The Covid-19 pandemic, and the knock-on disruption it is causing to economies and businesses, has changed everything – triggering a sell-off in credit assets that has been exacerbated by a structural lack of liquidity that many investors have had concerns about since the global financial crisis.
The dislocation in global credit markets in March was driven by several factors. Already aware of the lateness of the cycle, investors quickly became concerned about the economic impact of Covid-19 on companies’ leverage, free cash flow, and ability to pay down debt, particularly for companies where leverage was already high. This put significant upward pressure on credit spreads as investors scrambled to reduce risk. The credit market was also hit with record redemptions as investor sentiment soured, while non-traditional investors were trying to take short positions in certain segments of the credit markets – not unlike during the global financial crisis. As a result, too many investors were trying to sell at the same time, and there was insufficient capacity to allow this to happen in an orderly fashion.
Liquidity inevitably dried up, but we have also seen irrational behaviour. In a sell-off we would typically expect assets to be sold across the credit curve and quality spectrum; in this case, investors sold what they could rather than what they wanted to. The front end of the US investment-grade curve underperformed dramatically, as investors stood to suffer less (a few basis points) by selling shorter-maturity bonds. This in turn caused further panic and selling, compounded by the lack of liquidity in the market.
Source: Aviva Investors, Bloomberg, ICE BofAML, as of April 3, 2020
As post-financial crisis regulation limited the ability of investment banks to play their traditional role of market makers, in other words to warehouse risk, credit markets were undergoing a period of exponential growth thanks to easy access to capital and companies’ willingness to increase leverage.
US credit market size vs dealer inventory
Source: Bloomberg, ICE-BofA, Federal Reserve, Aviva Investors, as of April 8, 2020
The policy response is supportive
In response to the crisis, major central banks quickly announced the resumption of asset purchasing programmes, which are supportive of credit, complemented by measures such as backstops that encourage banks to play their role of intermediaries.
Such support is in some ways a double-edged sword. On the one hand, market participants’ reliance on central banks to consistently intervene during difficult periods for economies and markets may have contributed to corporate behaviours that have driven up financial leverage in the system. On the other hand, central bank and fiscal support from governments can have a great psychological impact to the benefit of markets – investors often only want reassurance in times of stress.
Indeed, March was a record month in terms of issuance across credit. While this may seem paradoxical given the uncertainty over the duration of this crisis and its ultimate economic impact, it is possible the initial sell-off may have been too great, and many traditional and non-traditional buyers stepped back in all at once. The key question now is whether this can continue.
At the lower end of the quality spectrum, while we expect a record amount of debt to be downgraded from investment grade to high yield, the Fed’s move to broaden its mandate and buy recently fallen angels will offer support for stronger US high-yield issuers. Unfortunately though, even the generous amounts pledged by governments and central banks will not be enough to support all high-yield companies.
Investors will have to be selective
As this situation endures, investors should prepare for more volatility, downgrades and defaults. Despite the market rally, March saw numerous downgrades and moves to negative watch or negative outlook by the major credit-rating agencies. The most significant ratings moves were in the hardest-hit sectors – travel and leisure (very few airlines and airports were untouched), energy and consumer cyclicals.
It is therefore important to maintain a balanced approach to credit portfolios, always having some dry powder available and being willing to take opportunities.
In both investment grade and high yield, sectors such as healthcare, pharma, telecoms and cable, present opportunities. When everyone is stuck at home, they will be using their mobile phones, internet and cable, while healthcare and pharma not only remain open for business, they also have a big role to play in all market environments as non-cyclical sectors.
Investment-grade banks are also relatively attractive – not because they are immune to today’s crisis, but because they are well capitalised and prepared for such a stressed environment. Yet even within stronger sectors, it is important to remain selective – Italian banks entered this crisis from much weaker positions than their US peers, for example.
We have not seen the end of volatility
At this point it is impossible to estimate how quickly the global economy might recover from such an exogenous shock. Some areas will be less impacted and will recover fastest, while others will not be able to bounce back as quickly. Particular attention should be paid to consumer psychology, which will take time to recover.
When capital preservation is your focus, the biggest task for investors is identifying which sectors and companies will have the worst earnings disruption, with the least certainty as to when they may recover. Investors can handle bad news better when they can fully understand the risks and calculate the downside impact. Finding companies in sectors where there is a relatively clear and stable picture over their prospects will be key to weathering this storm.
Colin Purdie is chief investment officer for credit and co-manager of the Aviva Investors Monthly Income Plus and Aviva Investors Corporate Bond. The views expressed above are his own and should not be taken as investment advice.