Hi, I'm Kevin Barr, Head of SEI's Investment Management Unit. I have asked Bill Lawrence, our CIO of Traditional Strategies and Head of Fixed Income, to join me today.
Thank you for joining me Bill. Let's take some time to address the changes in the fixed-income markets since we last spoke in March.
Thanks, Kevin. Capital markets are in much better shape today than they were in March, but it’s clear that we’re not out of the woods yet.
It goes almost without saying that the Federal Reserve’s near-term response since early March has been focused on providing liquidity and access to capital. In addition to the focus on liquidity, we should also consider the Fed’s thinking about inflation.
As I mentioned last time, a primary focus of Federal Reserve policy for most of the post financial crisis period has been on addressing the risk of deflation.
So it’s worth noting that inflation expectations have dropped about 1% since this new reality began to set in. We’ve had a significant drop in energy prices, but more important are the shifts in labor-market dynamics, which have also been terribly deflationary.
So, in the near term, we think the Fed’s main concern is more about the risk of lower inflation, if not deflation. This suggests interest rates will be low for an extended period of time.
Looking ahead several years, we think the massive debt issuance, and it will be large with over $3 trillion being auctioned this quarter alone by the Treasury, which has never been done in a twelve-month period much less one quarter. This debt will be monetized by the Fed’s purchases of Treasuries for its own balance sheet, which we believe will ultimately sow the seeds for an inflationary dynamic, but that’s the next chapter in the story.
When we think about the Fed’s response to this crisis, they’ve moved beyond the stimulus programs used during the financial crisis and have gone directly to the capital markets to ensure they’re liquid and functioning, and that issuers can access the market.
That seems like an important and positive development given that many businesses discovered overnight that their revenues and cash flow generation were going to be falling well short of expectations.
Agreed, and the news has been largely very good.
Since late March, yield spreads have narrowed quite a bit. But there’s still plenty of credit duress in sectors like energy, travel and retail.
We’ve had an increase in bankruptcy filings. About 2% of the high-yield market filed in April alone. For example, high-profile retailers like JC Penney, Neiman Marcus and J. Crew have all filed. We should expect this to be a continuing challenge in the corporate bond market.
There was also a significant amount of issuers whose credit ratings have been downgraded from investment grade to below investment grade, totaling about $90 billion of issuance so far in this cycle. Ford, Occidental Petroleum and Kraft Heinz accounted for the majority of these downgrades.
The Fed has begun intervening to help support these transitions. The announcement alone that they’re planning to provide support to these so-called “fallen angels” alone has been helping liquidity in these markets, even ahead of any concrete action.
We’ve seen the new-issue calendar accelerate dramatically from late March to early April. Improved liquidity and the desire to gain access to capital drove record investment-grade corporate issuance in March. $265 billion was issued in March, almost all in the last one-and-a-half weeks. April set another record—with $285 billion, mostly in higher-quality names. But even a name like Boeing was able to issue $25 billion in debt, and it was very well received.
This is more good news, and indicates that the Fed is succeeding in providing companies access to capital and returning functionality to the corporate bond market.
When the crisis first started, you said that you expected to see opportunities for our strategies as a result of it. Has that started to happen yet?
It has. Our core investment-grade strategies have added 5-to-6 percent to their corporate bond allocations, mostly through the new-issue calendar, where bonds were coming at concessions relative to where they were trading in the secondary market. That’s been a good source of alpha generation through active management.
The good news is two-fold here: liquidity conditions have improved dramatically, and that’s been good for both absolute and relative returns, but they haven’t completely normalized. So, we believe they still provide an opportunity.
Where do you see ongoing challenges?
We're looking at certain sectors of the high-yield market and securitized sectors more cautiously in this environment.
Rising high-yield spreads historically precede rising default rates. Moody’s expects the high-yield default rate to hit 14% over the next 12 months, which is far above its long-term average.
That’s obviously not an encouraging development. But the high-yield market is essentially bifurcated at this point, and the expected defaults are highly concentrated in retail, travel, leisure and energy companies. Where we have very good visibility about what might happen.
This tale of two high-yield markets can also be seen in the significant yield dispersion—the top half of the market in credit-quality terms has an absolute yield of about 5%, while the lower half yields in excess of 10%.
We think the state of affairs here highlights the case for active management again. Investors need to take care in identifying opportunities and avoiding downgrades. From a strategic perspective, we believe the high-yield market’s starting to offer value, and we’re considering adding exposure in some of our active asset-allocation strategies. But more broadly, we think the recovery in risk assets may have gotten ahead of itself. Tactically, high-yield is interesting, but we’re going to be cautious about how we implement our strategies there.
We’re taking a similar approach in the securitized sector. The Fed resurrected the Term Asset-Backed Securities Loan Facility given its success during the global financial crisis. That’s unquestionably positive news for helping to return functionality to the asset-backed markets, but we think opportunities will be more challenged there than in the investment-grade corporate market.
Commercial real estate is confronting long-term issues that have been catalyzed by the lockdown environment. With the residential mortgage market, there’s uncertainty about how the process of forbearance impacts delinquencies and foreclosures. We’re more careful to pursue opportunities here, but it’s good news that the Fed has begun to take action and is poised to commit capital.
And in closing, it’s worth noting the old adage that it pays to follow the Fed. And that remains the key to opportunities in fixed income.
Thanks, Bill. I appreciate your thoughts and insights.
Glossary of Financial Terms
- Alpha: Alpha refers to returns in excess of the benchmark.
- Basis point: 100 basis points equals one percent.
- Fiscal Stimulus: Fiscal stimulus relates to decisions about government outlays to support the economy.
- Issuance: Issuance is the sale of securities, typically used with regard to debt instruments such as bills, notes and bonds.
- Monetary Stimulus: Monetary stimulus relates to decisions by central banks to promote the availability of capital.
- Term Asset-Backed Securities Loan Facility: The U.S. Federal Reserve established the Term Asset-Backed Securities Loan Facility (TALF) on March 23, 2020 to support the flow of credit to consumers and businesses. The TALF will enable the issuance of asset-backed securities (ABS) backed by student loans, auto loans, credit card loans, loans guaranteed by the Small Business Administration (SBA), and certain other assets. Under the TALF, the Federal Reserve will lend on a non-recourse basis to holders of certain AAA-rated ABS backed by newly and recently originated consumer and small business loans. The Federal Reserve will lend an amount equal to the market value of the ABS less a haircut and will be secured at all times by the ABS.
- Bloomberg Barclays US Corporate Bond Index: The Bloomberg Barclays US Corporate Bond Index is a broad-based benchmark that measures the investment-grade, fixed-rate, taxable corporate bond market.
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