The policy response from both governments and central banks has risen to match the unprecedented healthcare and economic crisis in which we find ourselves today.
Central banks have sent a clear signal that they will do whatever it takes to keep markets functioning, including slashing interest rates to lower bounds and implementing quantitative easing programs of extraordinary magnitude. The four primary global central banks – Bank of England, Bank of Japan, European Central Bank and Federal Reserve – have purchased more than $1.5trn worth of bonds in the past month alone – compared to less than $300bn per month during the global financial crisis.
The situation remains extremely fluid: the most recent development is central banks’ willingness to extend down the risk spectrum and even buy so-called “junk bonds”, or corporate bonds rated below investment grade.
Governments have been keeping pace, quickly devising sizeable fiscal stimulus measures to support both individuals and businesses. These range from the UK’s circa £90bn spending package, which amounts to approximately 4 per cent of the country’s GDP, to the $2.2trn CARES (Coronavirus Aid, Relief, and Economic Security) Act in the US.
One notable laggard? Europe. While European leaders have agreed to the need for a large recovery fund, they have fallen behind the curve in the actual implementation of this fiscal stimulus.
These monetary and fiscal policy measures are having an important impact on the bond markets. Unparalleled demand for government and corporate bonds, from central bank purchase programs, is being matched by unparalleled supply.
In the government bond space, new issuance is being used to fund countries’ growing fiscal deficits, while corporates that have typically used the commercial paper market for near-term funding needs are increasingly turning to the bond market to shore up financing for longer periods of time. This dynamic creates opportunities for bond investors to selectively participate in the primary market, where new deals have come at attractive prices, and then benefit from the strong demand from central banks.
It appears that greed has overtaken fear in recent weeks, as the drastic market sell-off in March has been followed by a meaningful relief rally, with some parts of the bond market recouping nearly two-thirds of their losses. We remain cautious on the outlook going forward as the fundamental backdrop remains very bleak: the economy is in the midst of a recession, job losses in the US over the past month have erased all job gains made during the last decade, and many companies are expected to default on their debt. We believe that the economic repercussions of a prolonged global economic shutdown have yet to become fully evident, and we forecast a more severe recession than implied by current market pricing.
That said, support from central banks and the actual start of corporate purchase programs (which to date have only been announced, not begun) could provide a catalyst for further positive performance in the near-term.
Where are we finding the safety and income that investors expect from their fixed income allocation?
Our preference is to focus on assets that are back-stopped by central banks, including core government bonds, high-quality mortgage-backed securities in the US and investment-grade corporate bonds. While the yield may not appear obviously compelling in these sectors, they should act as a ballast to the riskier parts of an overall portfolio.
For income, there are large parts of the below investment grade corporate market which have gone through significant repricing and now look cheap. However, it is essential to do the research to avoid potential problems. We are favouring companies with strong balance sheets, access to capital and the ability to withstand a prolonged economic shutdown.
Peripheral European sovereign debt offers a bit of both worlds: Italian 10-year government bond yields around 1.8 per cent are meaningfully higher than their German or UK counterparts, and they are also being supported by the European Central Bank’s quantitative easing program. Nevertheless, we believe the aggregate monetary and fiscal response in Europe has been inadequate thus far, so we’d advocate a cautious stance on European peripheral sovereign debt. Pockets of spread widening, driven by heightened supply, could present attractive tactical opportunities in the future, though there is likely to be a ratings downgrade cycle for many of these countries later this year.
We have seen the policy response from central banks and governments, and we now need to see the virus response. There is evidence that the strict containment measures have helped to slow the spread of the virus, but it is yet to be seen whether economies are able to re-open without a resurgence in infections. Without this resumption of activity, we believe it’s prudent to stay cautious and not give in to the greed.
Marika Dysenchuk is a fixed income specialist at JP Morgan Asset Management. The views expressed above are her own and should not be taken as investment advice.