Fixed Income Week in Review –
March 25, 2020
Fixed income markets continued their unprecedented selloff last week, as realization dawned that the extraordinary measures to contain the Covid-19 crisis (social distancing, city lockdowns, etc.) will likely push the global economy into a severe synchronous contraction. Governments have struggled with the unenviable balance of virus containment versus economic impact, with more severe estimates for 2Q GDP declines in the -10% to -25% context. The scope of the uncertainty around the economic impact has prompted swift action from central banks and the emergence of proposals for unprecedented fiscal stimulus and regulatory relief globally. The US Federal Reserve (Fed) policies last week included a 100bp cut in the Fed Funds and Discount rates, a $700B QE4 targeting treasuries and mortgages, a cut to bank reserve requirements, an increase in FX swap lines, and the resurrection of three GFC-era credit facilities to backstop commercial paper, money markets, and overnight dealer credit. Similar actions were echoed globally, with the European Central Bank’s (ECB) record corporate bond purchases dampening the widening in European credit markets. While delays related to the political process have disappointed markets and prompted a sharp sell-off in risk assets, Congress is finalizing a complementary fiscal plan to bridge hard hit industries and an expected surge of unemployed, which will leverage lessons from the Global Financial Crisis (GFC) era and post-September 11, 2001. Similar actions are being pursued globally, with the German government abandoning austerity principles to mitigate the economic downturn. While markets are unlikely to stabilize in the absence of better economic clarity ahead, the velocity of the move has begun to create value in issuers and instruments capable of withstanding a severe economic contraction. The following provides further insights as they relate to taxable and tax-exempt fixed income markets.
Taxable fixed income
Fixed income sector returns were negative across the board last week, as a global flight to cash triggered heavy selling of any instrument with embedded credit and/or liquidity risk (see chart below).
||Total returns (%)
|Global Aggregate Bond Index US (investment grade index)
|US High Grade
Source: J.P. Morgan
Mutual fund net redemptions surpassed prior records, totaling -$36B (investment grade), -$19B (emerging markets), -$3B each for high yield bonds and loans. Bid-ask spreads gapped out across the board, in the extreme exceeding 10 points for distressed high yield bond and loan issues. Investment grade bonds widened by +120bp to close at 329bp, a one week change that exceeds the overall spread of the index prevailing at year-end. The pain was widespread, however, with spreads elsewhere widening 100bp (asset backed securities), 150bp (AAA commercial-mortgaged backed securities), 165bp (emerging markets), 242bp (high yield), and 362bp (bank loans). While new issuance halted virtually everywhere, the one exception was investment grade, where high quality issuers took advantage of the still low absolute yields to bolster liquidity positions bringing $63B in new borrowing which required significant selling concessions and put further pressure on the market. Given the extraordinary demand for cash and cash equivalents, the more liquid segments of the market such as Treasuries, short-term high quality securities and Agency MBS felt the brunt of the selling. Risk differentiation remained generally in place as higher quality securities and those more removed from the crisis fulcrum performed better. Within investment grade and high yield corporates, energy, hospitality, lodging, and cyclicals underperformed, while defensive sectors such as utilities and pharma outperformed.
Taxable bond returns during the trading week ending 3/20/20 reflect panic-driven selling into liquidity-challenged, over-the-counter markets, by investors struggling to assess a developing global pandemic that is without modern precedent, and without easy solution. Buffeted by an hourly and generally negative news cycle, market dislocations in the commercial paper, inter-bank funding, municipal, and even the Treasury market, Fed intervention on an unprecedented scale, and finally, the dawning realization that solving this stage of the viral spread will require the deliberate idling of entire industries, the loss of millions of jobs, and a deep Q2 contraction, investors voted with their feet. Despite this, markets continued to function, and investors were able to exchange risks even if at much more punitive levels. Over the last eight days the Fed has launched an open-ended QE4, demonstrated rapid and aggressive support for liquidity challenged areas of the market wherever they develop, including corporate bonds and municipals, and has plans to backstop small business lending. Meantime, Congress is close to finalizing a fiscal rescue plan estimated at $2T, or roughly 10% of GDP. The Fed-Fiscal support plan won’t head off recession, but should speed recovery, and at minimum eliminate some of the uncertainty that has elevated volatility and inflated the discount rate under stock and bond returns.
Tax exempt fixed income
The municipal market has experienced a significant sell-off on the back of record outflows from tax-exempt bond funds. Lipper reported outflows of $12.2B the week of 3/19, a record since the data series began reporting. Fears over the Covid-19 virus caused retail investors to redeem shares which led to indiscriminate selling by asset managers looking for liquidity. The combination of a break-down in the correlation between US Treasury yields and municipal yields, which has severely impacted dealers hedging capabilities, and generally a smaller dealer base with smaller capital lines in a post- GFC world, has exacerbated the sell-off.
The performance of the municipal asset class has been turned upside down. Credit and duration, the key factors which drove returns the past few years, has now reversed. The Bloomberg Barclays Municipal High Yield Index (BBMHY) has returned -13.2% year to date. If we compare the BBMHY index performance at this point in the cycle during the GFC, it was -5.9% (Source: Bloomberg). Municipal credit has performed significantly worse in this cycle. To further illustrate the severity of the sell-off, please note this has occurred in nine trading days.
Higher quality municipals have been significantly impacted as well. The Municipal Market Data AAA General Obligation (GO) scale is off 199 bpin both the 10- and 30-year spots, in nine trading days. The significant breakdown in the correlation between US Treasury rates and Municipal rates has caused municipal ratios, which are a measure of tax-free AAA municipal GOs yields divided by taxable US Treasury yields, to soar to a record 330% in 10 years and 237% in 30 years, at the closing print on March 20, 2020 (Source: Thomson Reuters, Municipal Market Data). This unprecedented underperformance has begun to attract non-traditional buyers: banks, life insurers, and P&C insurers, looking to take advantage of this anomaly.
While the performance may be reminiscent of the GFC, investors should note the cause of this sell off is very different. State and local governments, generally from a fundamental credit aspect, were in very good shape heading into this global pandemic. Many state and local governments established rainy day funds post GFC, enacted pension reforms, and were generally set up to withstand a moderate recession. The markets are contending with trying to assess the ultimate economic damage from the government forcing the economy into a recession to avert a significant health crisis from worsening. This unknown has created a vicious sell-off which has created significant opportunity for investors that take a long-term view of the market. While we are not predicting a bottom in the municipal market, we see value in the market which has materialized at unprecedented speed. Investors that focus on this opportunity may be rewarded in the long run.
The views expressed were current as of March 25, 2020, and are subject to change at any time.
The views expressed represent the investment team’s assessment of the market environment as of March 25, 2020, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice.
Data source is Bloomberg unless otherwise noted.
Diversification may not protect against market risk.
Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt. The securities may also be subject to prepayment risk, the risk that the principal of a bond that is held by a portfolio will be prepaid prior to maturity, at the time when interest rates are lower than what the bond was paying. A portfolio may then have to reinvest that money at a lower interest rate.
Substantially all dividend income derived from tax-free funds is exempt from federal income tax. Some income may be subject to state or local and/or the federal alternative minimum tax (AMT) that applies to certain investors. Capital gains, if any, are taxable.
Ex-US investors may not benefit from potential tax advantages associated with investing in US municipal bonds.
Index performance returns do not reflect any management fees, transaction costs, or expenses. Indices are unmanaged and one cannot invest directly in an index.
The Bloomberg Barclays Global Aggregate Index provides a broad-based measure of the global investment grade fixed-rate debt markets.
The Bloomberg Barclays US TIPS Index measures the total return performance of the market for inflation-protected securities issued by the US Treasury.
The Bloomberg Barclays US High Yield Index is an issuer-constrained version of the Bloomberg Barclays US Corporate High Yield Index, which measures US dollar-denominated, high yield, fixed-rate corporate debt. To be included in the index, bonds must be Securities and Exchange Commission (SEC)-registered, or exempt from SEC registration, or issued under Regulation S with less than five years to maturity and pay non-zero cash coupons.
The Bloomberg Barclays US Fixed-Rate Asset-Backed Securities (ABS) Index tracks the fixed-rate ABS market for bonds with collateral types of credit cards, autos, and stranded-cost utility (rate reduction bonds). To be included in the index, an issue must have a fixed-rate coupon structure, have an average maturity of greater than or equal to one year, and be part of a public deal.
The Bloomberg Barclays High-Yield Municipal Bond Index measures the total return performance of the long-term, non-investment-grade tax-exempt bond market.