What is normally the most resilient market in corporate credit? Short-dated credit. It’s been the place for safe, steady returns. But the Covid-19 crisis created a strange new bizarro world where up is down, left is right, and short-dated credit is the pain trade. Its strong attributes made it suffer disproportionately. A victim of its own success.
Here’s why we believe the short end is mispriced and offers fantastic risk-adjusted returns:
- Value: lack of price discovery and liquidity in the long end forced the short end to be priced well below its fundamental strengths
- Rare high yields: very high absolute and relative yield levels not seen in a very long time
- Central banks: CB measures supporting sentiment and trading technicals, also in the short end
- Fundamentals: ample near-term funding liquidity for the strong companies in our portfolios
Flight to liquidity: easiest to find buyers for the quality assets
Why did the short end suffer so much? Since the short end is typically the most liquid part of the curve, many investors relied on their short-end holdings as the best source of liquidity. But as short-end investors aren’t accustomed to extreme price action, this led to a greater urgency to exit positions. And let’s face it: it’s mentally easier to sell a short-dated bond still trading near par, rather than ask nervous traders for bids on the more volatile, longer bonds that were already well below par.
Now, with the markets stabilizing and some rebounding, investors are trying to dig themselves out of the (total return) hole and they’re piling onto the long end for short-term capital appreciation should the rally in spreads continue.
The crisis led to a rare occurrence: flat credit curves for many issuers. In the darkest hours, some curves were even inverted. But, fear not: as the maturities near, the roll-down effect along the credit curve is set to be quite rapid, thus providing powerful enhancement to the total returns for short-dated credits. In contrast, long-dated bonds will still carry the greater credit risk that comes with time, duration, and maturity walls.
Through it all, our short-dated funds managed to maintain high liquidity and did so without sacrificing the overall creditworthiness of the portfolio. We sold across the spectrum of credit qualities and kept the average credit quality of the funds intact. Proof that the funds can operate in an organized manner even in the most extreme scenarios, without being forced to sell the crown jewel assets or alter the portfolio from its optimal mix.
ECB support growing and going deeper in credit quality
The central banks are providing much-needed help toward credit market sentiment and technicals. These will certainly help the short-end also. The ECB is looking for ways to ensure that short-term yields (including Euribor) will remain low in order to help the banks to operate.
The biggest measures (QE upsized by EUR 120bn, new EUR 750bn PEPP programme) will directly benefit the ECB-eligible Investment Grade credits and that rising tide will lift boats in the non-eligible space (like High Yield and Nordic credits). Soon, we will hear more about the eligibility of fallen angels too. These factors will benefit our crossover holdings. Nordic credits will have further support from the Norwegian purchase programme (NOK 50bn), which even includes unrated bonds.
The normally stable Nordic credit market was shaken badly by the oil price crash. While its direct impact is mainly on the oil-exposed Norwegian market, contagion from the huge hit to Norwegian credits (and Covid-19) spread to Swedish funds whose illiquid positions could not withstand big outflows. Fortunately, Finnish bonds remained relatively stable throughout all this, behaving more like they have in past crises.
Both the Norwegian and Swedish markets also suffered from certain funds being gated from redemptions, thus spooking investors. We’re proud to inform that we did not face any difficulties with liquidity and that Evli’s funds have been open for trading every banking day since their inceptions.
Aggressive return chasers go long, but best risk-return is in the short end
Short maturity offers now exceptionally high total return potential given the wide spreads. The near-term outlook is still foggy but fundamentally strong companies have ample liquidity resources and can tap new liquidity sources that will enable them to sail through the crisis comfortably. The longer-term is more uncertain. That’s also why we think the risk-return is best in the short end. A rapid spread tightening doesn’t require Covid-19 to disappear, as the markets tend to lead the real economy by months.
A benefit for investors in our funds is participation in the crossover universe. As we mentioned earlier, the ECB’s involvement will grow here too. Crossover bonds offer the combination of good credit quality and attractive pricing. Likewise, a crossover discount can come from inefficient pricing when a split-rated credit is not a natural fit for IG or HY investors.
Our funds also offer the chance to invest in Nordic credits, rated and unrated. Despite the recent weakness, the Nordic market still has a strong and stable local investor base. And Nordic credit issuer fundamentals remain healthy, along with their bonds’ low duration and attractive spreads.
For the cautious investor who is not just aiming for the highest possible absolute return, but rather focuses on the best possible risk-adjusted return, Evli offers great absolute return potential with low duration (Evli Short Corporate Bond, Evli Nordic Corporate Bond) or even minimal duration (Evli Euro Liquidity).