Q1 2020 Commentary
Executive Summary
- During the quarter there was a repricing of financial assets the magnitude of which we have not seen since the Global Financial Crisis.
- Central banks have acted quickly to backstop credit markets in an unlimited fashion - with the US Federal Reserve going so far as to announce last week that they will buy corporate bonds recently downgraded to high yield.
- This has created a unique opportunity for us to invest in quality, defensive businesses that will exist post-COVID-19 at levels not seen in over a decade.
The double “Black Swan” of COVID-19 and the Saudi/Russia-induced oil price collapse rocked markets in March. It’s hard to imagine now, but early this quarter leading economic indicators had turned positive and progress had been made on a US-China trade deal. Two “black swan” events then occurred in quick succession to dramatically change the global investment landscape. First, the spread of COVID-19 led to an unprecedented shutdown of the world economies that is likely to reverberate for several quarters. In addition to this, there was an energy supply shock as Saudi Arabia dramatically increased oil production. These twin developments sent financial markets into a tailspin with stocks and bonds experiencing their biggest draw-downs since the Global Financial Crisis. It also set-off a liquidity crisis, with corporations drawing down on bank lines and individuals selling assets of all types – even risk-free assets such as government bonds – in order to generate cash. With trading desks thinly staffed due to social distancing, the resulting downward pressure on prices was exacerbated.
Against this backdrop, corporate bonds of all types dropped significantly in value. There are two reasons why corporate bonds moved so violently during March. The first was an increase in the Credit Risk Premium – in other words, as investors (correctly) started to anticipate a recession, they demanded more compensation to lend to corporations. This put downward pressure on bond prices. The second was an increase in the Liquidity Premium. Against an uncertain backdrop, investors reappraised the value of having cash now rather than at a future time. This sharp change in the Liquidity Premium pushed prices of corporate bonds lower again. Generally speaking, investment grade rated corporate bonds close to maturity tend to behave defensively during “risk off” periods. This was not the case during March as investors liquidated even high-quality securities close to maturity. In fact, the considerable selling of these types of securities became so pronounced that some credit curves inverted during the month.1
Central banks acted quickly to effectively backstop credit markets in an unlimited fashion. The speed at which corporate bonds retraced to levels not seen since 2009 was astonishing, occurring in a matter of three weeks. In response, the US Federal Reserve (“the Fed”) took the 2008 playbook and went even further by cutting interest rates to zero, purchasing huge quantities of government debt, and, for the first-time ever, setting up to buy corporate bonds. While economic activity has been halted in an unprecedented fashion, the Fed has taken a “whatever it takes” approach to ensure the economy’s capacity to produce once the threat of COVID-19 has passed. In a similar vein, the Bank of Canada responded quickly by announcing a raft of measures to provide liquidity, including programs to support the market for Bankers Acceptances and Commercial Paper. As a result the Canadian system seems to be operating well. The Bank of Canada has also made it clear that they have plenty of additional tools available should they be needed.
On Thursday of last week (April 9th), the Federal Reserve surprised the credit market very positively. It achieved this by announcing its intention to purchase securities that have been downgraded to high yield ratings of BB- and above since March 22nd, as well as High Yield ETFs. This was unexpected and markets began to rally on Thursday even though it was only a half day for fixed income. April had already seen an improvement in conditions in the corporate bond market, although liquidity continued to be challenging amid the height of COVID-19 in NYC/US and as investors digested the impact of initial policy responses for credit. While higher-rated securities had started to retrace some of the price declines of the previous month, BBB and lower rated securities did not meaningfully participate in this retracement. However, on Thursday we saw a strong rebound in the BBB and BB segment of the market after the Fed expanded the eligible securities for the Primary and Secondary corporate bond programs. The programs were increased in size as expected, but the inclusion of a large portion of high yield securities is a major positive ahead of the upcoming challenging earnings season and we believe that will enable investors to feel comfortable adding risk once again.
There is an opportunity in high-quality credits that will continue to be integral to the functioning of society and the economy. During the last month, we would argue that the baby was thrown out with the bathwater. We saw bonds issued by companies in the cable and wireless, technology, healthcare and utilities sectors come under severe pressure – even though many of these companies provide essential services. During the last financial crisis, commentators assumed that people would prioritize their mortgage payments first, and then car lease payments second. This turned out not necessarily to be the case as cars were essential for people to get to their jobs. This flew in the face of everything we knew up to that point. This time around, there are certain industries like communications which were once thought of as luxuries but are now known to be essential – and will therefore be less sensitive to a recession. There is an opportunity today to acquire securities issued by companies that meet this criteria and stand to benefit from central bank programs – at exceptional levels. It is also worthy of note that the current crisis is different to the Global Financial Crisis. Banks are well-capitalized today after a decade of stricter regulation, and as such the global economy is underpinned by a healthy banking sector.
We believe a lack of clarity about future earnings at many companies will mean continued volatility in equity prices. Many corporations have reduced or cancelled their equity dividends, and around $190 billion of share buybacks have also been suspended. These are exactly the types of shareholder value actions that have driven much of the equity market rally in recent years. These actions will support balance sheets and we know that the Fed is set to start buying up to $4 trillion in corporate credit. As a result, we think the value in credit markets is much easier to analyze than in equity markets going forward. With much uncertainty about the long-term impact of COVID-19, we would expect continued volatility in the equity market.
However, we believe the outlook for corporate bonds is very compelling at this point. Against a highly uncertain background, credit has some noteworthy characteristics. As a bondholder you are higher up in the capital structure than equity investors, and coupons are fixed and can’t be cut like dividends. Bonds are contractual obligations so returns are known as one has done one’s credit analysis. We believe the forward-looking return from credit is very attractive at this point given credit spreads which are extremely large by historical standards. Simply put, high quality securities are available at prices not seen for a decade. Although there is uncertainty with respect to COVID-19, central banks have demonstrated a “whatever it takes” approach to ensuring that companies that were viable before COVID-19 will be viable again afterwards. In addition to credit spreads not seen for over a decade, there is the potential for short term gains from credit spread compression. Finally, after previous crises, credit markets have typically recovered from drawdowns significantly faster than the equity market. We would expect that to be the case this time around also.
Relative Value and Active Trading Opportunities tend to be best after a period of disarray. In addition to a passive return, the opportunities to actively add returns from active management / trading tend to be best after periods of violent market correction. We expect that to be the case this time around also. This environment is a fertile one for the relative value opportunities that have been the mainstay of our investment approach for many years. We feel that this is an ideal time to put capital to work at valuations we have not seen for many years. In addition, with the re-opening of the new issue market we have seen some exceptional opportunities to buy high quality bonds at steep discounts. Indeed, the last week of March was the biggest week ever for new issuance in the US market with $110bn of deals.2 Actively participating in the new issue market has historically been a very profitable activity for us, particularly so when concessions are elevated. As a result, we are encouraged by the opportunity to add significant additional value for our investors in our mandates.
Materially higher yields have started to attract new buyers of corporate bonds. Prior to the recent market repricing fixed income investors have been pushed into taking more risk and exploring private asset classes in order to find incremental yield. Now the yield on public investment grade credit has moved dramatically higher from 2.6% to 4.6% for the universe overall (US market). For BBB rated credit, yields have gone from 2.9% to 5.3%. There is even more yield available lower down in the rating spectrum with BB yields moving from 3.9% to 8.7%.3 Last week we saw deployment of capital from investors that don’t typically focus on investment grade credit – equity managers, distressed investors, high yield managers - investing at levels that until recently were only obtainable in the high yield market. This “new buying” is another encouraging fact that gives us reason to be very optimistic on forward-looking returns from here.
Our business continues to function well despite the challenges of COVID-19. We are pleased to say that our disaster recovery procedures and infrastructure have allowed the firm – and the Portfolio Management team – to function well, despite the logistical and operational challenges posed by COVID-19. Our preparations have paid-off, supported by our significant investments in technology. A core team of five of the Portfolio Management team are physically present in the office every day, fully respecting social distancing rules. Others are working at the disaster recovery site and the remainder of the firm working from home. This has allowed us to keep moving and keep doing our jobs.
We are aiming for genuine transparency – and welcome the opportunity to dialogue with you. In the following performance commentary sections we have aimed to be even more transparent than normal about how the portfolios were positioned coming into the quarter and how they are currently positioned to make the best of the opportunity ahead. The first quarter of this year witnessed an exceptional combination of events that has dramatically repriced financial markets. We have adjusted the positioning of our portfolios to strike what we believe to be the right balance between defense and offence going forward. We believe the outlook to be very well-suited to our strategies. While there is uncertainty given then unprecedented nature of COVID-19 we feel confident that corporate bond valuations today are very attractive, particularly given the unambiguous policy backdrop.
Should you have any questions or concerns, please feel free to reach out to a member of the team and we would be glad to address them. Many thanks for your support – and we hope you and your families stay well.