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.
- We see potential value in money markets, corporate bonds, and securitized debt as spreads widen and flows near record pace.
- The Fed’s lending facilities are helping to ease a liquidity crunch in the financial markets amid the coronavirus (COVID-19) pandemic
- High-yield bonds face the possibility of higher default rates.
Joanne M. Driscoll, CFA, Portfolio Manager:
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. Investment-grade outflows have been at a record pace. Institutional prime market portfolios have seen redemptions of $130 billion month to date.
Putnam’s short duration portfolios have been impacted by the extreme spread widening in a such a short period of time. When you look at the option-adjusted spread on the 1- to 3-year corporate index, it moved to 390 bps on the month. That is just an unbelievable move in a short time. In mid-February, the spread was at +40 bps. The forced selling drove this spread widening. In a liquidity situation, the highest quality on-the-run securities are typically the first to be sold. These type of fixed-income securities are held in our short duration portfolios. This has caused a gap in price moves. The portfolio is currently positioned with a high amount of liquidity, and with high-quality securities and a low beta.
Emily E. Shanks, Portfolio Manager:
Compared with the market shock that happened on September 11, 2001, what makes this different 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 corporate entities). We have been going through a stress test and downside scenarios to see how these companies will potentially hold up in a 6- to 9-month contraction. Our focus will be on the fallen angels (companies that lose their investment-grade rating and are downgraded into junk territory); they will be a big driver as we look ahead.
The second issue is market technicals. Understanding the dynamics between what is driving these buyers and sellers is quite important. Pricing is moving very rapidly within the belly of the curve. What you have seen is very “gappy” price action. Within the investment grade (IG) market, volatility has been driven by dislocated fundamentals. It has driven some pretty dynamic two-way flows. The current average trading volume has risen to $27 to $30 billion daily compared with last year’s daily average of $20 to $22 billion. Corporates have been very active in coming to the market and issuing new bonds to either replenish liquidity or pay down commercial paper. In the depressed oil price environment, oil companies are under quite a bit of strain. Airlines, shipping, cruise lines, consumer cyclical, lodging, restaurants, and retail are also vulnerable.
Brett S. Kozlowski, CFA, Portfolio Manager:
The two pressing issues all investors face are fundamentals and technicals. 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 is going to run.
What we have always done is seek 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 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 off swaps. They were trading at 30 to 40 bps previously because they are considered a good fit and good asset class to hold in a diversified portfolio in the bond space. So, liquidity premium gets priced in. When we look at our portfolios, we want to make sure we are investing to gather that premium and be cognizant of what we need risk-wise to be prepared for a variety of outcomes.
From a fundamental standpoint, the U.S. 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 decline in the housing market.
The commercial mortgage-backed securities (CMBS) is a very fragmented market. It is very important to think about where your exposure lies. We look at these underlying loans (backing CMBS). We believe that seasoned securities have more protection. The new issue mortgages are riskier. Liquidity has fallen quite significantly. It’s a very real problem. In our view, we still have a fundamental reason to buy these securities because of the credit protection we have and the prices we are buying them at.
The Fed’s measures to support the flow of credit
The magnitude and speed of the events that have unfolded have really been dramatic. We are confident the Fed understands that and continues to add programs to inject liquidity. They have responded aggressively but it takes time. Over the past week, the Fed 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. It will be rolled out in the coming week. 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 solves the mounting risk due to 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 corporate bond market by basically introducing an unlimited quantitative easing (QE). The initial reaction to the corporate bond buying has been positive. It will help relieve some pressure on spreads. This is all much-needed liquidity to 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. That 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. The banks here are part of the solution and not part of the problem.
Fallen angels and defaults as investors reassess risks
The default rate would apply to the high-yield marketplace. Investment-grade cohorts tend to be very large investment-grade companies. You rarely see an investment-grade company default on its bond obligations or its debt obligations. The market is pricing in more than 10% single-A-rate debt getting downgraded to triple-B, and more than 10% of triple-B credit getting 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 fallen angels will be higher this year. That risk does exist in the marketplace. A lot of our focus is on stress tests, fundamentals, and what liquidity looks like. Within high yield, we expect you will certainly see a spike in default rates.
For informational purposes only. Not an investment recommendation.
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