The old curse, “May you live in interesting times,” is frighteningly appropriate now. But remember also, you may invest in interesting times. Although this is an unprecedented era for global finance, we remain calm and measured.Here’s why credit investors don’t need to panic:
- Stimulus. When policymakers panic - as they are now - is when the market panic tends to stop.
- Strategy. Our operating model is clear and we’ve stuck to it since the late 90s: we buy bonds with the best credit quality and hold for the long term. A successful track record in good markets and bad.
- Value. Credit spreads are very cheap. Buying at these spread levels has historically led to strong returns in the following 12-month and 3-year horizons.
- Timing. During times of crisis, credit spreads spike but they don’t typically stay elevated for long. An opportunity to add may not last long either.
Credit markets more orderly and operational than 2008
Credit suffered in March, like all other asset classes. Spreads widened dramatically. High Yield spreads have risen back above 1000 bp, to similar levels of past recessions. But spreads were much higher in the Great Financial Crisis, which featured a triple whammy: a banking crisis, a liquidity crisis, and a lengthy recession.
Unlike the 1.5-year GFC recession, we expect a sharp, but short, two-quarter recession in mid-2020, followed by a rebound by year-end. Though it will be a shorter recession, it will still be painful: as unemployment is spiking, stores are closing, oil is crashing, and most of humanity is self-isolating, it’s no surprise that some corporate restructurings have already been announced.
Although liquidity is hurting, it is still fully operational in a similar manner to that of the Euro-crisis in 2011 and much better than what we saw during the GFC. The larger bonds have better liquidity. Unrated bonds have had similar liquidity as rated bonds.
In Nordic credits, liquidity has suffered in line with that of Euro IG and HY, but it too remains operational. Two sectors (Swedish real estate and Norwegian oil) were particularly hit hard, as many Swedish & Norwegian funds were gated for a while, thus adding to selling pressure. For us, these sectors have always been the least attractive in the Nordics due to their volatility.
As a result of the weaker liquidity, even the short-end has felt some rare pain. Managers under selling pressure have had an easier time selling short-dated bonds at a price close to par rather than accepting a more painful loss in longer-dated bonds that had lower liquidity and inefficient price discovery. The shorter bonds tend to rebound quickly though, with a strong pull to par.
Defaults will rise but credit already pricing in a worst-in-history scenario
The markets already had a slight rebound and we think there is a chance for it to continue. Many have been seeking safe havens lately, but investors with too little risk could miss out on future returns if the rebound continues. We think it is too risky to start panicking now, because the forward return potential is huge, and the markets are already pricing in a lot of pain.
Tremendous return potential. Historically in the US, when HY spreads have risen above 900bp, the following 12-month returns have consistently been strong. It’s the same in Europe, when spreads have risen above 800bp. Taking the US market (with its longer history) as an example, the median return after spreads rose above 900bp has been 37% over the following 12 months, and a median of ca. 20% p.a. over the following 3 years.
Heightened volatility will continue over the next 3-6 months. We will see defaults, bankruptcies and fallen angels from IG to HY. This is normal during recessions. But the return potential is huge for investors who can sit on the position for 12 months or longer. During the great depression, corporate bonds were the best performing asset class with a healthy return of 6.9% p.a.
While the number of fallen angels will rise, they actually give great opportunities for HY and crossover investors who pounce on the heavily discounted bonds from forced sellers in the bigger IG market. These end up being a catalyst for great returns, like the post-GFC, very strong 2009 experienced in Euro HY.
Worst already priced in. While we expect the recession to be short-lived, the severity of it will certainly have a negative impact on default rates. But current spread levels are discounting a worst-ever scenario for defaults. Euro HY is discounting that the cumulative defaults in the next 5 years will be close to 42% (at a 20% recovery). How extreme is that? Well, the worst 5-year period since 1980 amounts to 32.5%. Euro IG is pricing in 5-yr defaults of 15% (40% recovery) compared to a worst-ever 2.9%. These highlight the huge amount of value available.
Equities are also discounting a major recession, with earnings expected to drop dramatically over the next couple of quarters, especially in Q2. Equity markets are already discounting a drop of at least 25% in earnings. This is extremely painful, but we believe it is not long lasting, as we expect a U-shaped recovery to start already in Q3, led by Asia, especially China, which has already started to recover in Q2.
Stimulus will reduce recession severity, boost liquidity and sentiment
Stimulus helping. Heavy stimulus packages have been introduced, both in terms of monetary and fiscal stimulus. The ECB’s role is very important. The measures so far have been positive. The ECB’s expansion into the commercial paper markets also helps short-term papers. They’re really trying to stabilise markets. Sovereign risk has started to recede also. Deflation is a risk now, but continuous stimulus could reverse that or even lead to inflationary pressures going forward.
We expect that growth figures will reveal a rather short recession, about 2 quarters, and then a rebound later this year. We will see bad figures in the headlines, but it is positive that the Chinese data is already showing a comeback of activity. If China recovers, we might expect the same in Europe and the US in the next 4-6 weeks. The western data will be worst in April. This could be the shortest and sharpest recession in history.
Stimulus has also come to the Nordics, with local central banks (Norway, Sweden, Finland) finally about to start their own bond buying programs. And these will include HY and unrated names. We are confident in the very high quality of the issuers, although Nordic bonds tend to react slower to market swings.
Liquidity returning. Liquidity is weaker but still operational. There was a liquidity squeeze, as the crossover and Nordic markets are very flow driven and, as might be expected, when the panic hit, everybody ran for liquidity. However, already last week, the inflows have started coming back into credit funds.
The recent weakness also affected the commercial paper market. For example, the Finnish CP market was ‘over-offered’ as companies started issuing papers to fill up their war chests, while funds were trying – unsuccessfully – to sell. The ECB’s new plans will help liquidity in this segment, as well.
Sentiment will improve. Volatility may remain high in the coming weeks and lead to new lows in the markets. But eventually we will start to see a rebound in investor sentiment, and flows.
We expect sentiment could turn positive in a big way if:
- infections peak in the next 3-4 weeks in key markets;
- volatility levels, which have fallen from the 80s to the 50s, continue to drop; and
- Chinese data continues to improve and western data starts to improve.
So yes, sentiment is currently very weak – but that’s typically a buy signal. The ECB has really ramped up its buying program, much more now than even before. The ECB is buying IG, which is now having a direct and visible impact on the market. It also boosts sentiment for credit in general, which helps HY.