Corona curves: what next for short-dated credit?
The COVID-19 virus and its impact on global financial markets have been nothing short of exceptional, much like the unprecedented measures governments and central banks around the world have implemented in response.
While the sharp sell-off of equities may have caught investors’ attention, fixed income has also had its fair share of volatility. This abrupt switch in market sentiment has also caused corporate bond spreads (the difference in yield between a corporate bond and an equivalent government bond) to widen faster than investors have ever experienced, even outpacing the selloff in the wake of the Lehman Brothers bankruptcy in 2008. It has also led to the US credit spread curve flattening completely in March.
What does this mean?
The credit spread curve is the difference in spread between a long-dated corporate bond and a short-dated corporate curve from the same issuer. In a normal environment, investors would expect this spread to be wider to reflect the fact that if you invest over a longer period of time, you should receive a higher yield in return.
However, this is not always the case: sometimes, the credit spread curve flattens (i.e. there is less of a difference between shorter- and longer-dated bond yields). This happened in 2002 and at the end of 2008, when the credit spread curve not only flattened but subsequently inverted (i.e. shorter-dated yields were higher than longer-dated yields), and only returned to an upward-sloping shape in the summer of 2009.
The chart below shows recent spread movements in US credit, and the differential between long- and short-dated credit spreads.
In 2008, fears that the distress in the financial sector would overflow into the real economy prompted many investors to sell their short-dated bonds on a vast scale, causing short-dated yields to rise and making the credit curve flatten and then invert.
This time, the distress in financial markets is being caused by a shutdown in the real economy (not the other way around, as in 2008). Banks appear to be much more resilient than they were in 2008, making them a key pillar of support for the authorities’ efforts to stabilise the economy. The COVID-19 virus has significantly disrupted businesses and industries around the world, which is likely to cause the default rate to rise. In these difficult times, corporate short-dated bonds are becoming less attractive to investors because it is hard at this juncture to assess which companies will survive the immediate impact.
Additionally, short-dated debt has seen exceptional inflows over the past few years from institutional investors who have viewed it as way to generate modestly positive returns over cash.
However, the recent market volatility has caused record outflows across all fixed income holdings. This has led many asset managers to sell money-market funds and short-dated debt – often seen as ‘cash proxy’ assets – in a bid to fund investor redemptions in other areas of their portfolios. As a result, in the past few weeks the two have experienced $150 billion and $38 billion in outflows respectively.
The outlook for short-dated corporate debt
Amid these challenging conditions, we believe there are some select opportunities in US short-dated corporate debt. On 23 March, the US Federal Reserve (Fed) announced the creation of a Market Corporate Credit Facility to purchase bonds and bond exchange-traded funds (ETFs) to provide liquidity for the corporate bond market, with a focus on short-dated maturities.
We believe that this measure, alongside the exceptional actions that the Fed has taken to support liquidity, should release some of the pressure in short-dated corporate bonds, where yields have risen significantly.
In fact, the credit spread curve has already begun to normalise and we believe last week’s announcement that the Fed will expand its purchase programme to buy high-yield bonds should lead to further normalisation as short-term default risks will be alleviated by these extensive support measures.
As mentioned above, the current crisis is very different from that in 2008 and we are maintaining due caution as it unfolds. While we are keen to act on any attractive opportunities we identify in these times, it is important to note that we believe that default risk will rise this year, so we are concentrating on issuers that we think will be the most resilient to a prolonged shutdown, with conservative balance sheets and lower business risk. While short-dated corporate debt is currently showing signs of strain, the more resilient companies should be able to weather this storm.
 Wells Fargo, April 2020
 Bank of America Merrill Lynch, March 2020