As a host of countries begin easing lockdown restrictions, we are entering a highly sensitive period from both a human and economic perspective. As the lockdown ends in the US and Europe in May-June, and a phased return to work and schools with long term social distancing measures come into force, it is inevitable that there is an increased contagion risk of both virus and subsequently to markets. This risk tops the agenda of all stakeholders, with some possibly arguing that this is already discounted as a high probability. In any case, positioning yourself for the eventuality would be advisable.
The intuitive way of doing this is by exposing yourself to typically “safe” assets, such as investment grade credit. From a policy perspective, central banks are setting the scene for investment grade credit to benefit bondholders. Significant policy-support measures and abundant liquidity make for advantageous market conditions for credit, with cyclicals/high yield set to gain the most once a recovery is on the cards, and travel/leisure once a vaccine or effective treatment method is globally available, albeit this is not expected until at least 2021.
In terms of sectors, as society transitions from the lockdown phase to the social distancing phase we would be eyeing a gradual preference to industrials, consumer discretionary and tier 1 financials compared to the current preferences of utilities, telecommunications, healthcare and technology.
Caution remains high on the agenda though, as the credit sell-off and subsequent rally in February-April has been closely linked to the steeping and flattening of the virus curve. The continued strength of the support from central banks will continue to be key to market sentiment as corporates continue to raise liquidity buffers in order to weather the storm. Policy execution remains a key threat too, as funding programs are exhausted, the support for further measures remains of utmost importance.
In the US high yield space, the Fed has extended its safety net of bond buying to include fallen angels, which is important in terms of confidence as credit rating agencies are in the process of its largest ever fallen-angel downgrade cycle. The default cycle in US high yield credit is expected to be shallower but longer than the 2008 cycle due to the severe fundamental virus-inflicted shock, but which is mitigated by policy measures intended to keep credit conditions benign. Across the pond, European high yield is expected to follow a similar trajectory, with default rates remaining well above recent lows well into 2021. The European Central Bank (ECB) is yet to add fallen angels to its quantitative easing programme, however this is widely expected to happen.
The ECB is on schedule to own a massive 30% of the investment grade non-financial corporate bond market by the end of the year, as analysts estimate that it has absorbed around half of all funding in April since the launch of its Pandemic Emergency Purchase Programme. This unprecedented support is key to the maintenance of liquidity for corporates, and is the driver potential yield tightening.
Similarly over in the US, the Fed announced its Corporate Credit Facilities programme, which already has had a significant impact on the market, with strong bid support in investment grade credit. Furthermore the Fed will soon start its unprecedented move of buying corporate ETFs and corporate bonds in the next few weeks.
All markets have reacted strongly to the unprecedented support that central banks have provided during these turbulent times. Its significance cannot be underlined more. Favourable markets are highly dependent on the execution of these measures, and its continued support throughout the virus cycle. As the maxim goes, “Don’t fight the Fed”. Be diligent, very selective and ensure that your bond picking analysis is strongly focusing on the availability of liquidity.
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