Credit Crunch – a paradox. It has never been cheaper to borrow money...

In 2008, the spread, which in simple terms is the difference between the yield on government bonds and the yield on corporate bonds, for European high yield (HY) bonds widened from around 2.0 percent to around 11.0 percent. This was a drawn-out process that happened over about two years. Essentially, investors demanded about 11 percent more in return for taking risk on HY bonds compared with government bonds. The pace of the current crisis has been exceptional, and in just one month we have seen a movement from 2 percent to around 7 percent in the European HY spread. The Western world is only at the beginning of this virus infection, and entering it from an environment that has been good.

The overall theme for the entire fixed income market, irrespective of what kind of securities you look at (see below), is that the flow of capital is currently the main driver of market activity. Big asset managers like pension companies are having to raise capital to secure their pension commitments with customers, while the value of their listed shares is falling.

In recent years, a large amount of capital has flowed into fixed income investments from private investors and companies alike, not least into corporate bonds, in the form of both direct investments and investments in fixed income funds. A lot of these investments are now being sold off to either settle debts or move into cash or lower risk fixed income investments.

The rotation of capital in the market is placing enormous pressure on the valuations of interest-bearing assets, and all fixed income managers in the market are simultaneously having to sell off holdings to meet customer withdrawals. This has created a market with high supply and low demand.

In general, the more risk a fixed income security contains, the higher the current yield offered to investors. The risk consists mainly of two parts: firstly, that the company may fail to meet its borrowing obligations, and secondly the liquidity risk. The liquidity risk is the danger that the ability to trade these securities could become compromised if the market or the company performs badly.

In a crisis, like the one we are in now, many investors want to sell their bonds so there are lots of holdings that need to be sold to cover cash withdrawals. Because there are not many buyers, the pricing becomes very weak for the sellers of securities, regardless of the quality of the company and regardless of whether the company is actually impacted by the spread of the coronavirus. Market pricing/valuation is now almost entirely governed by these flows.

Let us briefly describe what things looks like right now in a few different areas of the fixed income market.

Government securities

You will be well aware that interest-bearing securities issued by Western governments, both long-term bonds and shorter treasuries, have largely traded with a negative yield even before this crisis broke out. The exception is US securities. At the end of 2018, a US 10-year government bond offered around a 3.2 percent return. Throughout 2019, the yield was gradually traded down as the Federal Reserve lowered the interest rate. In February 2020, when we knew about the coronavirus problem in China but had not yet begun to price it in in the West, the US 10-year bond was at 1.5 percent (January 31, 2020). Following the Fed's swift action with interest rate cuts, the market has followed suit and the bond is now trading as low as a 0.6 percent yield. Consequently, a decline from 3.2 percent to 0.6 percent in just over a year. It is now at 1.1 percent.

Every time that great uncertainty arises in the market, the normal course of action is that large numbers of investors choose to move their capital to safe assets like government bonds. The consequence of this is lower yields than before, even if they were already negative like in Sweden. The yield goes down because inflation expectations are lower in the longer term and demand for these securities is high.

At this moment, we can see that the yield level on Swedish government bonds with slightly longer maturities is no longer falling and has even risen slightly, from -0.5 percent (March 9, 2020) to 0.0 percent (March 19, 2020). We are seeing the same pattern in several Western economies, for example with German yields having recently risen by 40-50 bps on a 10-year bond. So, why is this? The most likely answer right now is that anything that can be sold is simply having to be sold, anything that is liquid, in order to cover withdrawals by investors.

Western government bonds have historically been regarded as very safe, and that remains the case in terms of issuer risk, or the risk of default. Nowadays, however, government bonds contain a significant risk in terms of returns – if the interest rate on these rises, a holder of government bonds would lose money. If we assume that we have a 5-year bond that rises by 1 percentage point, the price loss will be about 5 percent. This means that you will not lose money if you stick with it for the whole maturity, but you lose in terms of value if you need to sell the bond in connection with the interest rate rising. The longer the maturity of the bond, the greater the risk for the holder. In a bad market scenario, it is conceivable that confidence in the whole system will weaken and investors will demand higher interest rate compensation and that we will have higher interest rates in the market, even though we have policy rates close to zero. This mechanism has been completely disrupted for a number of years due to the actions of central banks, with them buying up large numbers of government bonds in the market. It is expected that central banks will continue to buy in the market and thus act similarly again this time around.

So how is the market acting now?

Right now, there is great uncertainty about how long this will last and what will be the economic consequences of the measures to prevent the continued spread of the coronavirus. We can note that capital is currently being moved primarily to settle loans, which means that money previously created in the market will disappear to a large extent from the system. Otherwise, capital is seeking out securities with the lowest risk, like cash, short-maturity government and municipal bonds and, to some extent, longer-maturity government bonds.

Corporate bonds with lower risk – known as Investment Grade (IG)

Corporate bonds with lower risk have been an option for many investors to try to generate returns when traditional fixed income securities no longer offer any return. The consequence has been that a large amount of capital has flowed into the segment from all types of investors in the market. In recent years, many institutional investors have expanded their investment policies from including investments only in government, municipal and housing-related fixed income securities to even include IG, but not HY. In Europe, but so far not in Sweden, the central banks have also chosen to buy IG paper. As a result, the yields have been historically low, but this has changed dramatically in recent weeks. The spread has widened considerably for IG securities, from around 0.5 percent to about 2.0 percent. This means that someone who lent at the 0.5 percent level over, for example, 3 years has made a price loss of around 4.5 percent.

There are a large number of bonds in the market that are rated BBB, i.e. the bonds with the lowest rating in the IG segment. There have been fears that a number of these companies on the threshold could slide down to an HY rating in a poor market, which would mean a large number of forced sales as many investment mandates do not allow investments in HY instruments. We are not seeing any such trend in the market yet. We have come from a market with an unusually low proportion of defaults and bankruptcies, partly because loan financing has been so cheap in the market. We expect the number of defaults to increase, and end up at more normal levels going forward. Some BBB-rated companies will thus receive new and lower ratings in the HY segment.

However, many of the companies in IG segment have strong balance sheets and, among these, more support measures can be expected in the wake of the crisis. Capital flows in the IG segment are strongly negative and this is why the spreads are widening so substantially right now. In a time of real crisis, the market in some BBB papers will not differentiate at all in terms of compensation for maturity. In other words, the yield curve will be entirely flat or, in some really absurd situations, may even be negative. This was the case for Ericsson in 2003, for example, when the yield curve became negative as the market realised that Ericsson's problems would be resolved further in the future. In other words, you no longer get paid more for longer maturities since bankruptcy could very likely just as well happen in the near term.

Corporate bonds with higher risk – known as High Yield (HY)

Companies with lower credit ratings are classified as high yield (HY), and the pattern is the same as for IG. An enormous amount of capital is flowing out and it is very difficult to sell in the market due to the lack of buyers. Spreads have widened markedly for HY in recent weeks and you now get a yield of about 7 percent on average, according to the European iTraxx Crossover HY index, compared to around 2 percent just two months ago. There is an almost complete absence of liquidity in the HY segment under the current market conditions. It is important that anyone who manages portfolios and who has chosen to invest in HY has taken into account the liquidity risk and therefore has offset the holdings in the segment with holdings in cash and cash-like investments. However, it is worth remembering that a portfolio manager cannot simply sell everything liquid and then be left sitting on a high-risk portfolio of locked holdings. A portfolio manager must also always try to sell parts of the portfolio that have the lowest liquidity when flows are strongly negative. The consequence of this is that you see sharply negative returns on all fixed income portfolios with more risk like HY bonds. Even if you were a lucky portfolio manager who for some reason does not have any outflows to take into account in your portfolio, the outcome will still be negative as the pricing of all your holdings will deteriorate in the market and you will incur the price loss in the valuation of the portfolio's holdings.

Let's move on to the positive – there is almost always a light at the end of a tunnel!

Is there anything positive about this? Yes, certainly! Pricing in the market has been far too tight, and opportunities are now opening up. For anyone investing in a fixed income fund, the consequence of everything described above has been that the yield on the remaining maturity of the held securities will be higher. Provided the companies do not go bankrupt or end up restructuring, and meet their borrowing commitments, the higher current yield going forward will offset the price losses that occurred in the wake of the crisis. However, some companies will probably not do well and end up in default. This usually means a restructuring where lenders write down their claims, but often this does not mean a 100 percent loss. If we look at 2008, which was one of the really bad periods, the number of defaults rose to about 10 percent on single-B bonds during a short period when it was at its worst, and the amount recovered was about 40-50 percent. Even in really bad periods, anyone that can stay put is usually still able to obtain a reasonably good return measured over a slightly longer period of time. In a normal market, over a cycle, the number of defaults on a single-B bond is more likely to be around 2.5 percent and with a higher recovery rate. The fixed income market is somewhat late cyclical, so expect a turnaround first on the stock exchange. Once portfolio managers no longer just need to sell to cover withdrawals, individual opportunities will arise to capture certain deals at really good or even fantastic terms.

We believe in a brighter future!

Until then, take good care of yourself and your fixed income investments! We at Catella Fonder are of course available by phone or email if you have any questions / concerns.

Read: 

Mid-crisis – what can people do with their investment portfolio?

Two weeks into March 2020 – at the epicentre of Covid-19!

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