The article below is from our BRIEFINGS newsletter of 24 March 2020
Even as the Federal Reserve announced plans to expand its bond-buying program, liquidity challenges in the fixed income markets have become another feature of the current crisis. Last week, Goldman Sachs Asset Management’s (GSAM) Mike Swell, co-head, Global Portfolio Management of Global Fixed Income, hosted a client call with members GSAM’s Global Fixed Income team to discuss recent developments and the policy response.
Mike Swell: Ashish, can you provide an overview of the fixed income market, the steps being taken by the Federal Reserve toward recovery and what could drive valuations?
Ashish Shah: The combined shock of Covid-19 and drop in oil prices created a liquidity shock in fixed income. In short, the broad selloff in equities led to significant selling of fixed income securities. Much of this selling was driven by rebalancing—investors selling fixed income and buying equities to rebalance their portfolios when the stock market sells off—and by investors selling fixed income to raise liquidity. As a result, broker-dealer balance sheets have become clogged with securities, reducing their ability to intermediate between buyers and sellers in the bond market.
As central banks cut rates and expanded quantitative easing, we started to see liquidity improve, especially in Treasuries and agency mortgages. From an investment strategy perspective, we’ve been focused on areas of the market that are in the path of policy response, and have been buying bonds that offer the potential for strong free cash flow backed by strong assets. Mortgage-backed securities are one example, as the Fed recently launched quantitative easing purchases of at least $200 billion in mortgage-backed securities. We’re very much in the thick of the crisis—where we will likely remain over the next several weeks—but expect to see opportunities in high-quality, short-term credit which will benefit from improving liquidity.
Mike Swell: The short-term commercial paper (CP) market—which companies tap to fund their day-to-day operations—began to show signs of strain when yields moved higher than certain long-dated bonds. That’s usually an indication that companies are hoarding cash or that buyers are disappearing. But in recent days, the Fed introduced policies to help the CP market. Pat, what impact are these mechanisms having on the funding market?
Pat O’Callaghan: The Fed took a page from its 2008 financial crisis playbook by implementing initiatives that would backstop the $1.13 trillion market for commercial paper. One such measure included the launch of a Commercial Paper Funding Facility in which the Fed will buy three-month debt from firms with high credit ratings. And as we saw during the financial crisis, we’re also seeing a similar rotation out of prime money market funds into government money market funds. For example, government money funds have picked up close to $300 billion of inflows while prime funds have seen outflows of $209 billion as of March 19. This time, however, the Fed also indicated that it will support firms that choose to use its capital and liquidity facilities—which many were required to build up after the financial crisis—as long as they deploy the capital in a “safe and sound manner.” For example, on March 26—the start of the next reserve maintenance period—the Fed will eliminate reserve requirements, effectively freeing banks to deploy all of their capital to support lending.
Mike Swell: We’ve obviously seen a lot of policy action in the US. Alex, can you share what you’re seeing globally?
Alex Stiles: Central banks have already cut interest rates dramatically but appear to be out of room for further cuts. In Europe and Japan, where central bank policy rates are already negative, the European Central Bank and Bank of Japan both appear to have decided that cutting rates further into negative territory would be ineffective. We believe the Fed is also unlikely to adopt negative interest rates. That means fiscal is now in the spotlight. We’ve already seen the US announce large fiscal stimulus packages and expect to see more. In Germany—a country with a lot of fiscal firepower—we’ve seen the finance minister describe his willingness to do whatever it takes to help German businesses, including a large-scale lending program to businesses. The UK also recently unveiled a large-scale government lending program that is estimated to cost 16% of the country’s GDP. But as we see similar policies being unveiled throughout Europe, we could see fiscal positions deteriorate far more rapidly than they did during the 2008 financial crisis. As a result, it will be important to monitor the interactions between fiscal and monetary policies.
Mike Swell: So far, the central bank policies appear to be aimed at the short-term funding and mortgage markets. But the credit markets are more in the eye of the storm when you consider the implications of an economic downturn. Ben, what’s your outlook for the sector?
Ben Johnson: In investment grade corporate bonds, we could see rating downgrades in sectors directly affected by the virus and lower oil prices, including companies in the energy, travel and leisure sectors. We believe the banking sector is well capitalized and well positioned to navigate near-term volatility. Based on our estimates, around $200-250 billion of BBB-rated bonds (the lowest investment-grade rating) could enter the high yield market over the coming year, equal to around 17% of the current US HY market value. We expect energy to account for around one half of these rating migrations, with the auto sector accounting for another one-third and the balance being comprised of issuers from travel and other sectors sensitive to the coronavirus.
Meanwhile, flows out of investment grade funds and ETFs continue to remain negative and we expect that to continue, especially as investors rebalance portfolios at month end. New issue activity is also modest, although we did see a pickup of high-quality companies, including Verizon, Bank of America and Progressive, issue bonds in recent days with attractive concessions.
Mike Swell: The investment grade sector has gotten hit harder than the high yield sector in part because it’s more liquid. Yet there are plenty of companies with strong cash flow that will likely able to weather a recession. Any credit downgrades will certainly have an impact on high yield. Mike Dimitri, as global head of leveraged trading, can you tell us what you’re seeing in your sector?
Mike Dimitri: As Ben mentioned, the potential for investment grade downgrades into high yield will put significant pressures on the sector. The spread widening that we’ve seen in the last two weeks has taken us to spread levels that we last saw during the financial crisis. But while trading volumes are up 20% to 25% from the start of the year, the market has remained relatively orderly in the context of the widening spreads. The high yield market has experienced significant investor outflows, contributing to the liquidity challenges in this market. In high yield, we think default risk has increased, although we estimate the market is pricing in a 12-month default rate of about 9%, which is above our expectations.
For more, read GSAM’s report, Taking the Temperature of the Bond Market
All investments contain risk and may lose value. Investments in fixed income securities are subject to the risks associated with debt securities generally, including credit, liquidity, interest rate, call and extension risk. Although Treasuries are considered free from credit risk, they are subject to interest rate risk, which may cause the underlying value of the security to fluctuate. Below investment grade (high yield) bonds are more at risk of default and are subject to liquidity risk.
High-yield, lower-rated securities involve greater price volatility and present greater credit risks than higher-rated fixed income securities.
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