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It's The Liquidity, Stupid.

Posted by Ian C. Carroll on Mar 24, 2020 4:59:21 PM
Ian C. Carroll
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Over the past few weeks the bond market has been on a rollercoaster of such velocity that it's leaving investors with whiplash.

The Federal Reserve's two interest-rate cuts, totaling 150 basis points, was a useless and desperate attempt to boost the economy and the market. That it barely registered shows the Fed's impotence. Making money cheaper doesn't help if there's no demand. The problem is people aren't leaving their homes. But it doesn’t hurt either, and could speed the recovery when it comes.

Companies are not taking risks. They're in retrenchment mode, hoarding cash and planning for worst-case scenarios. At Aware Asset Management, we think it sends the message that the Fed will do whatever it can in these extraordinary times. But we don't think moving toward negative interest rates will help. What will negative rates do in an era when people worry if they will be alive tomorrow?

Non-traditional means of liquidity used in the 2008 Fiscal Crisis, such as operation twist and commercial paper (CP) purchases, are more likely to help. We would like to see the Fed purchase corporate bonds, as the European Central Bank (ECB) did with its corporate securities purchase program (CSPP) in the last crisis, which would require Congressional approval. But at this point, fiscal measures, which are the domain of Congress and beyond the Fed's powers, are much more important than monetary moves.

The massive swings in U.S. Treasury yields are unprecedented. But, Treasurys aren't the issue. The real problem is the lack of liquidity in the corporate bond market.

My corporate credit research team and I spoke with the New York Fed Markets Group. We told them -- and we're sure they heard the same from the other institutional investors they surveyed -- that credit spreads are moving largely on fear, not fundamentals. The lack of liquidity is driving yields haywire. Trading in a rational manner is impossible in this market.

Over the past few years, all anyone cared about was the search for yield. This led to massive issuance of Triple-B-rated and high-yield bonds. Many companies that weren't performing well were able to sell bonds because investors were willing to buy almost anything. This is where due diligence is essential.

When the tide goes out, only then do you see who is standing naked.

With spreads widening it becomes hard for investors to sell because hardly anyone is buying. According to Bloomberg (as of March 19th):

  • The spread between high yield and investment grade bonds climbed to 647 basis points, wider than at any point since
  • The spread between double-B and triple-B corporate bonds, which crosses the divide between investment-grade and speculative-grade, jumped to 350 basis
  • The spread between triple-B and single-A bonds widened to 130 basis

When bond managers can't sell what they want to sell, they sell whatever they can to raise money for investors cashing out. Typically, that means Treasurys. But if the Treasury market locks up that will mean a credit crunch for the entire country.

The Aware team has been closely monitoring the market and here is our analysis. It is only a partial view, but covers sectors where we see opportunity.

The high-yield corporate sector has notable areas of weakness, with clear vulnerability among energy, airlines, and hospitality-related names. Energy bond prices, in particular, plummeted on the back of the oil-price meltdown between OPEC and Russia and the drop in gross domestic product (GDP) as the country shuts down to fight the outbreak.

We believe that our investment grade (IG) companies will be fundamentally sound and positioned to recover. They have the balance sheet strength to manage through this crisis, and that is one reason they’re IG in the first place. Aware does not believe that any part of our portfolio is at high risk of default, but we are going through sectors and evaluating the risks from COVID-19.

Actually, we’ve purchased BBB+ debt at 6% yields. In addition, we can see rates rise and still see positive returns due to spread tightening. One area we have been focusing on is overnight commercial paper where we can get 300 or more basis points in excess (of cash) yield.

The biggest red flags are in energy, autos and air/travel/tourism-related companies. Ford Motor's high-yield bonds face significant downgrade risk. We don't expect many fallen angels in energy, but with oil reaching insane lows this becomes a more likely scenario daily. We see opportunities in software, banks, and aerospace and defense (A&D) companies, such as Boeing, with defensive characteristics.

Our outlook for select sectors:

Aerospace and Defense: Stable

Multi-year order book declines are not an issue. Defense spending is growing 3-5% annually. But, the suspension of Boeing 737 MAX production will have far-reaching adverse consequences for the broad A&D supply chain. The affect of the coronavirus will be negative and immediate on the commercial airplane segment. Significant reductions in airline travel are already hurting air carriers, which are worrying about going into bankruptcy, not the purchase of new planes.

U.S. Banks: Stable Despite Expected Earnings Pressure

The diverse revenue streams at the big banks drive resiliency. Regional and community banks that are more concentrated in lending, however, are more exposed to lower interest rates. The sector's overall credit risk remains stable, and virtually a non-factor, due to disciplined underwriting, diverse balance sheets and prudent business practices (off-balance-sheet credit exposures like liquidity backstops are a thing of the past). On balance sheets the main driver of consumer credit risk is employment and for commercial credit it's corporate defaults and GDP.

Capital adequacy is not a concern for most U.S. banks and remains well above requirements. The eight biggest banks are held to a high standard and capital adequacy is stress tested annually for severe economic scenarios. Smaller banks, particularly those with less that $100 billion in assets, are held to a lower standard.

Software/Services: Positive

An economic downturn harms software companies more than information technology (IT) services, given the discretionary nature of software spending. We expect to see Increased scrutiny over the use of personal data and privacy regulations. The impact from coronavirus could be positive by driving strong demand. Prolonged quarantine will change how companies function and how people work and live, which could boost spending on software/services, especially cloud services.

Energy outlook: Negative

OPEC and Russia will dominate headlines until at least mid-summer, but most likely longer. Both OPEC and Russia can sustain discounted energy prices for a prolonged period if they believe it will enhance their market share by driving shale producers out of business.

Oil is highly correlated with global GDP growth according to the classic oil economists’ rule of thumb. Coronavirus has hit global GDP growth and that will keep a brick on oil prices. Still, the main driver is OPEC and Russia’s failure to agree on caps on production and selling oil at a discount. We see the sector bifurcated with some strength in midstream companies and high-quality integrated companies.

Semiconductors: Stable

Semiconductors may experience more volatility in the first half due to delayed demand and the possible supply chain disruption. The chip market is betting on a combination of three trends to lii the sector's sales and earnings in the second half: 5G telecom networks, the Internet of Things (IOT), and autonomous vehicles.

Ian C. Carroll, CFA, CIPM

Head of Corporate Credit Research Aware Asset Management

Investing involves risk, including the loss of principal.


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