Issue date: 2020-06-29
The year started positively, as the US and China signed into effect ‘phase one’ of their trade deal. However, before long, news of the worsening coronavirus (COVID-19) outbreak in China began to drive fear into markets. First, this saw investors shun risk in favour of higher-rated assets, in a reversal of moves seen in late 2019. US Treasury yields fell, helping investment-grade to outperform high-yield debt. But then came the oil price war and the evolution of COVID-19 to global pandemic status, so began one of the fastest ever sell-offs, pushing credit market valuations to levels normally seen in times of recession. Credit markets recently staged a partial recovery, following the rollercoaster first quarter.
Nowhere to hide
One of the starkest aspects of the recent market volatility has been just how correlated credit asset classes became in the depths of the sell-off. Of course, history has taught investors that in periods of significant market stress (global financial crisis - GFC; dotcom bubble) asset class correlations inevitably rise. But both the pace and violent nature of the recent shift in market mechanics have been unprecedented.
The upshot of this sharp and homogenous sell-off is that many flexible credit investors found themselves with nowhere to hide. The selloff was that indiscriminate in nature, meaning that in many cases traditional ‘safe havens’ (i.e. higher rated credit segments) underperformed other traditionally more volatile parts of the market.
While there were numerous drivers of this spike in volatility and correlations, we believe they largely revolve around two central themes: significant fund outflows across all asset classes (including the historically safest investment-grade market); and a lack of trading desk balance sheet and risk appetite (i.e. limited capacity and risk appetite to make a two-way market).
Investment-grade market was the catalyst for the broader market capitulation. Against a backdrop of tumbling equity and bond markets, investors scrambled for liquidity, frantically trying to raise cash and redeeming investment-grade holdings at irrational market prices, which then further fuelled a further vicious cycle of price falls. US investment-grade bond funds saw weekly outflows of approximately U$30 billion in March which was compared to the previous weekly record of $8 billion in 2008.
While significant central bank action has helped to alleviate some of this stress, starting in the US Treasury market, the global credit market remains in recovery mode, following this brutal onslaught. The uniformity of the sell-off is best illustrated by the chart below, where at its nadir, almost every credit asset class was down between 10 and 25%.
The brutal nature of the recent sell-off
Source: Bloomberg, ICE BofA Merrill Lynch. US Loans: S&P/LSTA Leveraged Loan Total Return Index; Global High Yield: ICE BofA Global High Yield Index; Global Investment Grade: ICE BofA Global Corporate Index; Short Duration High Yield: ICE BofA 1-3 Year Global High Yield Index; CoCo's: ICE BofA Contingent Capital Index. As at 31 March 2020.
However, the indiscriminate nature of the sell-off has produced some particularly compelling investment opportunities, right across the credit spectrum. From high-yield bonds to loans, and from investment-grade debt to structured credit, risk compensation is at levels we haven’t experienced in many years. And while the outlook remains highly uncertain, we believe that this pronounced repricing of credit spreads offers a variety of attractively priced opportunities for the discerning credit investor.
The support measures provided by various central banks and governments, most notably the Fed, has created a significant tailwind for credit markets, first acting to stabilise markets before then igniting the rebound.
The Fed’s support for credit markets is undoubtedly positive for investor sentiment, and it is likely to help maintain the daily functioning of investment-grade credit markets and broader risk asset sentiment. Furthermore, we believe there will still be significant opportunities both within the Fed programme’s remit and in the credit markets outside of it, as the coming economic fallout unfolds.
As such, selectivity, and dynamism will be key, especially with a marked increase in credit defaults looming. We think the challenge now for investors is less about trying to buy into markets at attractive headline valuations, but rather about finding attractive, resilient, sustainable individual investments, that will survive regardless of the range of outcomes that lay before us. Given the disconnect discussed above, and likely variable default experience across different markets, we believe these investments are highly likely to come from a variety of credit markets. And as we get deeper into this cyclical turn, relative valuation metrics are likely to evolve further, pointing to the need to stay nimble and dynamic in capturing the investment opportunities arising from these historic market twists.
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