Manager insights: Bulls, bears, and bond markets

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Commenting on the extreme swings in the market over the past few weeks, several of Putnam’s senior fixed income managers shared their insights on the bond markets, liquidity, and the Federal Reserve’s actions as of March 24.

• Extreme dislocations in money markets, corporate bonds, and securitized debt, as spreads widen and flows near a record pace, will eventually lead to potential opportunities for investors as they look to redeploy cash.
• The Fed has acted swiftly and often by announcing numerous lending facilities to ease a liquidity crunch in the financial markets amid the coronavirus (COVID-19) pandemic.
• High-yield bonds are pricing in the probability of higher default rates, particularly in the energy sector as oil prices have plummeted.

Money markets, corporate credit, and securitized debt amid market volatility

Joanne M. Driscoll, CFA, Portfolio Manager discusses money markets:

In the money markets, the decline in market liquidity at the front end of the curve has been the most challenging issue we have seen in the past few weeks. Institutional prime market portfolios have seen redemptions of over $140 billion (as of March 23, 2020), and we’ve seen record outflows in investment-grade bond funds as well, especially in short-duration products.

Putnam’s short-duration portfolios have been impacted by the extreme spread widening that has occurred in such a short period of time. The option-adjusted spread of the 1- to 3-year Investment Grade Corporate Bond Index hit a wide of +390 bps on Monday, March 23, after trading as tight as +40 bps prior to the crisis. This +390 bps widening in spreads, which reflects increased liquidity risk in the markets, not credit risk, has had a dramatic impact on prices of short corporate bonds, which is our largest holding in a fund like Ultra Short Duration Income. Even though we ourselves were not forced to sell bonds to meet liquidity needs, as other investors sell securities in the market, positions in our portfolios are marked at these new price levels.

We feel very strongly that the aggressive programs that the Fed has rolled out, such as the Commercial Paper Funding Facility, the Money Market Investor Funding Facility, and finally the Secondary Corporate Credit Facility, which was announced March 23, will all have a material impact on improving the liquidity situation in the short end of the curve.  Although it will take time for these facilities to be put in place, we are encouraged that the Fed has acted swiftly and aggressively, and has listened to the feedback from members of the investment community, including ourselves.

Emily E. Shanks, Portfolio Manager discusses corporate credit:

Compared with the market shock that happened on September 11, 2001, what makes this scenario difficult to navigate is that the longevity and depth of this shock is unknown. We are focused on core building blocks of the credit market. In terms of fundamentals, our biggest focus right now is liquidity at the corporate entities that we invest in. We have been implementing our stress tests and downside scenarios to evaluate how these companies will potentially hold up in a 6- to 9-month contraction. Our focus ultimately will be on the fallen angels (companies that lose their investment-grade rating and are downgraded into high yield). We believe they will be a big driver of returns as we look ahead.

The second issue that we are focused on is market technicals. Understanding the dynamics between what is driving the buyers and sellers is quite important. Pricing is moving very rapidly across the curve, and what you have seen is very “gappy” price action. Within the investment-grade market, volatility has been driven by dislocated fundamentals, which have driven some pretty dynamic two-way flows. The current average trading volume has risen to $27 billion to $30 billion daily compared with last year’s daily average of $20 billion to $22 billion. There has also been an extremely active primary market, as companies have come to the market issuing new bonds either to replenish liquidity or to pay down commercial paper. With over $60 billion in new-issue supply last week and a similar pace of new deals this week, we’ve now had over $120 billion in supply month to date, which already surpasses the amount of issuance that we had in March of 2019.

The other issue to remember is that we are not only dealing with the spread of  COVID-19 and the impact of the pandemic on the global economy, but the oil price war between the Saudis and Russia, which has reduced prices to near $20 per barrel. This has put the energy sector under quite a bit of strain, which will lead to a downgrade and a pickup in defaults in the high-yield sector. In addition to the energy sector, airlines, shipping, cruise lines, consumer cyclical, lodging, restaurants, and retail are also vulnerable.

Brett S. Kozlowski, CFA, Portfolio Manager discusses securitized debt:

Unlike what happened during the Great Financial Crisis, the U.S. housing market was not the epicenter of the problem that we’re now faced with. In fact, coming into this, the residential mortgage market was quite strong, thus the mortgage-backed securities market initially outperformed equities and corporate credit before the negative performance started to flow through to our markets. The two pressing issues all investors face are fundamentals and technicals. When analyzing securities in the mortgage market, it is not that different when you step over into securitized markets and start thinking about underlying credits and what drives them. COVID-19 is causing a significant amount of disruption, and the wild card here is how deep and how far this disruption is going to run.

Our consistent approach is seeking to buy fundamentally strong assets with the belief that those assets will outperform over time. The U.S. housing market, the commercial real estate market, and all of the underlying asset-backed markets are going to be dependent on policy actions and the length and depth of this crisis. Liquidity is a large driver. We now have AAA securities trading in the securitized markets at +300 bps over swaps. Earlier this year, they were trading at 30 to 40 bps because they are considered a good asset class to hold in a diversified fixed income portfolio. So, like we are seeing in other sectors of the market, a significant liquidity premium is now priced in. When we look at our portfolios, we want to make sure we are investing to gather that premium. We also want to be cognizant to consider risks and be prepared for a variety of outcomes, making sure that we are being paid to take these risks.

From a fundamental standpoint, the United States has one of the stronger housing markets because of relatively high demand and low supply. Although the government is taking massive steps, there remains a question on how people will pay their mortgages if they don’t have jobs or can’t go to work or get pay checks. We think that this will cause a bit of a slowdown in the housing market, causing home prices possibly to either decline or stagnate in some areas.

The commercial mortgage-backed securities (CMBS) is a very diverse and broad market, both geographically and in terms of property types, so it is very important for investors to remember where their exposure lies. We continue to focus our research efforts on the underlying loans that back a particular CMBS deal. Our view is that seasoned securities provide more protection because of the increase in commercial real estate prices that has occurred over the past 10 years. New issue CMBS deals do not have that underlying built-in price appreciation, and we’ll continue to avoid them. That said, liquidity has fallen quite significantly across all sectors of the market, making it difficult at times to transact. However, in our view, we still have a fundamental reason to invest in these securities because of the underlying credit protection that we have based on the covenants for the particular securities we own and where those securities sit in the capital structure, as well as how these securities are now valued based on current prices.

More on the Fed’s measures to support the flow of credit

Joanne Driscoll:

The magnitude and speed of the events that have unfolded have really been dramatic. We are confident the Fed understands the problem and will continue to roll out programs to inject liquidity into the system. The Fed recently took multiple actions and instituted a few key programs to support the front end of the fixed income market. On March 17, the Fed restarted the Commercial Paper Funding Facility (CPFF) to help U.S. companies borrow through the commercial paper (CP) market. It is a good step to help clear the new issue CP market, and it is being rolled out currently. It provides a backstop, and we think it can be a primary funding source for some companies struggling to issue in the CP market.

The second really important facility the Fed rolled out is the Money Market Mutual Fund Liquidity Facility (MMLF). This helps to solve a mounting risk resulting from the large redemptions seen in prime institutional portfolios. It will provide a big backstop for money market funds. There was also unprecedented Fed support for the mortgage and corporate bond markets when they basically announced unlimited quantitative easing and a Secondary Corporate Credit Facility that will purchase investment-grade corporate bonds maturing in under five years. The initial reaction to the corporate bond buying program has been positive, and spreads have begun to tighten back in that sector of the market today. This is all much-needed liquidity intended to help stabilize the short-term fixed income markets over the coming weeks.

The Fed will do whatever they need to do to inject liquidity. Today we are seeing some better two-way trading in CPs and short-dated corporates, but at elevated spread levels. We believe that the pressure on spreads will abate when the Fed programs kick in. The central bankers have really pulled out all the stops to ensure the markets function in a more orderly manner in unprecedented times. One last thing to remember, as we’ve mentioned on other calls this week, is that unlike in 2008 and 2009, the banks will be part of the solution and not part of the problem.  Because of regulatory changes that were enforced following the GFC, banks are significantly better capitalized today, so instead of being forced sellers, they will be able to step in and use their balance sheets to provide capital and liquidity to the system.

Fallen angels and the potential of rising defaults as investors reassess risks

Emily Shanks:

An increase in the default rate would apply primarily to the high-yield marketplace, and would generally not be an issue for investment-grade companies. It is rare that we see an investment-grade company default on its bond obligations or its debt obligations, with a company like Enron being a large notable exception. However, the market is pricing in the probability that more than 10% of single-A-rated corporate debt would be downgraded to triple-B, and more than 10% of triple-B corporate credit would be downgraded to double-B or to high-yield status. That is not our base case. We would estimate a lower amount of fallen angels than that. Still, we think the number of fallen angels will be higher this year. Our focus is on stress tests, fundamentals, and what the liquidity situation looks like for these companies. Within high yield, we expect to certainly see a spike in default rates, particularly in sectors like energy, airlines, shipping, etc., that will be impacted by both lower oil prices and/or the economic slowdown due to COVID-19.

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The views and opinions expressed are those of Joanne Driscoll, Emily Shanks, and Brett Kozlowski  (as of March 24, 2020), and  are subject to change with market conditions, and are not meant as investment advice.