Bond market liquidity and the dash to cash: making sense of the current environment
It had often been written that the extraordinary dislocations in the wake of the 2008 financial crisis were a once-in-a-generation event. Hindsight, as it often does, tells a different story.
On April 1ˢᵗ, the U.S. Federal Reserve (Fed) rolled out a virtually unlimited backstop for the repurchase market paired with significant new rounds of quantitative easing; Congress, meanwhile, just approved a $2 trillion stimulus package to try to soften the economic blow of nationwide lockdowns and business closures.1 Eleven years after the global financial crisis, investors are finding themselves in what feels like very familiar territory.
The bond markets weren’t immune from widespread sell-offs
As the extent and severity of the novel coronavirus pandemic became clearer, equity markets and other risk assets sold off dramatically—and in an unusually short period of time: The S&P 500 Index lost more than 30% of its value in just over a month, down precipitously from an all-time high on February 19.2 The plunge in risk assets, while severe, wasn’t hard to explain: Certain parts of the market were essentially priced for perfection and when investor confidence disappeared practically overnight, you’d expect stocks and other risky holdings to sell off.
But the trade investors were rushing to make was not one away from stocks and into the relative safety of high-grade bonds—it was to convert whatever holdings could be easily sold into cash. High-quality bonds, in fact, were a potentially easier, and certainly more desirable, asset to sell than stocks. With the market down so far so fast and most parts of the U.S. Treasury market in positive territory year to date through February, investors seeking to raise capital had incentive to sell high-grade debt instead of locking in losses in their equity positions. This fire-sale mentality is one of the reasons we saw yields rise in the U.S. Treasury market during some of the stock market’s biggest down days; investors large and small were clearing out their portfolios and everything had to go.
The flight to cash has turned traditional pricing models upside down
We’ve recently seen inverted credit curves in many segments of the corporate bond market, with the spread on short-term, high-grade debt exceeding that of longer-dated and lower-quality issues. This almost never happens, and we believe it’s a prime indication of the lack of liquidity in the system: Too many investors were trying to unwind positions all at once, and often trying to unwind the same types of holdings. Broker-dealer balance sheets quickly hit capacity, and the end result has been this abnormal price behavior in the spread sectors of the market. This dislocation has slowly started to correct but has a long way to go.
Since late February, the average spread in the investment-grade corporate bond market went from just over 1% to just around 4%, before recovering back to the low 3% range. The moves in the high-yield market were even more dramatic: Spreads shot up from around the mid 3% range to nearly 11%, before coming down to the 9% area. High-quality agency mortgage-backed securities (MBS) and asset-backed securities (ABS) were in the same boat. Current MBS spreads, at around 90 basis points (bps), are twice as wide as their mid-February levels of around 45bps, while ABS spreads, currently in the low to mid 300bps range, are about five times as wide as their mid-February levels. These types of valuations across these sectors are generally only seen during the heights of recessions.2
It’s important to note, though, that this doesn’t appear to be a systemic meltdown like we had in 2008; the banking system is well capitalized and there aren’t any serious solvency issues in the financial industry that need to be addressed.
"While it’s impossible to predict the bottom of any market, we don’t believe the pricing in many parts of the bond markets today reflect the true levels of risk going forward."
The Fed response: unprecedented and badly needed
The Fed was, unsurprisingly, quick to respond, first by cutting short-term interest rates to zero and then by introducing a massive new round of quantitative easing, which should help some of the liquidity issues we’ve been seeing in the markets—although it won’t happen overnight. While the program is multifaceted and likely to evolve, one highlight is that the Fed has introduced credit facilities in both the primary and secondary markets, which means that it’ll be able to help stable companies issue new debt and help investors sell debt they need to get off their books.3 This is significant because one of the real concerns in the corporate debt market was that issuers with debt maturing in the next few months might not have the option of extending their runways if the market were effectively closed; the Fed’s willingness to enter the commercial paper market in a meaningful way has helped alleviate some of those concerns.
The housing market isn’t likely to suffer a repeat of 2008
After a wave of activity, mortgage refinancing has slowed somewhat recently. The average rate on a 30-year fixed-rate mortgage actually rose in the month of March due to some of the irregularities in the bond markets sending yields higher; fixed-rate mortgages tend to track fairly closely with long-dated Treasuries.4 The process of refinancing, of course, has also slowed down due to social distancing, with appraisals being delayed and many bank branches closed to in-person business. Taking a bit of a breather in the residential mortgage market probably helps lend some stability to the MBS markets in general, and it’s important to note that the housing market was quite strong to start the year. Unlike 2008, there are no inherent weaknesses in the securitized debt markets that need to be unwound; rather, this has been an instance of forced selling in many segments of the fixed-income market, including in MBS.
This may not be the bottom, but dislocations have clearly created buying opportunities
While it’s impossible to predict the bottom of any market, we don’t believe the pricing in many parts of the bond markets today reflect the true levels of risk going forward. As we discussed, pricing for high-quality, short-duration debt has largely been a reflection of technical factors in the market rather than fundamental ones. A recent forecast by JPMorgan suggested that about 3.5% of the investment-grade corporate debt universe would get downgraded in the coming months.5 While not immaterial, that outlook suggests that 96.5% of the corporate debt market can weather this storm without being downgraded—and much of it is trading at distressed prices. Our own analysis suggests that investment-grade corporate debt, when purchased at these spread levels, has virtually always gone on to outperform Treasuries over the next year. There is, of course, no guarantee that this time won’t end up being different, but the fact is that solid issuers with good fundamentals were offering rather paltry yields just six weeks ago. Today, that dynamic has completely changed. In our own portfolios, we’d been reducing risk for a number of months prior to the pandemic, mostly because we appeared to be relatively late in the credit cycle; now, we’re looking to add or establish targeted positions in attractively priced securities. We’re finding a number of those in the corporate bond markets—both investment grade and high yield—as well as the agency MBS market, which looks to offer good relative value in our minds. While we imagine there will be plenty more volatility in the weeks to come, the fact remains that Fed is doing everything it can to support a healthy and functioning market and the valuations we’re seeing today haven’t existed in a decade. Getting back into a market that’s fully stabilized often means getting back in too late.
1 wsj.com, “Trump Signs $2 Trillion Coronavirus Stimulus Bill After Swift Passage by House,” March 27, 2020. 2 bloomberg.com, as of March 31, 2020. 3 forbes.com, “The Federal Reserve Moves To Buy Corporate Debt,” March 23, 2020. 4 Federal Reserve Bank of St. Louis, as of March 31, 2020. 5 JPMorgan, March 2020.
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