State of Bond Markets: An Expert View
Bond markets are currently exhibiting extreme and sometimes counter-intuitive behaviours, leaving investors confused and uncertain about where to put their money. In this article, we pick apart and explain some of the recent developments.
Government Bond Sell-off
Despite the current sell-off in government bonds, riskier assets have been selling off as well. The answer to this is that central bank reserves are mostly held in government bonds. As many central banks prepare for large liquidity support lines, they have to liquidate their bond holdings to realise the cash. Additionally, falling consumption due to the shutdown of Chinese factories is adding a demand shock to the existing supply shock. With many retailers keeping three months’ worth of operating cash flow on hand, if this crisis and reduced consumption last longer than that, many companies may go bankrupt. Interest rate cuts are relatively ineffectual in addressing such challenges, and fiscal spending and micro-level measures such as government loan guarantees are necessary to support companies.
Fed Policy Rate Cut
The recent Federal Reserve policy rate cut was not well received, as current circumstances are far from normal. Cutting rates achieves little other than providing liquidity to banks, which already have plenty of it. Banks are in good shape, well capitalised, with good asset quality, less leverage, and large liquidity coverage. Therefore, there is no impediment to lending. Credit markets have widened a lot to price in a bigger risk premium and higher defaults, indicating that lower rates are not the answer.
Fixed Income Opportunities
Indiscriminate selling has resulted in some extreme pricing, with some short-dated bank bonds trading at 5-7% yields. However, it is important to be selective and cautious as the disruption may last 3-6 months, and recovery may take some time. Investors must focus on selection to separate the ongoing risks from the opportunities. Default rates are going higher, and some companies will need to restructure.
Where to Invest in Fixed Income?
Governments are unlikely to default, and it's likely central banks will monetise government debt, making short-dated government bonds a good option for capital preservation but with low returns. Investors may be tempted to load up on higher yielding bonds, but a circumspect approach is necessary. The scale of the market re-pricing means that opportunities have arisen, but investors should be wary of passive exposure to the high yield market. The opportunities that have arisen are best approached from the bottom-up.
Securitised Credit
We remain of the view that the US consumer is in a better position than the corporate sector. Some sectors will become more vulnerable as unemployment goes up. However, all the abuses of the mortgage market are gone, and assets are of much better quality. It is still a better place to invest than the highly leveraged high yield energy sector.
In conclusion, the bond market is currently experiencing extreme and sometimes counter-intuitive behaviours, leaving investors unsure of where to put their money. Investors must be cautious and selective in their investment approach, focus on selection to separate the ongoing risks from the opportunities, and approach opportunities from the bottom-up.