Beyond the twin tragedies of COVID-19 and the related economic damage, the talk of markets this year has doubtless been the speed of drawdown and recovery. A bear market that took just weeks preceded a complete recovery, at least measured by the S&P 500 Index, that took under five months.¹ Even though it takes a lot less time to tear down a building than to construct one, the time it took for markets to come back was astonishingly brief.
With an eye on stocks, the recovery has been, while certainly not an illusion, a biased move. The work-from-home world has energized some of the largest-cap, highest-growth stocks, although smaller stocks have recovered as well, mostly to a smaller degree.²
Bonds too have rallied back sharply from March’s drawdown. The key questions are now how to allocate between stocks and bonds, the appropriate role for bonds in a portfolio, and the right selections within bond portfolios.
Fed actions led to historic bond issuance
The U.S. Federal Reserve’s (Fed’s) actions to support a variety of fixed-income markets led to a remarkable turnaround and level of new bond issuance. Those with dry powder when the markets bottomed and the new issuance started have been able to put up solid numbers for the year. According to the Securities Industry and Financial Markets Association, investment-grade and high-yield issuance for March through June 2020 was $1,123 billion, compared with $483 million for the comparable period of 2019.³ This doesn’t include a record stretch of convertible bond issuance, which was at a pace to threaten previous annual records⁴ after a long stretch of dull years.
Experienced managers recognized that the pandemic-driven drop didn’t reflect a deeply broken system as in the 2008 global financial crisis, which we’ve called a “slow-motion train wreck.” Such managers bought oversold yet highly solvent credits in the March debacle. While these managers weren’t necessarily relying on the Fed’s actions, they weren’t surprised to see the Fed come to the markets’ rescue and took advantage of new issuance, both quality and speculative. But that run may have played itself out as we reach late summer.
Some of the questions we’re asking are: Which sectors may be most vulnerable to another downturn, and which sectors have run the risk of missing the opportunity to strengthen their liquidity during this powerhouse stretch of capital raising? With no good way to measure the length and future severity of the pandemic, businesses with a high degree of indoor activity and people coming together, as well as economically sensitive issuers, might have substantial further capital needs. Bottom-up analysis can identify the issuers to avoid as well as the ones well positioned both before and after the Fed actions.
Measuring the turnaround
As of August 19, AA spreads, were only 75 basis points (bps), above the 52-week low of 48bps but well below the crisis high of at least 250bps.⁵ The heavily populated BBB sector tightened from 457bps basis points to 160bps, well above the 52-week low of 119bps but still evidencing a forceful comeback. It’s also worth noting that U.S. Treasuries were seeing their yields rise briefly in March, as investors wanted cash above all else. Now the 10-year has been straddling 70bps for some time. While there could be room for additional tightening, it may be more likely that fixed-income investors now could be hoping simply to earn their coupons. This adds to the attractiveness of bonds with somewhat higher coupons while being mindful of the incremental credit risk.
The risk in BBB bonds, especially energy
Regarding BBB bonds, there has been widespread concern about the potential for some of them to lose their investment-grade rating in the economic downturn. One of the Fed’s programs has been to buy not only investment-grade debt but also the fallen angels, or credits that have lost their investment-grade rating and fallen into the high-yield category. Well over a year ago, global BBB debt exceeded $7 trillion,⁶ with more than half coming from U.S. issuers.
Candidates for downgrade include larger energy companies, which threaten a reprisal of their 2015 collapse. Oil has bounced back from a quirky but still nearly unimaginable negative price, for a brief moment in April, to around $40 per barrel, but has stagnated there, and that may not be enough for many industry participants to generate positive cash flow. Standard & Poor’s said in March it would review energy credits assuming $35 oil instead of the previous $55,⁷ with nearly half a trillion dollars potentially at stake. Perversely, the impact of the significant number of BBB credits becoming high yield would lead to a higher-quality, lower-yielding investment-grade index, potentially causing investors to add more credit risk to find income.
The following corporate yield chart suggests a downgrade from BBB to BB might result, as a rough estimate, in a widening of 150bps to 350bps. It’s becoming increasingly important to use bottom-up analysis to avoid downgrades to fallen angel status. While a yield widening of 350bps implies a drop straight to single B—a very rare event—markets typically price in downgrade risk well in advance. Bottom-up analysis can help managers understand risk/reward dynamics and seek to avoid exposure to unexpected downgrades.
Bonds today in a balanced portfolio
At the same time, with equities having made such a phenomenal comeback, there’s a case for considering a traditional (if not greater) bond allocation. The debt of banks, healthier than in the last crisis, along with appropriately priced and diversified corporates, can have an essential place in many balanced portfolios. This means a mix of investment-grade and carefully chosen high-yield securities. Investment-grade issuers typically have the luxury of issuing for longer terms with lower coupons, a recipe for duration risk. Higher-yielding bonds tend to have somewhat lower duration risk thanks to their cash flows and generally shorter maturities.
With cash yielding essentially nothing, a modest amount of duration risk, measured carefully with a blend of investment-grade and high-yield bonds when mandates permit, also seems like a good fit even with rates near historic lows and the likelihood of further fiscal stimulus against the pandemic. The key is an approach that doesn’t sway when the markets do but relies on companies with strong fundamentals that can weather storms and whose bonds are appropriately priced for a world with a high degree of uncertainty. After all, we have not only the pandemic but all manner of government response in the air.
1 Wall Street Journal, August 20, 2020. 2 According to marketwatch.com, the S&P Midcap 400 Index was still more than 9% below its 52-week high. 3 sifma.org, August 4, 2020. 4 Retirementestateplan, July 2020. 5 wsj.com, August 19, 2020. 6 spglobal.com, May 29, 2020. 7 bloomberg.com, March 16, 2020.