The year started positively, as the US and China signed into effect ‘phase one’ of their trade deal. However, before long, news of the worsening coronavirus (Covid-19) outbreak in China began to drive fear into markets.
First, this saw investors shun risk in favour of higher-rated assets, in a reversal of moves seen in late 2019. US Treasury yields fell, helping investment-grade to outperform high-yield debt. But then came the oil price war, as cooperation within OPEC+ broke down. As Covid-19 progressed to global pandemic status, so began one of the fastest ever sell-offs, pushing credit market valuations levels normally seen in times of recession.
Nowhere to hide
One of the starkest aspects of the recent market volatility has been just how correlated credit asset classes became in the depths of the sell-off. Of course, history has taught investors that in periods of significant market stress (such as the global financial crisis and the dotcom bubble) asset class correlations inevitably rise. But both the pace and violent nature of the recent shift in market mechanics have been unprecedented.
The upshot of this sharp and homogenous sell-off is that many flexible credit investors found themselves with nowhere to hide. The sell-off was indiscriminate in nature, meaning that in many cases traditional safe havens (i.e. higher-rated credit segments) underperformed other, traditionally more volatile, parts of the market.
While there were numerous drivers of this spike in volatility and correlations, we believe they largely revolve around two central themes:
• Significant fund outflows across all asset classes, including the historically safest investment-grade market; and
• A lack of trading desk balance sheet and risk appetite, i.e. limited capacity and risk appetite to make a two-way market.
The investment-grade part of the credit market was really the catalyst for the broader market capitulation. In essence, against a backdrop of tumbling equity and bond markets, investors scrambled for liquidity, frantically trying to raise cash and redeeming investment-grade holdings at irrational market prices, which then further fuelled an additional vicious cycle of price falls.
To put this in context, in the week of 16 March 2020, US investment-grade bond funds saw outflows of approximately $30bn. This compares to the previous weekly record of $8bn in 2008.
Spoilt for choice, but selection skills are vital
By quarter-end, the indiscriminate nature of the sell-off had produced some particularly compelling investment opportunities, right across the credit spectrum. From high-yield bonds to loans, and from investment-grade debt to structured credit, risk compensation has reached levels we haven’t experienced in many years.
While the outlook remains highly uncertain, both in economic and virus-related terms, we believe that this pronounced repricing of credit spreads in the first quarter has opened up a variety of attractively priced opportunities for the discerning credit investor.
A continually evolving backdrop – post-quarter-end moves
Credit markets eventually found a floor in late March and have managed to sustain that rebound into April, however we believe this cyclical turn still has a long way to play out, and the opportunity is still very much in front of us.
A significant tailwind in initially stabilising credit markets and then igniting the rebound has been the support measures provided by various central banks and governments, most notably the Federal Reserve (Fed). One of these Fed initiatives was a corporate bond-buying programme aimed at providing an effective backstop to US investment-grade issuers, along with recent fallen angels (issuers downgraded from investment grade to sub-investment grade). The announcement of this programme, in particular, saw a decent bounce in markets, along with good inflows back into credit funds.
The Fed’s support for credit markets is undoubtedly a positive tailwind in terms of investor sentiment, and it is likely to help maintain the daily functioning of investment-grade credit markets. Furthermore, we believe there will still be significant opportunities both within the Fed programme remit and in the credit markets outside of it, as the coming economic fallout unfolds. In that vein, we believe selectivity will be key, especially with a marked increase in credit defaults looming.
We think the challenge now for investors is less about trying to buy into markets at attractive headline valuations, but rather about finding attractive, resilient, sustainable individual investments, that will survive regardless of the range of outcomes that lay before us.
Investors need to be nimble and dynamic
Given the disconnect discussed above and likely variable default experience across different credit markets, we believe investment opportunities will present themselves in a variety of credit markets. And as we get deeper into this cyclical turn, relative valuation metrics are likely to evolve further, pointing to the need to stay nimble and dynamic in capturing the investment opportunities arising from these historic market twists.
Jeff Boswell, co-portfolio manager of the Global Total Return Credit Strategy at Ninety One Asset Management. The views expressed above are his own and should not be taken as investment advice.