Today’s podcast features a discussion about fixed income markets since the coronavirus liquidity crisis and what may lie ahead. To discuss, we’ve asked George Bory, Managing Director of Fixed Income Strategy and Product Specialists at WFAM, and Janet Rilling, Senior Portfolio Manager, Head of the Multi-Sector Fixed Income – Plus team, WFAM Global Fixed Income, to join us.
Laurie King: I’m Laurie King and you are listening to On the Trading Desk®. We’ll be talking about fixed-income markets since the coronavirus liquidity crisis and what may lie ahead.
Just for reference, since the depth of the crisis, equity markets have been clawing their way back, whereas fixed income has outperformed. We’ll be asking our experts if we can expect more of the same.
With me today are George Bory, Managing Director of Fixed Income Strategy and Product Specialists at Wells Fargo Asset Management and Janet Rilling, Senior Portfolio Manager and Head of the Wells Fargo Asset Management Multi-Sector Fixed Income – Plus team. Welcome to the program, George and Janet.
George Bory: Thanks for having me, Laurie. It’s great to be on the show.
Janet Rilling: Happy to be here, Laurie.
Laurie: 2020 has been a wild ride for the markets due to the COVID-19 crisis, energy price volatility, and now, the upcoming presidential election. Despite all that, year-to-date total returns for most of the fixed income asset classes look pretty good. This is based on Bloomberg Barclays Global Agg [Bloomberg Barclays Global Aggregate Index] first six months of the year: U.S. treasuries are up 8.7%; corporates are up 5%; securitized bonds are up around 5%.
Two notable exceptions were high-yield corporates and high-yield munis, or municipal bonds. I was certainly shocked to see Hertz, the rental car company, declare bankruptcy.
Janet, can you tell us a bit more about what you saw happening as you were managing portfolios?
Janet: Well, calling the first half of 2020 eventful is probably an understatement. If you think about it, we entered the month of March in an expansion, and by the end of the month, we were moving into a recession.
The dramatic shift really caused a sharp fall in equity prices and then also a widening of credit spreads. In fact, in both markets, these were levels we hadn’t seen movements so severe since 2008.
Further within the credit markets, it led to a locking up of liquidity, including in the very important commercial paper market. So in order to stop the liquidity crisis from going any further and pushing the economy into a depression, the Fed [Federal Reserve] and Congress stepped in with very forceful and dramatic action.
On the fiscal front, stimulus was introduced via the CARES Act, and then from the Fed, they borrowed from their global financial crisis playbook, taking rates directly to zero and introducing a series of programs designed to ease liquidity and the funding stress.
The corporate bond market was a target of one of those programs, and the announcement of the program really helped to alleviate the locked-up situation in the market trading.
The first positive development post those announcements was the opening of the new issue market. It was really open to the highest quality borrowers and the largest companies, but that was helpful in terms of prying open normal functioning of markets.
These companies were able to source liquidity by borrowing through the debt markets, though they did have to do it at higher rates than they had seen just a few months before.
The high-yield market, on the other hand, was slower to respond. Further, if you think about it, given the fact that high-yield companies have weaker balance sheets the market was trying to sort out really who would be a survivor with the new COVID environment that we were in and who was going to have problems.
We saw energy have a particularly large set of problems, given the depressed level of oil prices, and then the leisure space, such as airlines and lodging, were hit pretty hard, too. And that’s where the Hertz story comes in. It was really already a challenged business model, but its close ties to travel was just too much to keep it out of bankruptcy.
Laurie: George, from your perspective, what do you think this means for asset returns in the second half of 2020?
George: That’s a good question, Laurie. As Janet mentioned, very volatile start to the year, and bond markets have been what I’d call a double-edged sword.
On the one hand, and as Janet pointed out, risk premiums went materially wider earlier this year, but the flight to quality and the shift into bonds during that volatility helped push up bond prices pretty significantly.
But as you kind of look forward, what we would suggest is that bond prices should remain pretty well supported by the central bank activity, and that’s very good news for the markets.
However, it’s going to be tough to achieve material capital gains in this kind of environment. And the only way to do that would be for a material weakening in the economy, which would weigh on asset prices, but that would likely spur more activity from the Fed in their effort to try and maintain some sense of order in the market and likely drive down interest rates further.
This is not our central scenario, so for fixed-income investors, as you think about the second half of the year, your return is mostly going to be due to simple carry or the coupon that you collect from the bonds that you hold. So our base case for the second half of the year is relatively modest returns, mostly focused on basically yield and carry.
But importantly, investors are going to have to be very sensitive to any material downside risk because that lost capital could really erode into your income, if you hold a security or a company that gets pressured by the market.
Laurie: And what about U.S. versus non-U.S. or emerging markets bonds?
George: So the U.S. versus the rest the world can be a great diversifier for fixed-income portfolios, because the correlations between different markets often diverge.
That being said, the U.S. tends to outperform during periods of market stress, and that’s exactly what happened earlier this year.
If you look so far this year, the U.S. has considerably outperformed the rest of the world—would say the U.S. Agg [Bloomberg Barclays U.S. Aggregate Bond Index], having a total return this year so far of over 6%, that compares to, say, the European Agg [Bloomberg Barclays Euro Aggregate Bond Index] with a year-to-date total return of just 1.3%. And if you look into the emerging markets, those returns look much closer to equity-like returns. And so the U.S. has materially outperformed.
Now looking forward, the trend to the U.S. outperformance is vulnerable to much more volatility.
On the plus side, the U.S. still maintains a considerable yield advantage to the rest of the world. This suggests that the demand for U.S. dollar fixed income should remain pretty robust, and that’s the good news.
The negative news, or the more challenging part, is that the dollar has weakened versus several major currencies this year. And if you look at it versus a broad basket, the dollar is trading very close to the bottom end of a relatively long-term range.
And so U.S. dollar fixed income investors need to be very sensitive to that. One way to hedge some of that risk is for investors to look or to hold, say, a small allocation to non-dollar currencies. Now that goes for the developed world, so maybe holding euro-denominated bonds, but also maybe taking a look at emerging market currencies, which are going to have a much lower correlation and being able to provide a much better diversification to the dollar-dominated positions in the portfolio.
So when you go global, Laurie, there’s a lot to do. It can be very beneficial to your portfolio, but you need to be careful and be very disciplined as to how you position those bonds.
Laurie: Well, thanks for explaining that. And let me ask you, Janet, within our core and core plus strategies, investment grade credit is important, and that largely means corporate bonds.
Given what you said about the economy before, why should anyone invest in investment grade credit now? Aren’t we in a recession?
Janet: Well, certainly on the face of it, now doesn’t seem like a good time to invest in investment grade credit.
If you think about how we entered the COVID crisis, debt levels are elevated on the balance sheets of investment grade companies. And of course, now we’re in the midst of a deep economic downturn, and looking out to the next quarter or two, credit quality is sure to deteriorate even further. And certainly some businesses are not going to make it. I mean we are going to see bankruptcies increase.
But I think those observations miss a number of other key factors.
So first of all, I look at what investment grade companies have done to react to the COVID crisis. In March and April, I think they acted very prudently in liquefying their balance sheets. They came to market, borrowed heavily, and have kept the proceeds in cash to give them financial flexibility.
Further, we’ve seen them adjust their cost structures wherever they could. They’ve also reduced share buybacks, halted their merger and acquisition activity. I think all these actions put many of them in a good position to just sort of hunker down and weather the storm that we’re in right now.
Secondly, the Fed has come in with a corporate bond purchase program, and that’s a very important support to market dynamics. They’ve also developed a credit facility for companies to tap if they need access to capital and aren’t able to get it in the public markets. I think both of these actions help to blunt any tail risk in the market.
Third, I think demand is going to outweigh supply in the second half of the year. So investors are looking for a place to get additional income in their portfolio, and investment grade credit is a place they can do that. On the supply side, because so many companies came to market in the second quarter, we are expecting a decline in supply as we round out the back half of the year. So that’s a favorable supply/demand balance for the credit market.
And then lastly, and in our minds, always most importantly, valuations are important to look at. Admittedly, they’re not cheap like they were back in March and April, but we still deem them to be reasonable. Certainly, we expect volatility to continue in the second half of the year, but when we look at the level of yield spreads, they’re basically in line with long-term averages, and we think that makes the carry advantage attractive.
Laurie: And when we talk about attribution, the source of total returns in our bond portfolios, sector strategy and security selection are the main sources of return. Are there certain industries that you favor in this environment?
Janet: We certainly have areas that we favor. They tend to be some of the less cyclical areas.
One in the financial space is the life insurance sector. Life insurance companies are exposed somewhat to the market-related pressures, but they’ve come into this period with strong credit profiles, and we expect those to remain intact. So given the fact that there is a yield pickup versus the more general investment-grade universe, we find this sector attractive.
We think another good sector to look at is cable. A lot of that is due to the nature of their product. High-speed broadband is really an important service for people in this environment. Whether you’re working from home or you’re looking for entertainment options, people have put a higher value in having a good internet connection, and high-speed broadband has shown it’s a better choice than DSL.
And then lastly, I round out with telecom. Looking at the wireless industry, it has proven to be really an essential service for Americans. That leads to stable and a recurring revenue stream, which we really like to see as credit investors.
So those are three sectors that I would highlight as a place that we find attractive.
Laurie: Well, I can certainly identify with the importance of cable and wireless in this environment. What other areas of the credit markets are there opportunities?
Janet: Well, we think there are opportunities in high yield, as well, and we would argue valuations are not nearly as attractive as they were in the early second quarter, but we do still think there is value here.
We are tending to focus on the higher-quality part of the high yield market, as these companies tend to have more capacity to weather a longer economic recovery.
We’ve also tended to focus on less cyclical industries for this exact same reason.
<pAs a side note, our team always emphasizes good diversification in this part of the market with the idea you want to reduce idiosyncratic risk. It's better to have a broad diversified exposure, given a wider range of outcomes in this part of the market. But in the current environment, I think that point is even more valid, given economic risk has grown.
And then lastly, I’d say outside of the U.S., we’re beginning to nibble a bit on European investment grade credit. Fundamentals in this space were good going into the crisis, and the valuations were getting a bit rich, so we had exited this sector, or at least reduced our exposure earlier in the year. So this for us is now a good opportunity to relook at the space. The valuations in our minds now look more attractive versus the U.S. credit market. Further, the most recent COVID trajectory has been a bit more benign in Europe. We’re not certain that’s going to hold, but in the short term, it does seem like the trends are a bit better, and this is a way to take advantage of perhaps a better economic outlook in the next quarter or two.
Laurie: And what are your biggest worries for the second half of 2020? And are your portfolios set up to deal with that, or how are they set up to deal with that?
Janet: Well, certainly the range of outcomes is very wide as we look at the second half of this year.
Our base case scenario is for what we’re calling a dog leg-shaped economic recovery. So what that means to us is it will likely start out looking like a V-shaped recovery, but then the improvement starts flattening out and loses some momentum. We’ll get to that type of recovery by resuming some economic activity, but also by living with higher infection rates from COVID.
The risk to this scenario is that we move to much more far-reaching closures and lockdowns, either due to higher infections or just public policy to try to limit the spread. That would be a very negative scenario for the markets.
We’re not positioned for that draconian scenario, but I will say our process is designed to be able to quickly adjust the portfolio to changing circumstances. We do that by taking a shorter-term view when we set up the portfolio positioning. And by that, I mean we look out maybe two, three quarters when we think about valuations and we think about different scenarios, rather than trying to predict where things are going to go over a longer maybe 3- to-5-year type period. This approach allows us to be much more dynamic in our asset allocation and we can be nimble when we shift the risk in the portfolio.
Laurie: And George, how would you answer that question? How are the other bond portfolios, in general, set up to weather worries that the investment teams may have about the second half of the year?
George: The reality is all fixed income investors face three big challenges, and those challenges are not going to go away anytime soon.
In the near term, as Janet mentioned, it’s the trajectory of the COVID crisis, which is going to dominate both investors’ attention and also the level of prices in capital markets. As Janet highlighted, a very good bottoms-up strategy that focuses on companies and securities—so the types of securities matter—that have the ability to adjust to a COVID-dominated world and still generate the cash flows that they are projected to deliver is really your number one line of defense.
The second big issue is policy, both fiscal and monetary. We’ve had a quantum leap forward, if you will, over the course of this year, as both the federal government and, importantly, the Federal Reserve moved into various corners of the bond market. That had a calming effect on volatility, which has kind of helped restore confidence in the market. And so the Fed has been very successful in that strategy. However, as you look forward, the market is now highly dependent on the Fed’s ongoing participation. Any suggestion that the Fed is backing away from their market level support could send a meaningful shockwave through markets, could cause risk premiums to go higher, and really cause volatility to go up pretty meaningfully. And that could be a challenge. As Janet mentioned, it’s not our central case going into the end of the year, but that is a risk that we have to watch pretty closely.
And then lastly, as we discussed on this call, a zero interest rate world or a very, very low interest rate world presents some meaningful, profound challenges for fixed-income investors. The most notable challenge is the ability to generate income. It is and will continue to be at the top of investors’ list of challenges over the course of this year and well into next and possibly even beyond. The Fed’s success in squashing volatility is a double-edged sword. It calmed down the markets, but it also drove interest rates down to record lows.
So pretty much all fixed income investors will need to expand their investment strategies. This includes both extending along the yield curve and going down in credit quality.
Laurie: Well, thanks so much for being a part of this conversation, George.
George: Thanks very much for having us on.
Laurie: And thank you, Janet, for sharing your insights.
Janet: Thank you, Laurie. It’s really been a pleasure talking with you.
Laurie: For our listeners, if you’d like to read more market insights and investment perspectives from the fixed income teams at Wells Fargo Asset Management, you can find them at our AdvantageVoice® blog, as well as on our website at wellsfargoassetmanagement.com. Thanks for listening. I’m Laurie King; take care.