The End of the World As We Know It?

Around the Curve

The End of the World As We Know It?

While the coronavirus commands the headlines, one can't understand the global economy's prospects in the months ahead without considering the state of the oil market, too.

 

As we sit here evaluating asset markets, one of our portfolio managers, Steve Smith, occasionally thinks about markets in terms of music. Thinking about the issues facing credit investors, both corporate and structured, REM’s "It’s the End of the World (And I Feel Fine)" starts reverberating through our heads. But is it really the end of the world as we know it?

Yes, we are facing a global pandemic and authorities have taken bold and significant action to address the virus on both healthcare and economic levels. Yet, COVID-19 is not the only issue confronting investors at this time—West Texas Intermediate (WTI) crude oil below $20 is a significant issue as well. It was only a few short years ago, in 2015, that oil falling precipitously caused a severe dislocation in asset prices. So is it really the end of the world as we know it?

Much ink has been spilled analyzing and discussing COVID-19 and we may not be able to add much to the substantive conversation. However, we remind investors that low oil prices are of equal importance to analyze and understand. Current market conditions should have a notable impact on the U.S. energy sector as well as households—investors should heed signals from both of these areas.

The Energy Sector

The launch of an oil war between Saudi Arabia and Russia surprised markets that weekend of March 7. Although it may appear that Saudi Arabia and Russia are in conflict, the true foes for both countries are technology and capitalism. The advancement of fracking technology and capitalism have seen the rise of U.S. exploration and production (E&P) as a significant competitor to both Saudi Arabia and Russia.

The increase in domestic U.S. production has come at a cost to both these countries. Investors need to be wary of the outcome and understand how committed Saudi Arabia and Russia are to breaking U.S. E&Ps. As we have seen in the recent past, capex will most likely be significantly impaired and energy producers across the globe will need to plan accordingly. Our expectations are that both the private and public sector participants will face similar issues as they did in 2015. High yield issuers within the energy sector could experience acute pain. Chart 1 shows how much spreads widened in this sector back in 2015:

U.S. High Yield Energy Minus 5-Year U.S. Treasury (basis points)

Sources: Bloomberg Finance LP, Bank of America Merrill Lynch, as of 3/27/2020. U.S. High Yield Energy represented by the Bank of America Merrill Lynch High Yield Energy Index. 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.

We have generally avoided high yield issuers within the sector and have not partaken in recent new issuance from some of the largest investment grade energy corporates. We may reevaluate this exposure on a company-by-company basis, particularly within the investment grade universe.

U.S. Households

The health of the residential real estate market and household balances sheet have been the bulwark of a relatively strong U.S. economy. The exogenous shock of COVID-19 will be severe and hopefully shorter-lived, creating a sharp income shock for households and the commercial real estate market. Social distancing will further impact service industries, including retail, restaurants, and lodgings. The stimulus package should be able to mitigate the near-term stress to some degree. Eventually household consumers will build confidence when they see the slowdown of the spread of the virus and the stimulus package working through the system.

Both corporate and structured credit markets have seen significant dislocations due to COVID-19 and the collapse of oil and natural gas. Spreads on an absolute yield basis have reached distressed levels when looking at a high yield index while structured credit has seen similar moves in cash bonds.

U.S Bank of America Merrill Lynch High Yield Master II Index

Option-adjusted spread (OAS) in basis points

Source: Bloomberg Finance LP, as of 3/27/ 2020. 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.

Certain pockets of the structured credit market have seen spreads widen as well:

AAA: 5th Percentile – 95th Percentile

Source: Brandywine Global, as of 3/27/2020. 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.

BBB & Below: 5th Percentile – 95th Percentile

Source: Brandywine Global, as of 3/27/2020. 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.

Looking at Charts 3 and 4, spread widening has been indiscriminate across investment grade and high yield structured, though yields have sharply risen on floating-rate debt, auto loans, and commercial mortgage-backed securities.

Whether these spread levels widened due to the unwinding of risk parity models or the liquidation of leveraged funds, the reality of the market is these securities are trading at these levels whether justifiable or not. And it’s not only these lower quality markets that have seen challenges but also Treasury markets as well, which are normally highly liquid.

No, It’s Not the End of the World as We Know It

We have seen a very strong and authoritative response from central bankers and policymakers around the world on both the monetary and fiscal sides. Policymakers have taken swift, decisive action, perhaps because of lessons learned from the Great Financial Crisis (GFC). The Federal Reserve, European Central Bank (ECB), People’s Bank of China, and other central banks have all taken steps to support the financial markets and prevent an exogenous demand shock from becoming a financial crisis. The Fed has launched a seemingly infinite quantitative easing program along with providing access to a variety of facilities that were used during the GFC. Chart 5 tracks the size of some of the major central banks’ balance sheets since the onset of the GFC:

Central Bank Balance Sheet*

Source: Brandywine Global, as of 3/11/2020. *Rebased as of January 2007 = 100. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Similarly, the ECB is looking to support member states and corporations. Additionally, politicians are coming through with fiscal support to plug a hole in GDP caused by a sudden stop of global economic activity due to COVID-19. In our view, these actions are putting a floor under investment grade assets and higher quality, below-investment-grade assets. Although the spread widening may present buying opportunities within higher-quality corporates and structured credit, we suggest proceeding with caution in terms of security selection, particularly given the lag in how long it may take for the benefits of low crude oil prices to work through households and businesses.

…And I Feel Fine.


Definitions:

Capital expenditures (Capex) , also called capital spending, is an amount spent by a company to acquire or upgrade productive assets (such as buildings, machinery and equipment, vehicles) in order to increase the capacity or efficiency of a company for more than one accounting period.

An AAA rating is the highest investment-grade rating.

A BBB rating is the lowest investment-grade rating; it reflects an opinion that the issuer has the current capacity to meet its debt obligations but faces more solvency risk than A-, AA- or AAA-rated issues.

The Bank of America Merrill Lynch (BAML) High Yield Master II Index is a market capitalization-weighted index of all domestic and Yankee High-Yield Bonds.

The Bank of America Merrill Lynch (BAML) U.S. High Yield Energy Index tracks the performance of high yield bonds issued by companies in the energy sector.

The Bank of Japan (BoJ) is the central bank of Japan and is responsible for the yen currency.

One basis point (bps) is one one-hundredth of one percentage point (1/100% or 0.01%).

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.

A Commercial Mortgage-Backed Securities (CMBS) is a type of mortgage-backed security that is secured by the loan on a commercial property.

COVID-19 is the World Health Organization's official designation of the current coronavirus disease.

E&P (exploration and production) is a specific sector within the oil and gas industry, focused on finding, augmenting, producing and merchandising different types of oil and gas.

The European Central Bank (ECB) is responsible for the monetary system of the European Union (EU) and the euro currency.

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.

Floating rate debt refers to a bond that has a variable coupon, equal to a money market reference rate, like LIBOR or federal funds rate, plus a quoted spread, which remains constant.

Gross Domestic Product ("GDP") is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.

The the Great Financial Crisis (GFC), also known as the Great Recession, the financial crisis of 2007–08, 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.

High yield, or below-investment grade bonds are those with a credit quality rating of BB or below.

An investment-grade (IG) rating (AAA, AA, A, BBB for example) is one that indicates that a municipal or corporate bond has a relatively low risk of default. Bonds with below investment-grade ratings (BB, B, CCC for example) are considered low credit quality and have a higher risk of default.

An Option-Adjusted Spread (OAS) is a measure of risk that shows credit spreads with adjustments made to neutralize the impact of embedded options. A credit spread is the difference in yield between two different types of fixed income securities with similar maturities.

The People's Bank of China (PBC or PBOC) is the central bank of the People's Republic of China with the power to control monetary policy and regulate financial institutions in mainland China.

Quantitative easing (QE) refers to a monetary policy implemented by a central bank in which it increases the excess reserves of the banking system through the direct purchase of debt securities.

R.E.M. was an American rock band from Athens, Georgia, formed in 1980 by drummer Bill Berry, guitarist Peter Buck, bassist Mike Mills, and lead vocalist Michael Stipe

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.

Structured credit investments include collateralized bond obligations (CBOs), collateralized debt obligations (CDOs), syndicated loans and synthetic financial instruments.  A CBO is understood to be of investment grade, but is backed with the use of a pool of below-investment-grade bonds. CDOs are a kind of asset-backed security, holding a pool of collateralized debt, such as mortgages and auto loans, that may be subdivided into various tranches representing different levels of risk.  A syndicated loan is a loan offered by a group of lenders (called a syndicate) who work together to provide funds for a single borrower. Synthetic financial instruments are artificially created investment vehicles or instruments intended to meet requirements not met by existing, conventional instruments. They are designed to reduce risk, increase diversification or offer a higher return. A synthetic floating rate instrument can be produced by combining a fixed-rate bond and an interest rate swap. Or an asset with the same risks and rewards as the underlying share can be created by the purchase of a call option and the simultaneous sale of a put option on the same share.

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.

West Texas Intermediate (WTI), also known as Texas light sweet, is a grade of crude oil used as a benchmark in oil pricing. This grade is described as light because of its relatively low density, and sweet because of its low sulfur content. It is the underlying commodity of Chicago Mercantile Exchange's oil futures contracts.

Top

Important Information

 

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 approved for distribution in those countries and to those recipients listed below. Note: this material may not be available in all regions listed.

All investors and eligible counterparties in Europe, the UK, Switzerland:

In Europe (excluding UK and Switzerland), this financial promotion is issued by Legg Mason Investments (Ireland) Limited, registered office 6th Floor, Building Three, Number One Ballsbridge, 126 Pembroke Road, Ballsbridge, Dublin 4, D04 EP27. Registered in Ireland, Company No. 271887. Authorised and regulated by the Central Bank of Ireland.

All Qualified Investors in Switzerland:
In Switzerland, this financial promotion is issued by Legg Mason Investments (Switzerland) GmbH, authorised by the Swiss Financial Market Supervisory Authority FINMA.  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 the UK:
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 Financial Conduct Authority. Client Services +44 (0)207 070 7444

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: (98) Jin Guan Tou Gu Xin Zi Di 001; 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.

Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.

High yield bonds are subject to increased risk of default and greater volatility due to the lower credit quality of the issues.

Asset-backed, mortgage-backed or mortgage related securities are subject to additional risks such as prepayment and extension risks.