• Although liquidity has improved dramatically with bonds becoming easier to sell, challenges remain amid credit-rating downgrades as well as rising bankruptcies and mortgage forbearances.
  • With conditions having yet to fully normalize as of mid-June, we believe opportunities remain for active investors.

Capital markets have returned much closer to normal function since the peak of their pandemic-driven dislocation in late March, thanks to the unprecedented amount of monetary and fiscal government stimulus that immediately followed. Investors got a much-needed confidence boost from the Federal Reserve’s (Fed) actions, which dramatically expanded liquidity and access to capital, making bonds much easier to sell.

Despite this improvement in fixed-income markets, plenty of challenges remained as of mid-June—including widespread credit-rating downgrades, rising bankruptcies and a spike in mortgage forbearances. It’s clear that we are not yet out of the woods. But we do not see these ongoing issues as cause for concern; at SEI, we see them as opportunities for active investors.

The benefits and consequences of bold action

The Fed pledged to err on the side of maintaining lower interest rates as the U.S. begins to slowly emerge from lockdown and the economy starts to recover. We expect the absolute level of interest rates to stay quite low across most parts of yield curve. But the U.S. government’s new fiscal stimulus comes with a price tag—$3 trillion in debt that the U.S. Treasury Department expects to issue during the second quarter of 2020—that we believe will create challenges over the intermediate and long term.

For example, while the steep debt issuance provides necessary relief to individuals and businesses economically impacted by the pandemic, it also presents a headwind to low interest rates (particularly on the long end of the yield curve) as a heavier supply of U.S. Treasury issuance strains investor demand. Lenders traditionally compensate for a borrower’s growing debt burden by charging higher rates, but we expect this supply-demand dynamic will be partially offset by the Fed’s commitment to purchase Treasurys.

In examining U.S. Treasury inflation-protected securities (TIPS) breakeven inflation rates—that is, inflation rates at which TIPS and U.S. Treasurys of comparable maturities are considered equally attractive investment opportunities—we can clearly see the point at which investors realized the dramatic economic impact of the COVID-19 outbreak (as illustrated in Exhibit 1). Since this new reality began to set in, inflation expectations have declined about 1%.

Exhibit 1: Pandemic Pushes Inflation Projections Lower

Exhibit 1: Pandemic Pushes Inflation Projections Lower

Calculated based on 10-Year Treasury Rate minus 10-Year Treasury Inflation-Indexed Security Rate. Source: Bloomberg, as of 6/11/2020.

Energy prices over the last few months—as manufacturers, commuters and consumers drastically reduced their energy needs amid the economic standstill—initially put sharp downward pressure on inflation. Record-shattering unemployment over the same period has also been terribly deflationary; shifts in labor-market dynamics are arguably even more important in this respect.

While the market appears to be appropriately pricing in lower inflation expectations in the near term, we think there are inflationary concerns in the long term. Historically, inflation is the expected outcome when the amount of money in circulation grows faster than economic productivity. Therefore, with the U.S. economy not expected to fully recover in the foreseeable future, we expect the Fed’s recent efforts—massive expansion of the monetary base, significant issuance of new Treasurys, and the monetization of debt—will ultimately sow the seeds of inflation several years out.

If our longer-term outlook for increasing price pressures is correct, the market’s subdued inflation outlook could prove to be cause for concern when the Fed changes its policy stance to counteract rising inflation. In the near term, however, we think the Fed is more focused on the risk of lower inflation, if not deflation.

Corporate bonds were caught in the storm

During the “flight to quality” in March, the yield spread (difference in yields offered by different types of bonds) between Treasurys and corporate bonds widened—indicating that investors preferred the relative safety of government bonds despite their lower yields. While the magnitude of this spread widening did not reach the degree experienced during the global financial crisis, the speed at which it unfolded was unprecedented (Exhibit 2).

This spike occurred in an extremely illiquid market. We witnessed massive outflows from investment-grade, high-yield, and tax-exempt funds alike—indicating the severity of the panic—as sellers exited their positions and buyers became scarce.

Exhibit 2: Yield Spreads Sprinted to Widen

Exhibit 2: Yield Spreads Sprinted to Widen

Calculated based on 10-Year Treasury Rate minus 10-Year Treasury Inflation-Indexed Security Rate. Source: Bloomberg, as of 6/11/2020.

The Fed’s actions during this crisis have extended beyond those made during the global financial crisis. It essentially began targeting an additional policy objective in going directly to the capital markets—to not only ensure they are liquid and functioning, but also that issuers can access the market. In other words, the central bank stepped in when would-be buyers became hesitant to engage.

We think this represents an important positive development given that many businesses discovered almost overnight that their revenues and cash-flow generation were going to fall well short of expectations—and troubled companies need access to cash in order to remain in business.

Shopping for investment-grade deals

Spreads have narrowed quite a bit since reaching their widest point in late March as the Fed’s actions convinced bond buyers to re-engage. But there’s still plenty of credit duress in sectors like energy, travel and retail. We expect this to be a continuing theme for the corporate bond market over the coming months.

Another consequence of the crisis has been a significant number of credit-rating downgrades—totaling about $90 billion of issuance through mid-May—from investment grade to below investment grade. Bonds generally lose value when the issuing company gets downgraded. Since yields and prices have an inverse relationship, this typically means that investors expect higher yields from downgraded companies that issue new bonds, which increases the cost of capital for these companies.

The Fed has since begun intervening to support these transitions. This has already proven beneficial; in fact, its announcements of support began to help improve market liquidity even before the central bank took concrete action.

As Fed action improved liquidity, companies rushed to raise money—and the rate of debt issuance dramatically accelerated from late March to early April. A record $285 billion of debt was issued in new investment-grade corporate bonds during March, almost all within the last 10 days of the month. April set another issuance record, mostly in higher-quality debt.

In our view, this is an indication that the Fed is achieving its objectives to provide companies with access to capital and return functionality to the corporate bond market.

From a long-term perspective, we think one of the most attractive investment opportunities an investor could possibly find in the capital markets may be one that provides compensation with a great deal of excess liquidity premium in exchange for committing capital that they do not need. Liquidity premium is the amount of return that can be expected for buying a less-liquid investment than a comparable more-liquid investment.

Our core investment-grade strategies increased their corporate bond allocations by 5% to 6% in an effort to capitalize on excess liquidity premium—mostly through new-issue debt, as new bonds coming to market were more attractively priced than those available in the secondary market. We believe this will represent a source of excess return generation through our active management.

The good news here is twofold: liquidity conditions have improved dramatically, yet still provide an opportunity for investors since they have yet to normalize as of mid-June.

Low expectations for troubled areas of high yield

The high-yield bond market has historically suffered higher default rates when spreads start to rise, as illustrated in Exhibit 3. The current default rate stands slightly over 4%, in line with the long-term average, but above the levels of the last few years.

Exhibit 3: Historical High Yield Spreads and Default Rates

Exhibit 3: Historical High Yield Spreads and Default Rates

As of 5/31/2020. Source: ICE BoA, Moody’s

Credit rating agency Moody’s expects the high-yield default rate to hit 14% over the next 12 months, which is not an encouraging forecast. The high-yield bond market is essentially bifurcated at this point; expected defaults are highly concentrated in retail, travel, leisure and energy companies.

This tale of two high-yield markets can also be seen in its significant yield dispersion: BB rated US corporate bonds (the highest credit rating for high-yield bonds) yielded more than 9% less than US corporates with ratings of CCC and lower (representing the low end of high yield in credit-quality terms) on June 16. Exhibit 4 shows this spread is above the long-term average, but off the high touched on May 11.

Exhibit 4: A Tale of Two High-Yield Markets

Exhibit 4: A Tale of Two High-Yield Markets

January 1, 1997 through June 16, 2020. Calculated by subtracting the effective yield of the ICE BofA BB US High Yield Index from the effective yield of the ICE BofA CCC & Lower US High Yield Index. Sources: ICE BofA, Federal Reserve Bank of St. Louis

In our view, the high-yield market is beginning to offer more value. More broadly, however, we think the recovery in riskier assets may have gotten ahead of itself. High-yield bonds are interesting tactically, but we remain cautious about how we implement our strategies for the long term.

We think this also highlights the case for active management, as it underscores the importance of thoughtfully identifying investment opportunities and attempting to avoid exposure to downgrades.

Spelling support for securitized sectors

The Fed resurrected its Term Asset-Backed Securities Loan Facility (TALF), a program that saw success during the global financial crisis. This has helped return function to the asset-backed securities markets, but we expect opportunities there will be more challenged than in the investment-grade corporate market.

As a result, we have also been taking a careful approach in the securitized sectors. Long-term issues confronting commercial real estate have been catalyzed by the lockdown environment. Within the residential mortgage-backed securities market, there is uncertainty about how the process of forbearance (temporary payment relief) and property foreclosures will impact payments.

SEI’s View

The monetary and fiscal policy responses to the COVID-19 pandemic have been big, fast and global in character. We expect more fiscal support to emerge around the globe, but the outlook for additional stimulus in the U.S. is less certain.

For the sake of context, the global financial crisis was borne of traditional macro-economic factors: extended leverage and speculation in the late stages of an economic growth cycle, which led to asset bubbles that eventually burst.

We are therefore encouraged that the underlying health of the U.S. economy and financial system coming into the COVID-19 pandemic-driven crisis was much stronger relative to the fragile environment leading up to the global financial crisis.

Ultimately, we believe the key to ending this crisis will be predominantly scientific and medical in nature. State and local officials in some areas of the U.S. have had success in “flattening the curve.” But we do not expect to put this period behind us until there is more universal testing and an approved vaccine that is made universally available.

Capital markets were in extreme duress until late March, and then mounted a very encouraging recovery so far throughout the second quarter as a result of the policy response.

We’re a bit cautious that valuations have improved so rapidly since the capital markets were under extraordinary stress in March. However, we think this has been a solid example of how the Fed’s ability and willingness to put capital to work can provide underlying support for the performance of fixed-income asset classes.

Spreads have narrowed quite a bit since reaching their widest point in late March as the Fed’s actions convinced bond buyers to re-engage. But there’s still plenty of credit duress in sectors like energy, travel and retail.

The good news here is twofold: liquidity conditions have improved dramatically, yet still provide an opportunity for investors since they have yet to normalize as of mid-June.

Glossary of Financial Terms

Basis points (BPS): 100 basis points equal 1%.

Option-Adjusted Spreads (OAS): Option-adjusted spreads estimate the difference in yield between a security or collection of securities and comparable Treasurys after removing the effects of any special features, such as provisions that allow an issuer to call a security before maturity.

Index Definitions

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.

ICE BofA BB US High Yield Index: The ICE BofA BB US High Yield Index tracks the performance of U.S. dollar-denominated below-investment-grade-rated corporate debt publicly issued in the U.S. domestic market with a credit rating of BB.

ICE BofA CCC & Lower US High Yield Index: The ICE BofA CCC & Lower US High Yield Index tracks the performance of U.S. dollar-denominated below-investment-grade-rated corporate debt publicly issued in the U.S. domestic market with a credit rating of CCC or below.

Legal Note

Important Information

All information as of June 16, 2020.

There are risks involved with investing, including possible loss of principal. Diversification may not protect against market risk. Bonds will decrease in value as interest rates rise. High yield bonds involve greater risks of default or downgrade and are more volatile than investment grade securities, due to the speculative nature of their investments. There can be no assurance that strategies discussed will or won’t be successful.

This material is provided by SEI Investments Management Corporation (SIMC), a wholly owned subsidiary of SEI Investments Company (SEI). This information should not be relied upon by the reader as research or investment advice. This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results.