Black Monday (II): credit markets suffer
Global markets recorded heavy losses on Monday after the oil price plunged and it became increasingly clear that the coronavirus had turned into a global health emergency. This was the culmination of a turbulent fortnight where:
- Credit spreads had reached levels that suggested we were living in a near-perfect world.
- The total number of coronavirus cases reached more than 100,000.
- Italy – home to the second largest number of cases – announced it was quarantining a quarter of its population.
- The Federal Reserve (Fed) tried – and failed – to calm markets with a 50bp rate cut.
- The Organisation for Petroleum Exporting Countries (OPEC) and Russia failed to reach an agreement to curb supplies, causing the oil price to fall by 30%.
Even though equity markets have been particularly affected – stock markets in Asia and Italy are down more than 25% from peak to trough – the impact on fixed-income markets has also been significant. The oil-price war has exacerbated this, as credit is more exposed to oil and gas markets than equities.
The US 10-year Treasury yield fell to a record low on Monday, while the UK equivalent sank below zero for the first time in history. High-yield spreads have soared and the iTraxx Crossover Index jumped 152bps on Monday morning, trading wider than 500bps – an increase of 150% on the middle of February.
Some context for these market moves is required. Credit markets outperformed equities last week and, in our opinion, credit spreads have been too tight and volatility too low for some time. Investors also largely failed to discriminate between good and poor-quality issuers.
A focus on quality credit
Our bias towards higher quality names has come to the fore over the last couple of days. While this is central to our approach, our concern about credit fundamentals, valuations and the prevalence of covenant-lite loans and lower expected recovery rates has increased our aversion to low-quality credit in recent months. Our exposure to B and CCC-rated credits is currently under 10%, compared to 50% for the high-yield market.
Counterintuitively, our preference for high-quality credit hasn't started to benefit us yet. This is because low-quality credit tends to be less liquid and therefore hasn’t found a clearing price amid the volatility, while some of the more liquid instruments we are exposed to have been exited and suffered price declines, as expected. Over the coming days (or possibly weeks) we expect the shakeout to be priced into less-liquid credits, like CCC-rated names, which so far have not moved as much as expected.
Price action: leading or lagging?
We surveyed our analysts and portfolio managers, asking them to subjectively and qualitatively opine on spread movements across their sectors, asset classes and instruments. Figure 1 shows their views on whether spreads have widened more or less than expected.
Figure 1. Market movements relative to our expectations, as of 10 March 2020.
Source: Federated Hermes, as at March 2020.
For example, a 300bp move in the Crossover Index was deemed appropriate in the market environment, while a 65bp jump in the CDX Investment Grade Index was more than we expected. Our survey highlights a few interesting trends:
- Europe seems to have been more affected than the US. The Europe-based iTraxx Main Index moved too much, compared to the US-centric CDX Investment Grade index, which was modestly overdone. Likewise, the iTraxx Crossover Index moved more in line with expectations, compared to the CDX High Yield Index, which seems to be lagging.
- Probably because they are the most visible, derivative forms of indices have experienced greater spread movements than single-name derivatives. Cash had also not moved as much as expected and needed to catch up.
- Similarly, BB-rated credits have been more realistically priced than those rated B or CCC. In our view, the latter two have yet to find a clearing level.
- Emerging markets seem to have fared well so far and may be subject to a further repricing. The collapse in rates and better convexity seems to be supporting this asset class more than the developed-market high-yield sector.
- Oil-market credit instruments have been significantly affected. While this may be warranted for issuers with more precarious balance sheets, at the margin our energy analyst feels that this was overdone on long-end exposures for solid investment-grade credits.
Defending against downside risk
With volatility at its highest level in equity markets since 2008 (see figure 2) and also affecting credit indices, we have used defensive trades to guard the performance of our flexible-credit strategies. In our Absolute Return Credit and Multi-Strategy Credit strategies, we have used a combination of index, curve and single-name positions to establish defences. These have underperformed the physical market as people buy the most accessible protection.
Figure 2. The VIX surges to its highest level since the financial crisis
Source: Bloomberg, as at March 2020.
Our outright and curve index positions are employed as liquid hedges to mitigate the turbulence. Flatter credit curves have benefited the portfolios, and Absolute Return Credit has a 5-to-10-year flattening trade on the European investment-grade market. In addition, Multi-Strategy Credit has been boosted by its exposures to loans, investment-grade and emerging-market credit, which have provided an extra layer of defence compared to a traditional high-yield solution.
In terms of single names, before the drawdown we had already taken out credit-default swaps on issuers that we disliked from a fundamental or relative value perspective or that had exposure to the coronavirus. Our negative positioning in the auto sector through Avis and American Axle continue to perform well for us.
We have also used opportunistic defensive trades to protect our pro-cyclical bias and best-selection ideas across basic industries. Before the sell-off we had already purchased protection on issuers like Glencore and FCX on value and environmental, social and governance grounds. And as dispersion increases, we should benefit from our capital-structure trades in Ineos and Tenet Healthcare.
In our Unconstrained Credit Fund, we have used options to reduce the impact of the market shock. The notional value of the options when we purchased them was very meaningful and their strikes were deep out-of-the-money. Since the underlying spreads having widened, these have moved to in-the-money and have provided powerful gamma and upside over this period.
As a result, we have rolled them into longer-dated, bigger notional and further out-of-the-money positions. We now have an options exposure which maintains convexity and protection for our long positions, and also manages to crystallise some of the major gains from the strategy.
This has yielded positive results (see figure 3). Our Unconstrained Credit Fund’s options exposure helped it deliver 0.49% in the week to Monday, compared to a loss of 0.77% for the average global flexible bond fund as tracked by Morningstar. To read more about how we defend against market headwinds, see our recent piece ‘Flexible credit: the upside of downside protection’.
Figure 3. Unconstrained Credit: our options exposure supports performance
Figure 4. Hermes Unconstrained Credit Fund, net rolling year performance, %
||31/01/19 to 31/01/20
||31/01/18 to 31/01/19
||31/01/17 to 31/01/18
||31/01/16 to 31/01/17
Past performance is not a reliable guide to future performance. Source: Federated Hermes, as at March 2020. Performance shown is F share class US Dollar Accumulating net of all costs and management fees since seeding on 30 May 2018.
Opportunities amid the shock
Our liquid bias and downside-protection measures mean we have the ability to reposition into names that we may like on a relative-value basis but that have underperformed recently. Like in Q1 2019, we are better placed to buy credits that other investors are selling.
Given the recent turbulence and lack of clarity, we are mindful of uncertainty and prefer to stay ‘close to home’. Sometimes it is logical to seek the biggest movers, seeing them as likely to provide the best opportunities. For example, we recognise that the energy sector looks very attractive on a price basis. However, we remain cautious as the disintegration of the OPEC+ alliance suggests that there will be a new oil-price equilibrium that will challenge break-even prices and cash flows.
Looking beyond the market shock, we continue to see opportunities throughout the fixed-income universe. Every quarter, we compile a relative-value framework of fixed-income assets across the public and private credit spectrum, ranking them by 11 different factors. This guides asset-allocation decisions across our Multi Asset Credit solutions. We publish the framework in our quarterly 360° report.
Figure 5 shows this framework at the end of December. At this point, the coronavirus was not a concern, risk sentiment was positive and credit markets were trading at close to the tightest levels in five years.
Figure 5. Our Multi-Asset Credit relative value framework, December 2019
Source: Federated Hermes, as at December 2020.
The challenge was to find attractive risk-adjusted opportunities across a set of assets which had, in the main, been heavily targeted by yield-hungry investors. In January, our top-three ranked assets were also the best performers, with emerging market credit and financials leading in public credit markets. Collaterised-loan obligation (CLO) mezzanine exposures also rallied as investors captured the spread premia on offer (something we highlighted in our last issue of 360°).
Fast forward two months and the credit landscape is very different. Spreads are now closer to the widest levels in five years, as investors assess the impact of the coronavirus and the oil-price crash – two unforeseen events. These developments obviously leave our current framework outdated and the rankings should change significantly when we refresh them at the end of this month.
By then, we expect to have a clearer knowledge of price movements when assets are actually traded rather than being priced on a mark-to-market basis (as most public and private credits currently are). Although fundamentals will be weaker, current credit spreads suggest there will be more opportunities for yield-hungry investors.
The extreme moves in both investment grade and high-yield public-credit spreads mean their value scores should rise, pushing them further up the rankings. And as asset-backed securities and CLO spreads have lagged those of corporate credit, the premium we saw in January between CLO and corporate credit spreads will be eroded, making Euro CLO mezzanine less attractive on a relative-value basis.
By contrast, private-credit exposures like direct lending have moved only modestly wider. The illiquidity premium of these assets has therefore shrunk, meaning they have become less attractive on a risk-adjusted basis. But as we have seen over the last fortnight, a lot can change in just a few weeks. To find out more, look out for our Q2 2020 edition of 360°, which will contain our updated relative-value framework, and will be published in April.
Viral volatility: coordinated action is required
We urge investors to act cautiously in the coming weeks. Unlike the recovery we witnessed in the first quarter of 2019, we do not expect markets to rapidly regain all the losses recorded over the past fortnight. Rather than a ‘v-shaped’ bounce that followed previous virus outbreaks like SARS and MERS, we suspect that this time there is more likely to be a ‘u-shaped’ recovery – and this is assuming the virus is contained in a well-orchestrated manner.
Global economic growth will clearly slow in the first half of this year. While the v-shaped precedent indicates a temporary economic effect, we would caution that the coronavirus seems to be spreading faster. Furthermore, we have little knowledge at this point of real mortality rates, infection rates and the potential for mutation.
Indeed, while the market currently looks oversold, this does not mean it cannot go lower. Developments depend on the trajectory of global growth in the second half of the year and whether the pandemic can be contained. There is still a chance that markets could be subject to trading suspensions, effectively placing them in quarantine, as they were in 2008 and 2011.
The situation requires close coordination between central banks and a mix of monetary and fiscal easing. While Chinese authorities should pump out more stimulus, monetary policy has its limits – particularly when reacting to a supply-side shock like the coronavirus. Moreover, interest rates are at record lows and there is a limit to how much quantitative easing can depress long-term yields. Any monetary easing should be coupled with meaningful government action that directly supports individuals and companies through the surgical use of fiscal stimuli and safety nets.
How credit markets fare depends on what happens in the second half of the year. While a short-term hit to corporate cash flows is manageable, a whole year in the red is not. The trajectory of the coronavirus is hugely uncertain, exacerbated by the likelihood of it spreading to other developed markets.
An unnatural calm: the road to Black Monday
On 11 February, the World Health Organisation formally named the virus as Covid-19. By this point, 43,000 people were confirmed to be infected and 1,000 had died. Yet credit spreads languished around all-time tight levels, with the iTraxx Crossover Index trading at 210.
As the number of cases rose to about 100,000 and the virus spread to more countries, the rubber band was getting taut. OPEC’s failure to support markets by cutting the supply of oil was the event that caused it to snap, triggering a phenomenal short-term market move.
On balance, given the ‘new’ fundamentals, this move was arguably overdone. Yet there is still a great deal of uncertainty surrounding the coronavirus. And credit markets, with a more asymmetric risk profile than equities, loathe uncertainty.
Fundamentals will continue to deteriorate and technicals could get worse. Funds that weren’t positioned as defensively – either in terms of risk or liquidity – going into Black Monday may suffer redemptions. Given the scale of intervention required, it is not impossible that funds could be gated in addition to markets closed.
With such a precarious backdrop and so much volatility, there will obviously be opportunities as prices become dislocated from the underlying quality of assets. The most obvious one, which has served the markets so well since the financial crisis, is the ‘buy the dip’ mentality. However, given that we see a u-shaped recovery ahead of us, we do not think that now is the time to rush in.
In the meantime, we believe that the best approach is stay nimble and capitalise on our liquid and higher quality bias, working to add alpha and mitigate negative beta through active management. Most importantly, we will keep our channels of communication open to help our investors navigate these choppy waters.