Substantial moves in credit markets so far this week have resulted in a dramatic 70-90% widening in global credit spreads over the year to date. While we are mindful of the fact that the virus will have serious implications for the global economy, markets are now pricing in a very weak environment – a scenario which may be too pessimistic in light of the policy steps being considered. Emergency monetary and fiscal measures being considered and – which in some cases are already being implemented – will be supportive for global economic growth and credit markets.
Furthermore, in an environment with zero or negative interest rates, fixed income investors will need to invest in credits to generate positive returns on. While it is always difficult to call the bottom in credit markets, we do think that at current valuations it is worth considering an increased allocation to credits.
Our global credit funds and mandates have maintained a quality bias with credit betas around neutral. Most funds and mandates hold a short position in the US high yield market via CDX North America High Yield as a hedge against market downturns.
Importantly, because of our liquid holdings, we are in a position to add risk to our portfolios without the need to sell corporate bonds and can fully benefit from opportunities as they arise: our portfolios hold sufficient cash and, in addition to our general cash holdings, we own large volumes of short-dated AAA-rated asset-backed securities as a buffer, which are highly liquid.
CDS markets – high yield – are pricing in a severe downturn. With the iTraxx Crossover at 500 basis points spread, the market is pricing in a default scenario with 26% defaults, and assuming a very low recovery rate of 20%. From a historical perspective, too, the spreads are wide.
The Bloomberg Barclays Global Aggregate Corporate Bond Index is trading at 140 basis points, as at Friday close. With cash markets around 15-20 basis points wider by mid-week this week, the index spread is likely to widen to around 160 basis points. This would be in line with levels seen in 2001 and 2016. During the 2008 and 2011 crises, which were more severe, spreads were wider.
The Bloomberg Barclays Global High Yield Index is trading at 610 basis points. Levels are historically at similar levels as investment grade.
The JP Morgan Corporate EMBI is trading at 346 basis points as at Friday’s close. The market was trading around 50 basis points wider by mid-week this week, implying an index level of around 400 basis points. This is still historically on the expensive side, as 2016 saw spread levels of 485 basis points.
Several parts of the market are now looking attractive after the repricing, as can be seen from the table, with current/median spread ratios now clearly above 1 for all segments of the global credit market.
The global spread of the coronavirus has forced policymakers as well as investors to reassess their outlook. To counter the fresh downside risks, central banks have started a new wave of easing.
After the emergency rate cut of 50 bps by the Fed last week, markets are pricing in a further 50 bps easing of the fed fund rate. In addition, other central banks have cut rates, too, including Australia, Canada, Brazil, Indonesia, Turkey and Russia. In the Eurozone the ECB may be compelled to do more than offering indirect liquidity support to businesses. We believe a rate cut and a temporary increase in the pace of net QE is becoming more likely by the day.
More fiscal stimulus is also to be expected, to provide relief to people and companies that are most affected by the negative economic impact from the Corona virus outbreak. The Japanese government announced that they will provide interest and collateral-free loans to small and mid-size companies hit by the virus outbreak. France, Japan and Korea are providing wage subsidies to firms and individuals for leave taken to stay home to care for children during school closing. Italy is offering tax extensions to cash-strapped businesses.
These monetary and fiscal measures will be supportive for global economic growth and credit markets.