Investment-grade credit could offer substantial value, even in the current uncertain economic environment.
- The COVID-19 pandemic has produced so much market uncertainty that Fed Chair Powell has said on more than one occasion that forecasts in this environment are practically useless.
- Getting investment-grade credit yields down is essential to ensuring the eventual transition to an economic recovery.
- Investment-grade bond spreads have come down since their peak in March, but relative to implied default expectations we believe they still represent exceptional value.
“Only the unknown frightens men. But once a man has faced the unknown, that terror becomes the known.”
— Antoine de Saint-Exupéry
”Knightian uncertainty” is named after the University of Chicago economist Frank Knight, who distinguished risk and uncertainty. Knightian uncertainty is a lack of any quantifiable knowledge about some possible occurrence as opposed to the presence of quantifiable risk. The concept acknowledges some fundamental degree of ignorance, a limit to knowledge and an essential unpredictability of future events.
Today’s medical, behavioral, economic and market environments epitomise Knightian uncertainty. We have never before experienced anything like the COVID-19 pandemic, or what is perhaps the greatest experiment in world economic history: the voluntary shutting down of massive parts of the global economy with the hope/plan of restarting after some temporary period of time. As Federal Reserve (Fed) Chair Jerome Powell has said on more than one occasion, forecasts in this environment are practically useless.
As investors, how do we go about advancing through this fog? We think the key may be to lean on assets that have robust characteristics, and therefore might best weather even a long and protracted period of uncertainty. They must also be able to generate sufficient returns if a better or improving environment comes into focus. We would argue that investment-grade (IG) corporate bonds could fit this bill. The psychology of fear and uncertainty has driven fixed-income risk-based assets to distressed levels. Avoiding risk while waiting for clarity may seem reasonable, but a quick recovery would leave you under-invested. Investing in higher risk sectors could bring substantial returns in the event of a near-term recovery, but may not survive a period of prolonged economic weakness. This is the inherent uncertainty in today’s challenge—either a quick or prolonged recovery is possible.
“Getting IG credit yields down is essential to ensuring the eventual transition to an economic recovery.”
— Western Asset
The overarching goal of policy is to protect and maintain the key elements of the economic apparatus for the potential restart. In the US, the primary focus is on the IG credit market, which is represented by the premier corporations in America. Their solvency and performance ability are absolutely necessary if the economy is to come back. The CARES Act has provided the Fed with the ability to buy corporate bonds directly for the first time in its history. Without parsing all the specifics of the Act, the key takeaway is that the ability to actively support the IG credit market has been initiated. Many doubt whether the Fed will use this facility to continually support the market, as the European Central Bank, Bank of England and Bank of Japan have routinely done. There is also a thought that this program should be viewed only as a backstop. We, however, suspect that the Fed will use this authorisation strongly in order to improve financial conditions.
Getting IG credit yields down is essential to ensuring the eventual transition to an economic recovery. IG credit yields have come down in advance of every US economic recovery. Exhibit 1 shows the IG yield history just since 1990, along with descriptions of the yield declines—for corporate bonds generally and long corporates specifically—in every downturn since 1990.
Exhibit 1: US Corporate Yields*
Source: Bloomberg Barclays. As of 22 May 20. *Represented by Bloomberg Barclays U.S. Corporate Investment Grade and Bloomberg Barclays Long U.S. Corporate Investment Grade indices. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
Note in the graph that yields not only fell from the recession peak, but also were meaningfully lower than the levels that prevailed before the recession stress commenced. Additionally, they remained lower well after the recovery started. Lowering corporate borrowing costs is a paramount policy objective. Despite today’s economic uncertainty, this goal now has the benefit of an additional powerful Fed capability.
“Lowering corporate borrowing costs is a paramount policy objective.”
— Western Asset
Most important, though, is valuation and investment worthiness under stress. IG spreads have come down from their March peak, but relative to implied default expectations they still represent exceptional value. Currently, IG corporate bonds are priced for 14.33% cumulative defaults (as of May 22, 2020). The peak in cumulative IG defaults was only 2.5% in the aftermath of the global financial crisis. The degree of widespread corporate defaults necessary to justify today’s spread level is multiples of the worst experience in post-war US history. These valuations are also compelling from a global relative value basis. Exhibit 2 shows the yields of IG corporate bonds globally. Note that the US has the highest yields, the largest and most liquid market, and arguably the most financial resources to withstand the pandemic.
Exhibit 2: Credit Market Yields and Size
Source: Bloomberg Barclays. As of 01 Apr 20. Bloomberg Barclays Global Credit Index by Currency. JPY = Japanese yen; EUR = euro; UK = British pound; Asia = weighted Asia currencies; US = U.S. dollar. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
As little as three months ago (a lifetime in coronavirus time) investors were accumulating US corporate debt—both public and private—as the need for yield was so difficult to satisfy. Today, it is a reasonable prospect that global central banks will have zero or negative policy rates for years. The initial fear and resulting flight to safety that elevated US Treasuries and depressed corporate bonds are understandable. But over time, as investors start the process of portfolio construction with an eye to an eventual recovery, the need for “safe” yield will once again become a priority. Many fixed-income spread sectors could benefit. But IG bonds have the combination of valuation, credit resiliency over a long period of uncertainty and an explicit policy commitment.
The pandemic-related fear and uncertainty are today’s realities. But conditions can change—both for the better or the worse. Building portfolios that can withstand meaningful and prolonged economic adversity is crucial. But likewise, providing investors with the economic returns that might no longer be achievable once a recovery becomes clearly evident is also important. In that context, we believe that IG corporate bonds are deserving of careful consideration.
Learn more about Western Asset's Fixed Income solutions:
Legg Mason Western Asset Australian Bond Fund
Legg Mason Western Asset Cash Plus Fund
Legg Mason Western Asset Global Bond Fund
Legg Mason Western Asset Macro Opportunities Bond Fund
Investment-grade (IG) bonds are those rated Aaa, Aa, A and Baa by Moody’s Investors Service and AAA, AA, A and BBB by Standard & Poor’s Ratings Service, or that have an equivalent rating by a nationally recognized statistical rating organization or are determined by the manager to be of equivalent quality.
The Bloomberg Barclays U.S. Corporate Investment Grade Index is an unmanaged index consisting of publicly issued US Corporate and specified foreign debentures and secured notes that are rated investment grade (Baa3/BBB- or higher) by at least two ratings agencies,
The Bloomberg Barclays Long U.S. Corporate Investment Grade Index is an unmanaged index consisting of publicly issued US Corporate and specified foreign debentures and secured notes that are rated investment grade (Baa3/BBB- or higher) by at least two ratings agencies, and have maturities of 10 years or longer.
The Bloomberg Barclays Global Credit Index is an unmanaged index reflecting corporate credit issues worldwide. The index is available in several currencies, including the U.S. dollar, Japanese yen, euro, and others.
COVID-19 is the World Health Organization's official designation of the current novel coronavirus disease. The virus causing the novel coronavirus disease is known as SARSCoV-2.
A pandemic is the worldwide spread of a new disease.
The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
A spread is the difference in yield between two different types of fixed income securities with similar but not identical characteristics, with the possible differences including creditworthiness, maturity date, or other factors.
The “CARES Act” is short for the ''Coronavirus Aid, Relief, and. Economic Security Act''.
The European Central Bank (ECB) is the central bank for the European Union (EU).
The Bank of England (BOE) is the central bank of the United Kingdom.
The Bank of Japan (BoJ) is the central bank of Japan and is responsible for the yen currency.
Backstop is a term used in the financial industry to mean credit support or backup funds for a financial instrument or transaction.
“Long corporates” refers to corporate bonds with maturities of over ten years.
A central bank is a national bank that provides financial and banking services for its country's government and commercial banking system, as well as implementing the government's monetary policy and issuing currency.
The Great Recession, also known as the financial crisis of 2007–08, the Great Financial Crisis (GFC), global financial crisis and the 2008 financial crisis, was a severe worldwide economic crisis considered by many economists to have been the most serious financial crisis since the Great Depression of the 1930s, to which it is often compared.
U.S. Treasuries are direct debt obligations issued and backed by the "full faith and credit" of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.
Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.
All investments involve risk, including possible loss of principal.
The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested.
Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.
International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.
Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.
Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.
The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice. Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors.
The information in this material is confidential and proprietary and may not be used other than by the intended user. Neither Legg Mason or its affiliates or any of their officer or employee of Legg Mason accepts any liability whatsoever for any loss arising from any use of this material or its contents. This material may not be reproduced, distributed or published without prior written permission from Legg Mason. Distribution of this material may be restricted in certain jurisdictions. Any persons coming into possession of this material should seek advice for details of, and observe such restrictions (if any).
This material may have been prepared by an advisor or entity affiliated with an entity mentioned below through common control and ownership by Legg Mason, Inc. Unless otherwise noted the "$" (dollar sign) represents U.S. Dollars.
This material is only for distribution in those countries and to those recipients listed.
All investors and eligible counterparties in EU and EEA countries:
In Europe (excluding UK and Switzerland), this financial promotion is issued by Legg Mason Investments (Ireland) Limited, registered office Floor 6, Building Three, Number One, Ballsbridge, 126 Pembroke Road, Ballsbridge, Dublin 4. D04 EP27, Ireland. Registered in Ireland, Company No. 271887. Authorised and regulated by the Central Bank of Ireland.
In the UK, this financial promotion is issued by Legg Mason Investments (Europe) Limited, registered office 201 Bishopsgate, London EC2M 3AB. Registered in England and Wales, Company No. 1732037. Authorized and regulated by the UK Financial Conduct Authority.
In Switzerland, this financial promotion is issued by Legg Mason Investments (Switzerland) GmbH.
Investors in Switzerland: The representative in Switzerland is FIRST INDEPENDENT FUND SERVICES LTD., Klausstrasse 33, 8008 Zurich, Switzerland and the paying agent in Switzerland is NPB Neue Privat Bank AG, Limmatquai 1, 8024 Zurich, Switzerland. Copies of the Articles of Association, the Prospectus, the Key Investor Information documents and the annual and semi-annual reports of the Company may be obtained free of charge from the representative in Switzerland.
All Investors in Hong Kong and Singapore:
This material is provided by Legg Mason Asset Management Hong Kong Limited in Hong Kong and Legg Mason Asset Management Singapore Pte. Limited (Registration Number (UEN): 200007942R) in Singapore.
This material has not been reviewed by any regulatory authority in Hong Kong or Singapore.
All Investors in the People’s Republic of China (“PRC”):
This material is provided by Legg Mason Asset Management Hong Kong Limited to intended recipients in the PRC. The content of this document is only for Press or the PRC investors investing in the QDII Product offered by PRC’s commercial bank in accordance with the regulation of China Banking Regulatory Commission. Investors should read the offering document prior to any subscription. Please seek advice from PRC’s commercial banks and/or other professional advisors, if necessary. Please note that Legg Mason and its affiliates are the Managers of the offshore funds invested by QDII Products only. Legg Mason and its affiliates are not authorized by any regulatory authority to conduct business or investment activities in China.
This material has not been reviewed by any regulatory authority in the PRC.
Distributors and existing investors in Korea and Distributors in Taiwan:
This material is provided by Legg Mason Asset Management Hong Kong Limited to eligible recipients in Korea and by Legg Mason Investments (Taiwan) Limited (Registration Number: (109) Jin Guan Tou Gu Xin Zi Di 035; Address: Suite E, 55F, Taipei 101 Tower, 7, Xin Yi Road, Section 5, Taipei 110, Taiwan, R.O.C.; Tel: (886) 2-8722 1666) in Taiwan. Legg Mason Investments (Taiwan) Limited operates and manages its business independently.
This material has not been reviewed by any regulatory authority in Korea or Taiwan.
All Investors in the Americas:
This material is provided by Legg Mason Investor Services LLC, a U.S. registered Broker-Dealer, which includes Legg Mason Americas International. Legg Mason Investor Services, LLC, Member FINRA/SIPC, and all entities mentioned are subsidiaries of Legg Mason, Inc.
All Investors in Australia and New Zealand:
This document is issued by Legg Mason Asset Management Australia Limited (ABN 76 004 835 839, AFSL 204827). The information in this document is of a general nature only and is not intended to be, and is not, a complete or definitive statement of matters described in it. It has not been prepared to take into account the investment objectives, financial objectives or particular needs of any particular person.
The aforementioned Legg Mason entities are wholly owned subsidiaries of Franklin Resources, Inc.