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Mind the gap

JIM JACKSON, CFA 22-Apr-2020

Without question, our current environment has been unprecedented from both a personal and professional perspective. For credit-focused fixed income investors, this has been the most challenging period since the Global Financial Crisis. As the pandemic took hold and the extent of the global economic slowdown became more apparent, markets significantly re-priced credit risk. This would be expected—normal even. But the rapidity of the increase was simply extraordinary, and the gap between “safe” and “riskier” assets widened into a chasm. 


This prompted us to take a step back, review market conditions, and explain what it all means for credit investors.


The good news is that even as the overall market remains highly volatile, we have seen a meaningful easing in the flight-to-quality trade during the first two weeks of April. After the Federal Reserve announced its array of new lending facilities to provide added liquidity for markets, corporate bond spreads--defined as the additional compensation investors require to hold securities that are not as safe and liquid as those issued by the U.S. Treasury--retreated from their record highs. The government’s new stimulus bill also helped, and even trading in the investment grade, high yield, and CMBS and ABS market segments have improved. 
In other words, credit spreads narrowed and prices improved, on the whole. Although the Federal Reserve’s programs are just getting underway, it’s clear that they have been successful in stabilizing the market thus far. 


So what does all this mean longer term for investors? With the caveat that this situation is dynamic and necessitates close monitoring, here are some high-level takeaways:

  1. Despite the turmoil and unsettling price action that occurred in the credit markets, building portfolios bond-by-bond and relying on independent, fundamental research offers potential advantages for actively managed portfolios.
  2. The Federal Reserve’s actions have improved liquidity, including in the shortest maturities, and thus we do not see a sustained dislocation that jeopardizes the ability of companies to obtain funding from this part of the market. That’s good news.
  3. While the pace and timing of any economic recovery are unknown, we believe that the inevitability of renewed global growth is assured, and with it so is the vitality of credit.

Through all the turmoil it’s important to remember one key premise: the U.S. Government issues the very safest of securities in that they bear no credit risk. Thus, in compensation for assuming some credit risk when investing in other securities, credit investors receive a “spread” over U.S. Treasuries. Research suggests that incremental credit risk, when taken wisely, can add incremental income that provides more than enough compensation for the added risk.


Even the recent extraordinary volatility does not invalidate this theory. Rather, the recent market turmoil suggests that there is an opportunity for active fixed income management to identify and purchase securities that may offer extraordinary value over the longer term.