Like everything else, developed fixed income markets are in a ‘new normal’ as central bank action and fiscal policies hold volatility and defaults on a leash. Bad news is failing to perturb markets. Could positive news trigger the next major market move?
Developed fixed income markets are now firmly in the thrall of central bank initiatives and governments’ fiscal policies, to the extent that they are behaving more like policy tools than efficient markets.
While the introduction of quantitative easing (QE) in the wake of the 2008 financial crisis reduced bond markets’ ability to function normally, the actions taken in 2020 by central banks and governments have taken this to a whole new level. Before 2020 yields were being held at artificially low levels, but now bond markets no longer reflect company fundamentals and default risk.
All of which may sound nightmarish. However, it is worth remembering that COVID-19 and the current high levels of central bank and government support will be temporary, simply because it is not sustainable. Between February and October this year, for example, the US national debt has ballooned from US$23tn to US$27 trillion,[1] raising questions about the US dollar’s position as the world’s reserve currency. Quite how long ‘temporary’ is, and whether it is to be counted in months or years, we cannot know for sure, but we do expect to begin operating in a more normal market environment in due course.
Low vol, faux-vol
Perhaps the biggest oddity of these artificial markets is a massive fall in US treasury yields coinciding with US equities outperforming all assets. We would normally expect treasury yields and equities to move in opposite directions. For the time being, at least, the traditional pattern of risk-on/risk-off is broken and markets are moving in tandem and volatility is being spread evenly across asset classes.
'Since the Spring, markets have been range-bound by fiscal and monetary support'
Volatility shot up to extreme levels in March and April, leaving the impression that this has been a year of high volatility. In fact, prompt central bank and government action quickly brought volatility under control, where it has subsequently remained. Since the big moves in the Spring, markets have generally been range-bound by fiscal and monetary support. Dire economic news is being shrugged off remarkably quickly as volatility perks up briefly, then returns to its kennel for a nap.
This is music to the ears of governments and central banks, whose main aim throughout this crisis has been to ensure ample liquidity flowing through markets so that default rates are held at bay. A by-product of these actions has been a drastic curb on volatility. So if bad news is not shifting markets, what will?
We believe that the next major market move could be a positive one, in the form of a vaccine becoming available, winter COVID-19 infection rates being lower than expected, improving economic data or a less-than-fractious US election outcome. If any of these events were to materialise, volatility would move still lower.
'Extracting returns from unhedged currency exposures will be an important part of overall returns'
Any suggestion that central banks are even considering reducing their support for markets would certainly increase volatility, as we experienced during the 2016 Taper Tantrum. But major central banks have indicated that is most unlikely to happen before 2023. In the meantime, investors in sovereign bonds can expect a relatively smooth, if somewhat dull, passage in which skills such as extracting returns from unhedged currency exposures will become an important part of overall returns. For investors in corporate bonds, there is still potential to extract reasonable returns, but the outlook for the market is more mixed and therefore demands extra caution in asset selection.
Where have all the defaults gone?
'Current default levels are uncomfortably low'
Given the unprecedented size of the economic shock witnessed this year we would have expected a rise in corporate debt default rates, but so far these have been thin on the ground. Defaults have increased in the US to approximately 4% but in the EU they are still around 2%. These are low levels by historical standards. Given that the growth contraction delivered by COVID-19 is significantly larger than that of 2007-8, after which defaults rose to around 12%, current default levels are uncomfortably low.
Investors would naturally be wise to avoid the sectors most badly affected by the effects of COVID-19, such as property, physical retail, travel and leisure. Having said that, some names in distressed sectors may benefit from government support. For example, a transportation-related bond is not necessarily the kiss of death – many major airports are receiving government support as strategic national assets.
With yields at low levels in sovereign and investment grade bonds, more investors are venturing into lower-rated bonds in search of better returns or in pursuit of familiar names that have recently left or are on the verge of leaving the investment grade universe. As a result, we are seeing BBB spreads compressing as more investment grade investors seek to bolster their returns.
Central bank action and fiscal measures have held back a wave of corporate debt defaults – but only temporarily. The increase in ‘zombie‘ companies has been beneficial for bond markets but detrimental to the real economy, and the day of reckoning for ailing companies has been delayed, not averted.
Monetary support in the form of low interest rates and QE will be a durable feature of fixed income markets, but fiscal support will be more short-lived. Over the next two years we expect to see a pickup in default rates, debt restructuring and investors receiving haircuts as companies struggle to service high levels of debt - a sizeable portion of which was taken on in 2020 in a bid to offset falling revenues and make it through the crisis. This warrants a prudent approach to portfolio construction and highly selective, well-researched name selection.
Important Information
The value of investments may fall as well as rise and investors may not get back the amount invested.
The information contained in this document is provided for use by investment professionals and is not for onward distribution to, or to be relied upon by, retail investors. No guarantee, warranty or representation (express or implied) is given as to the document’s accuracy or completeness. The views expressed in this document are those of the fund manager at the time of publication and should not be taken as advice, a forecast or a recommendation to buy or sell securities. These views are subject to change at any time without notice.
CLI01747 Expiry on 31/03/2021
[1] US Treasury, https://www.treasurydirect.gov/govt/reports/pd/pd_debttothepenny.htm