Market Liquidity and the Fed

06.17.20

Risk selloff led to a wild quarter across fixed income

In the depths of panic over the COVID-19 pandemic, markets seized as investors rushed out of risk assets and into cash and U.S. Treasuries. At the epicenter of the slide was an effort to sell any asset that could be liquidated.

Equity markets declined sharply as uncertainty over earnings and liquidity made visibility over valuations difficult. Credit markets experienced a painful unwinding of leverage that was felt across a broad swath of instruments. Investment grade, high yield and emerging credit all experienced widening credit spreads and price declines at an unprecedented pace as did other parts of fixed-income markets, including mortgages, commercial mortgage-backed securities and municipals.

High Yield

Within credit, high-yield bonds suffered the most as investors worried about the impact from the economic shutdown on low-quality borrowers. Sellers outnumbered buyers and bid-ask spreads approached 250 basis points (bps). The bid-ask spread is essentially the difference between the highest price a buyer is willing to pay for an asset and the lowest price that a seller is willing to accept.

Among sectors within high yield, energy experienced the sharpest contraction as the pandemic’s impact was exacerbated by falling oil prices, when what began as an expended demand shock was compounded by Russia’s lack of cooperation with OPEC in cutting oil production, and then Saudi Arabia’s reaction to increase its own production punitively. Energy securities posted their worst quarter on record, losing nearly 50% over the course of three months.

Investment grade and U.S. treasuries

Similar to the pullback experienced within high yield, investment-grade credit spreads were volatile in the first quarter of 2020. Credits spreads measure the difference in yield that a corporate bond offers relative to a U.S. Treasury security with a comparable maturity. The spread is meant to compensate investors for the additional risks. From the start of the year to the end of the quarter, investment-grade credit spreads, as measured by the Bloomberg Barclays U.S. Corporate Bond Index, widened massively from 93 bps to 272 bps, a level not seen since the 2008–2009 financial crisis. Intra-quarter, the spread on the index reached 373 bps before rallying into the end of the first quarter.

Despite the volatile first quarter, U.S. Treasury securities performed well as yields fell and investors sought out safe havens. From the beginning of the year to the end of March, the yield on the 10-year U.S. Treasury fell 125 bps from 1.92% to 0.67%, while the yield on the 2-year U.S. Treasury fell 132 bps from 1.57% to 0.25%. This was driven by the Fed cutting rates twice in March, ending the quarter with a target range of 0–0.25%.

Fed intervention

As the stock market sank into a bear market at the fastest pace in history, the Fed dramatically increased efforts to save the economy, promising to do “whatever it takes” to ensure liquidity. Fiscal policy followed suit and Congress quickly passed the $2.2 trillion CARES Act. The equity and fixed income markets rallied on the news.

Ivy Securian Core Bond Fund Portfolio Managers Tom Houghton and Dan Henken noted that policymakers recognize this is a multi-pronged challenge — a correction in valuations, a liquidity squeeze, a collapse in energy prices, an upturn in defaults stemming from cyclically high corporate leverage and COVID-19-specific shocks.

In aggregate, the policy response has exceeded the actions taken during the Global Financial Crisis.

The Fed’s intervention consisted of several programs, including:

  • For the first time in history, purchasing investment-grade and high-yield corporate bond ETF securities
  • Main Street business lending program setting a target of $600 billion in loans for mid-sized businesses
  • Municipal Liquidity Facility offering up to $500 billion in lending Payroll Protection Program to help small businesses

The Fed is poised to buy various asset classes, except equities, and has made clear progress in opening the corporate debt market, which had been illiquid until it stepped in. Purchases by the Fed have brought credit spreads lower and normalized fixed income trading.

The Fed’s moves have also unleashed large amounts of new issuance. Despite the substantial increase in volatility over the past few months, investment-grade bond supply increased as companies rushed to issue longer term debt to term out shortterm funding, as well as ensure liquidity through this difficult economic period. In fact, as markets loosened starting March 23, investment-grade bond issuance in the quarter ended up 49% relative to the first quarter of 2019. For the month of March, issuance was up 129% year over year and surpassed the prior monthly issuance record from May 2016. In high yield, issuance rose in the quarter although not to the same extent as investment grade.

Lastly, economists are struggling to get a handle on the length and depth of a recession during a pandemic as well as the impact of a forceful policy response. Projections for gross domestic product vary widely for second quarter 2020 with estimates ranging from 9% to -40% annualized growth, and full-year 2020 estimates of -1% to -6%.

Outlook

While the U.S. job data shows how deep the incoming recession may likely be, some investors are hoping that additional stimulus from the Trump administration will further cushion the blow. It appears the market is looking broadly through a flattening of COVID-19 cases and the shortterm economic damaged caused to a recovery starting in the latter half of 2020. In April, we saw the best one-month equity return in decades, and the best two-week period since the depths of the Great Depression. Broad market increases again followed in May. With the “Great Lockdown” beginning to wind down, as investors, we need to balance this view with the reality that we still need to get through the earnings hole.

From the outset, we have been framing this environment in the context of three pillars: the public health impact, the economic impact and the impact on the markets. It is hard not to look at this environment without including a fourth factor: political implications. The decision to reopen is not just science driven; there will be political influence as well.

With this backdrop, within fixed income, we believe investors are showing more appetite for investment grade and high-yield corporate bonds, the latest sign of easing credit-market conditions and potential for solid performance ahead. We surveyed several Ivy portfolio managers to get their thoughts on fixed income positioning:

  • Ivy Crossover Credit Fund Portfolio Manager Ben Esty stated: “While we have long been cautious on the corporate credit market due to our views that excesses had built up, we now believe the combination of the valuations and stimulus programs, most principally the program to purchase investment-grade bonds by the Fed, has created an attractive environment to take risk in the asset class.”
  • The Ivy Asset Strategy Fund team, which can invest across the asset class spectrum commented: “Within fixed income, we have a strong preference for investment-grade credit. This is an asset class which sold off heavily in mid-March as leveraged unwinds drove spread widening in violent fashion. Investment-grade companies tend to have large liquidity buffers and credit metrics which help them to withstand economic shocks. In a world where most of the U.S. Treasury curve yields less than 1% and companies are cutting dividends, we believe the search for income will drive investment grade credit spreads tighter, providing good opportunities for total return.” We also recognize that should spreads move higher, however, the value of investment-grade corporate bonds could still fall depending on rapidly changing economic conditions.
  • Based on history, this is potentially a good time to invest in securities rated below investment grade. Ivy High Income Fund Portfolio Manager Chad Gunther noted, “Spreads historically rising above 800 bps have led to attractive return opportunities, and the case is even more profound above 900 bps. We believe the return profiles in periods following these points in time demonstrate the potential importance of holding high-yield bonds over longer timeframes, particularly during periods of heightened market volatility.
  • Municipal bonds suffered during the downturn as recent inflows quickly, and meaningfully, reversed. As with other fixed income classes, there has been renewed interest here as well. Ivy Municipal Bond Fund Portfolio Manager Bryan Bailey indicated, “While we had been proceeding with caution, expecting the beginning of an outflow cycle that would exert selling pressure on the municipal market, the Municipal Liquidity Facility implemented by the Fed has tempered our immediate concerns to some degree. However, in the long run, we do not believe that the facility provides the panacea that will solve all of the market’s problems.” Bailey expects renewed demand in the space which may improve valuations versus other investment-grade fixed income alternatives, as cross-over and non-traditional buyers have seized on the opportunity now that they are confident of backing by the Fed. We believe the key driver will be a renewed and sustained interest by the retail investor, which comprises approximately 70% of the market.

Given this backdrop, our Firm’s commitment to fundamentally driven, bottom-up credit research could prove to be a key advantage in navigating these choppy markets. Our portfolio managers and credit analysts review each credit to identify attractive risk-reward potential for our investors.


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Stay up to date with the latest views from our Chief Investment Officer
Dan Hanson, CFA

CIO Insights


1. Source: Morningstar. Performance calculated when spreads reached 900 bps on the following dates: 12/1/2000, 5/1/2001, 10/1/2001, 7/1/2002, 10/1/2008, 11/1/2011.

Markit iBoxx USD Liquid High Yield Index consists of liquid USD high yield bonds, selected to provide a balanced representation of the broad USD high yield corporate bond universe. Markit iBoxx USD Liquid Investment Grade Index is designed to provide a balanced representation of the USD investment grade corporate market and to meet the investors demand for a USD denominated, highly liquid and representative investment grade corporate index.

The Bloomberg Barclays U.S. Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market and includes USD-denominated securities publicly issued by U.S. and non-U.S. industrial, utility and financial issuers. The ICE BofAML US High Yield Index tracks the performance of U.S. dollar denominated below investment grade corporate debt publicly issued in the U.S. domestic market. It is not possible to invest directly in an index.

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