide 401k Plan Manager
Through March 24, 2020, the returns on most fixed income securities have been negative year-to-date. In fact, leveraged loans, investment-grade bonds, and municipal bonds have all lost money this year.
The only bright spot from a return perspective has been US Treasuries which garnered investor attention as they sought safety amid the equity market sell-off. The good news is that over the last couple of weeks, we have seen interest rates rebound slightly as the Federal Reserve has made multiple announcements regarding fiscal policy intended to instill investor confidence and provide support to the economy.
At the same time, mortgage- and corporate-bonds which initially benefited from falling yields in treasuries have been recently hurt by sharply widening credit spreads. Widening credit spreads like we have seen recently, highlight concerns that investors have about the ability of lower credit-quality corporations to pay off their debt. This has been reflected in corporate bond yields as they have spiked over the last two weeks, indicating that investors are requiring higher compensation to take on the risk of buying corporate bonds, particularly from lower-quality issuers. As the chart below demonstrates, year-to-date total returns (through March 24, 2020) for higher-rated A, AA, and AAA bonds have outperformed lower-quality BBB-rated bonds.
What we have noticed, perhaps unsurprisingly, is that the spike we have seen in yields and spreads coincides with the COVID-19 infection rate. In other words, as the infection rate has increased in the US, yields, and spreads have increased, reflecting a higher risk of default by bond issuers as many are forced to shutter their businesses. Of course, on a sector basis, spread performance has not been homogenous. The Energy sector, in particular, has been hardest hit as COVID-19 challenges have only been made worse by a collapse in the price of crude oil that is likely to impact energy company income statements, balance sheets and ultimately the ability of many issuers to service their debt.
In a historical context, the 300bps spread seen earlier this week in US investment-grade bonds was lower than the 550bps spread seen in March 2009. However, the magnitude of the widening has been dramatic as spreads have widened by more than 150bps, thus putting them at levels rarely seen.
So what has driven the spread widening? First, increasing
default risk as issuers try to navigate a hard stop on economic activity in
many areas of the world. Second, a lack of liquidity as investors seek to hold
cash. Third, strategic rebalancing that
often occurs in response to large moves in the prices of equities and fixed
income like we have had. This time around, we are likely seeing investors sell
down fixed income to allocate to equities and US Treasuries which leads to more
supply of bonds.
In plain language, what we are saying is that over the last
couple of weeks we have faced major liquidity issues in bonds that the Federal
Reserve had to address through emergency action. This has been an effort to maintain
a sense of order in bond markets.
So far, they have announced several policy actions aimed at
shoring up liquidity. First, they announced market purchases of assets all
along the yield curve. Second, they cut the Fed Funds policy rate and narrowed
bank borrowing costs to 0.25% while committing $700B to quantitative easing. This
was not enough for the market to respond positively so they finally removed the
cap on assets to be purchased in what some are hailing QE infinity. These
operations commenced this week with some success.
However, investors question how much the Fed can truly alleviate market stresses. The big concerns are that they already have limited balance sheet capacity with primary dealers already stretched and the scope and scale of the damage done by COVID-19 on economic activity are in many ways unprecedented. This is in many ways uncharted territory.
That said, we do expect these actions by the Fed and other
of the world’s central banks to help improve liquidity over time. Additionally,
we see a Fed funds rate that is lower than normal for the foreseeable future.
At some point, the Fed is likely to try to unwind these support mechanisms as
they once again try to normalize interest-rates like they did following the
Great Financial Crisis. The result may ultimately be a steeper yield curve. As
a result, investors should be at least thinking about how to position their
portfolios for that possible shift, if and when it happens.
We currently believe bond investors should focus on three
major themes. First, put a focus on high-quality bonds from issuers likely to
weather the current economic environment. Second, investors should be prepared
with a buy-list to take advantage of the price dislocations that may be caused
by indiscriminate selling over the coming weeks and months. There may be good
opportunities in fixed income to choose from. Lastly, for tax-sensitive investors, they
should look at municipal bonds. We are currently seeing an interesting
municipal market that might offer nice opportunities to pick up quality bonds with
low default risk.
To summarize, the recent drawdown in fixed income markets reflects a liquidity crisis, rather than a solvency crisis, as fundamentals for higher credit quality bonds remain healthy. These changes largely depend on the duration of the economic lockdown that has gradually taken hold around the globe and the world’s ability to halt the spread of Covid-19. However, the world’s central banks are doing all they can to help support fixed income markets in the interim. The Fed has explicitly stated they will be purchasing assets in the treasury and mortgage banked security markets as they try to stabilize markets and prevent the liquidity crisis from worsening. While the coming weeks and months will tell us about the success of their efforts, STA Wealth Management plans to stick to our discipline. Leading up to the recent volatility, our discipline led us to shorten the duration and improve the credit quality of our clients’ fixed income portfolios. As investors, it is important to examine individual bonds to make sure the default risk is low, especially in the current environment. More importantly, if your advisor is not helping you look at fixed income through a more nuanced lens, you should ask why.
KHOU 11 News Interview: Coronavirus: Have a plan to protect your investments
“An STA Wealth Management financial adviser said the unknown is fueling the roller coaster we’re seeing on the stock market.” Published: 10:09 PM CDT March 12, 2020
Over the years, I have written many articles on financial planning. Several of those have been “guides” to help readers through different stages of their life or lifecycle events. Two of those were the Retirement Survival Guide and Layoff Survival Guide.
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