Why Fixed Income is at the Epicenter of Market Volatility

Published on24 MAR 2020

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




General Disclosures

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.
Income from municipal securities is generally free from federal taxes and state taxes for residents of the issuing state. While the interest income is tax-free, capital gains, if any, will be subject to taxes. Income for some investors may be subject to the federal Alternative Minimum Tax (AMT).
The views expressed herein are as of March 18, 2020 and subject to change in the future. Individual portfolio management teams for GSAM may have views and opinions and/or make investment decisions that, in certain instances, may not always be consistent with the views and opinions expressed herein.
Views and opinions expressed are for informational purposes only and do not constitute a recommendation by GSAM to buy, sell, or hold any security, they should not be construed as investment advice.
Prospective investors should inform themselves as to any applicable legal requirements and taxation and exchange control regulations in the countries of their citizenship, residence or domicile which might be relevant.
Past performance does not guarantee future results, which may vary. The value of investments and the income derived from investments will fluctuate and can go down as well as up. A loss of principal may occur.
This material is provided for informational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities.
This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice. This material has been prepared by GSAM and is not financial research nor a product of Goldman Sachs Global Investment Research (GIR). It was not prepared in compliance with applicable provisions of law designed to promote the independence of financial analysis and is not subject to a prohibition on trading following the distribution of financial research. The views and opinions expressed may differ from those of Goldman Sachs Global Investment Research or other departments or divisions of Goldman Sachs and its affiliates. Investors are urged to consult with their financial advisors before buying or selling any securities. This information may not be current and GSAM has no obligation to provide any updates or changes.
Economic and market forecasts presented herein reflect a series of assumptions and judgments as of the date of this presentation and are subject to change without notice.  These forecasts do not take into account the specific investment objectives, restrictions, tax and financial situation or other needs of any specific client.  Actual data will vary and may not be reflected here.  These forecasts are subject to high levels of uncertainty that may affect actual performance. Accordingly, these forecasts should be viewed as merely representative of a broad range of possible outcomes.  These forecasts are estimated, based on assumptions, and are subject to significant revision and may change materially as economic and market conditions change. Goldman Sachs has no obligation to provide updates or changes to these forecasts.  
United Kingdom and European Economic Area (EEA):  In the United Kingdom, this material is a financial promotion and has been approved by Goldman Sachs Asset Management International, which is authorized and regulated in the United Kingdom by the Financial Conduct Authority. Switzerland: For Qualified Investor use only – Not for distribution to general public. This document is provided to you by Goldman Sachs Bank AG, Zürich. Any future contractual relationships will be entered into with affiliates of Goldman Sachs Bank AG, which are domiciled outside of Switzerland. We would like to remind you that foreign (Non-Swiss) legal and regulatory systems may not provide the same level of protection in relation to client confidentiality and data protection as offered to you by Swiss law.
Asia Pacific: Please note that neither Goldman Sachs Asset Management International nor any other entities involved in the Goldman Sachs Asset Management (GSAM) business maintain any licenses, authorizations or registrations in Asia (other than Japan), except that it conducts businesses (subject to applicable local regulations) in and from the following jurisdictions: Hong Kong, Singapore and Malaysia.  This material has been issued for use in or from Hong Kong by Goldman Sachs Asset Management (Hong Kong) Limited, in or from Singapore by Goldman Sachs Asset Management (Singapore) Pte. Ltd. (Company Number: 201329851H) and in or from Malaysia by Goldman Sachs (Malaysia) Sdn Berhad (880767W).  
Australia:  This material is distributed in Australia and New Zealand by Goldman Sachs Asset Management Australia Pty Ltd ABN 41 006 099 681, AFSL 228948 (’GSAMA’) and is intended for viewing only by wholesale clients in Australia for the purposes of section 761G of the Corporations Act 2001 (Cth) and to clients who either fall within any or all of the categories of investors set out in section 3(2) or sub-section 5(2CC) of the Securities Act 1978, fall within the definition of a wholesale client for the purposes of the Financial Service Providers (Registration and Dispute Resolution) Act 2008 (FSPA) and the Financial Advisers Act 2008 (FAA),and fall within the definition of a wholesale investor under one of clause 37, clause 38, clause 39 or clause 40 of Schedule 1 of the Financial Markets Conduct Act 2013 (FMCA) of New Zealand (collectively, a “NZ Wholesale Investor”). GSAMA is not a registered financial service provider under the FSPA. GSAMA does not have a place of business in New Zealand. In New Zealand, this document, and any access to it, is intended only for a person who has first satisfied GSAMA that the person is a NZ Wholesale Investor.  This document is intended for viewing only by the intended recipient. This document may not be reproduced or distributed to any person in whole or in part without the prior written consent of GSAMA. This information discusses general market activity, industry or sector trends, or other broad based economic, market or political conditions and should not be construed as research or investment advice.  The material provided herein is for informational purposes only. This presentation does not constitute an offer or solicitation to any person in any jurisdiction in which such offer or solicitation is not authorized or to any person to whom it would be unlawful to make such offer or solicitation.
Canada:  This presentation has been communicated in Canada by GSAM LP, which is registered as a portfolio manager under securities legislation in all provinces of Canada and as a commodity trading manager under the commodity futures legislation of Ontario and as a derivatives adviser under the derivatives legislation of Quebec. GSAM LP is not registered to provide investment advisory or portfolio management services in respect of exchange-traded futures or options contracts in Manitoba and is not offering to provide such investment advisory or portfolio management services in Manitoba by delivery of this material.
Japan:  This material has been issued or approved in Japan for the use of professional investors defined in Article 2 paragraph (31) of the Financial Instruments and Exchange Law by Goldman Sachs Asset Management Co., Ltd. 
Although certain information has been obtained from sources believed to be reliable, we do not guarantee its accuracy, completeness or fairness.  We have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources.
Any reference to a specific company or security does not constitute a recommendation to buy, sell, hold or directly invest in the company or its securities. It should not be assumed that investment decisions made in the future will be profitable or will equal the performance of the securities discussed in this document.

No part of this material may, without GSAM’s prior written consent, be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorized agent of the recipient.
© 2020 Goldman Sachs. All rights reserved. Date of first use: March 24, 2020.
Compliance Code: 198244-OTU-1161179

Explore More Insights