A lot of the material being written about the fixed-income market's correction examines which companies will see their bonds downgraded and the possible effect this will have. But, we think the big story is that the corporate credit market looks more attractive than it has in 11 years.
As we sit home amid the Covid-19 Pandemic, the outlook is scary because we have no idea how long the economy will be affected. The closest comparison we have is the Spanish Flu of 1918, a disease that spread rapidly and killed millions. Since the markets back then were not as developed as today, the past offers little guidance on what to expect. And this uncertainty is spooking markets.
But, let's break it down. A lack of demand didn't cause the decline. The government forced people out of the market for humanitarian reasons. This is important because there isn't some mental bias to overcome or financial conditions to be dealt with. Remember, the U.S. was in a goldilocks economy before this happened. Instead, the focus is entirely on the spread of the virus, plus a war over the price of oil between Saudi Arabia and Russia sprinkled on top. With no clear roadmap to follow, the market experienced a severe flight to liquidity and demand for risky assets disappeared. Credit quality may have deteriorated with uncertainty over future revenues, but not so much as liquidity simply dried up.
So, either the disease goes away or it doesn't. With Congress passing a $2 trillion stimulus, we're in a scenario where if Covid goes away and people go back to work, the economy could come back pretty big. In addition, the Federal Reserve has essentially said it will do anything in its power to protect and promote the economy. And an end to the oil price war would be icing on the cake.
Spreads are 2.5 times greater than they were six weeks ago. The G spread, the difference between the yield of a corporate bond and the yield on U.S. Treasurys, hasn't been this wide since September 2009, even when adjusted for duration. The overall average-option-adjusted spread was around 373 basis points. It has since come down about 20%, a trend we expect to continue.
The G spread captures the credit and liquidity risk of that particular bond. From a corporate credit standpoint, we would argue that right now, you're getting paid handsomely for the risk that you take. So, this is a great opportunity.
Bond investors want to buy when the yield is attractive, because that means the price is cheaper. Since, investors want price to go up, they look for places where the yield should fall during the investor’s holding period.
For instance, before the bond market turmoil, a Google bond with a 2024 maturity and a two-year duration, traded around 38 basis points higher than the Treasury note. That's a tight spread. It wasn't attractive to us because we felt we couldn't make much money owning Google credit in a benign macro environment. The spread has now widened to 135 basis points. Aware Asset Management finds that very attractive. There are many examples like this in the dislocated market of the past month.
However, this is not a credit environment where just anyone can do a great job. We believe the near future holds more negative news. This is where active management is critical. People have to do the analysis to separate the wheat from the chaff. This is always the challenge in active management, but research becomes especially valuable in dislocated markets.
Most companies have taken a hit and are trading a lot cheaper than they were in February. Our investment philosophy is that spread-focused fixed-income markets, given their relative illiquidity and lack of exchange trading, create buying opportunities.
Aware looks for a strong balance sheet and business profile that will allow a company to retain the credit profile it had before the correction. We like high-quality companies, the cream of the crop in the credit world. These companies have great business models and produce tons of cash. These are companies that will lead the comeback. We view this as a technical move that allows us to buy them on sale.
Another example is Johnson & Johnson, which has a rare AAA credit rating. J&J's 2021 bond has a very short time before maturity. In February, it was trading flat with Treasurys, basically a zero spread. At one point, it even had a negative spread, which means people believed lending to J&J was safer than lending to the federal government.
Two weeks later, this same bond's yield spiked more than 100 basis points. When presented with an outrageous opportunity to make money it's our job to recognize it and pounce. We were not alone. Over the past couple of weeks, buyers have driven up the price and forced the yield lower on this issue.
The peak may be behind us. Yet, there remains some excellent technical opportunities.
Aware thinks that we've seen the worst drop for the credit market. The reason spreads went as wide as they did was they reflected a lack of liquidity. With the Fed addressing the liquidity crisis, spreads began to tighten, even with 17 million people filing for unemployment.
Aware thinks people have priced in what they think the damage from the virus will be. We also think that inflation will rise, making holding cash a monstrous drag on returns. More encouraging is that the number of companies filing for new issues over the last two weeks has been extraordinary. Companies need cash to shore up balance sheets and investors are eager to lend.
Of course, the oil market remains a risk, but unless the coronavirus death totals start to spike, we think it may be another 11 years before you see prices like this again.
John E. Kaprich
Aware Asset Management
Investing involves risk including the loss of principal. The outbreak of COVID-19 has negatively affected the worldwide economy, individual countries, individual companies and the market in general. The future impact of COVID-19 is currently unknown, and it may exacerbate other risks of investing.