Market Outlook

Market Commentary

Uncertainty and Investment-Grade Credit

By Ken Leech, Chief Investment Officer
1 June 2020

Investment-grade credit could offer substantial value, even in the current uncertain economic environment.

Key Takeaways:

  • 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.

 


Definitions:

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.

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.

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.

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