Bond investors must weigh the current market interventions by central banks alongside the longer-term outlook for the economy.
Social and economic factors are being weighed against each other as most major economies begin to plan for a tentative re-opening.
As fixed-income investors, we have been monitoring developments closely and modelling potential future scenarios as we look ahead to the attempted return to normality around the world. A key question is the degree to which economic activity in certain sectors will fail to rebound.
From the 1920s to the 2020s
Unfortunately, we think it will probably be very difficult to assess the extent of economic scarring, both nationally and globally, until later this year or in 2021. Indeed, rating agencies may hold off downgrading many companies until there is greater clarity in this respect.
In the meantime, markets have responded well to monetary and fiscal support. From a historical perspective, credit valuations are now at levels that are only consistent with a modest recession, which is quite the testament to the US Federal Reserve (Fed), the European Central Bank (ECB), and the Bank of England (BoE) as the economic contraction in the second quarter of 2020 looks set to rival that of the Great Depression in the 1920s.
Supply and support
Looking at corporate bond markets, the rally in credit since mid-March has slowed as spreads have declined and issuance has accelerated. Companies remain focused on liquidity and plugging the substantial cashflow holes in their balance sheets.
Investment-grade issuance this year has reached roughly $750 billion to date, which is 187% of the corresponding amount in 2019. This has been led predominantly by US dollar credit, although both euro and sterling investment-grade markets have also seen increases in supply. Compared to four-year averages, the pace of issuance is just as striking: $547 billion was issued in March and April, according to JPMorgan, compared with an average of $202 billion for those two months between 2016 and 2019.
All central bark and no central bite?
The announcements of corporate bond purchase programmes by leading central banks did much to ease immediate market tensions. But there is now a worry that central bank interventions may not meet short-term expectations. On 22 March, the announcement that the Fed would buy corporate bonds significantly improved liquidity and market valuations. However, six weeks later, it is yet to make any of these purchases as the programme is not yet operational.
One school of thought is that the requirement for firms to deem themselves eligible for the programme may be causing a problem, as companies might be worried about stigma or future political interference.
A further criticism of the programme is that relative to the size of the US investment-grade credit market, it is too small – particularly when compared with the size of the ECB’s parallel programme and the size of the euro investment-grade market. This could be interpreted as a sign that the US programme is designed more to enable the Fed to become a lender of last resort to large companies than to control credit spreads across the market.
Weighing the risks
Our credit teams are generally confident in the ability of the US and European central banks to adapt when needed. However, geopolitical risk seems to have increased over the past month, with European sovereign risk again a topic of discussion, along with the possibility that the China-US trade deal could unravel amid aggressive rhetoric from the US administration.
While the risks have increased, we still believe the credit market offers value at this juncture over horizons of both 1-3 months and 12 months, although this will not be a straight line. As the return to business as usual must be gradual, longer-term changes in market dynamics may also take longer to be revealed. Although short-term volatility has occupied many investors’ minds over recent months, we remain focused on trying to anticipate the potential changes in behaviours caused by COVID-19 and their impact on longer-term trends.