News & Views

What has happened to Fixed Income?31 March 2020

Coronavirus has not only affected equities, but also the bond market. Sentiment has changed from the beginning of the year, when government yields were low and credit spreads tight as investors were optimistic as some of the geopolitical headwinds had been removed. Whereas now, safe haven assets have taken a sharp decline.

The week before last, US long bond yields moved as much intraweek as they did in the entire 2013 taper tantrum. Dollar investment grade spreads widened by 130 bps and dollar high yield spreads widened by 400 bps. Another noteworthy development in the bond market was that more spread could be found in a 1-year corporate floating rate note than for lending to a company of the same issuer for 8 years.

However, US index spreads are now all tighter after the 24th March rally in the derivative market. This hasn’t pulled through to the Sterling & European indices yet, but we believe it is only a matter of time. US corporate and high yield spreads, as well as European high yield are tighter, as are Emerging Markets. High quality credit is outperforming for the first time in weeks.

The rational for safe haven assets’ sharp decline is simple: investors were in a dash for cash and are hoarding it like shoppers are hoarding soap and toilet paper. Investors were selling what they could and perhaps not what they should, as they knew they might need their cash in the near future or with institutions distress dumping whatever they could to meet margin calls or reduce leverage. In the longer term, this is somewhat irrational and might contribute to a powerful rebound. We have seen an incredible volume flow in a very short space of time and asset prices have reacted to this and overshot, which tends to happen in both the bond and equity markets when there are times of market stress.

Last week though, the new issue bond markets in the US and Europe reopened. The new supply of bonds was met with considerable demand which indicates investors are now more comfortable with their cash balances, which wasn’t the case a few weeks ago. We believe this suggests a much more balanced bond market. Also, we feel we are close to the end of forced selling, as it tends to happen when investors have their cash balances at levels where they are comfortable again. US mutual funds have added $95 billion to cash balances this past week alone, so we are on our way there.

We believe the good news is that historically, buying the market at these kinds of spreads and higher, delivered exceptionally strong subsequent one and two-year returns. Global Strategic Bonds, Short Dated bonds and High Yield bonds, which are Fixed Income themes we play out in the portfolios, are in a great position to offer strong returns. A bullish view would be that the policy response has been much quicker than in 2008 and that the economic shock might be much more short-lived. Depending on government action, we believe the recovery could take anywhere between 6 months to 2 years. Regardless of which outcome prevails, we would expect markets to be higher in 2 years’ time, if not sooner.

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