In a world famished for income, high yield has been one of the last bastions for those seeking a form of income which resembles a decent return. It has been quite a journey to today’s levels however it wasn’t always this way.
The risk of liquidity has mounted its head in the recent years. This refers to the fact that a number of bond issues may not trade regularly for weeks, months and even years. This lack of liquidity issue has become more serious as a result of the recent decade policy of abysmally low base interest rates. The recent market retreat has laid bare this situation, with central banks intervening on the buy side to create liquidity. This lack of liquidity was however visible from last year, when the repo market ran into difficulties requiring the intervention of the Federal Reserve.
Investing in bonds is always about being adequately rewarded for the level of risk on a credit being undertaken. In this regard two main forces are shaping the market. First is that, as a result of the long stimulus programs, many of the debtholders have been pushed out of sovereign and high-grade debt, a term known as overcrowding. Second is that, given the significant increase in money supply, and a bigger tendency to save, there has been an increase in the total level of demand over less asset classes.
In a post Covid-19 world, whenever it may come, all asset classes will face challenges, the high yield asset class included. The decade long of easy monetary policy has kept companies alive which would have otherwise been consigned to history. The Covid-19 reality has put the resilience of corporations to the test, resulting in a significant credit deterioration. Despite all the good intentions of central banks across the world in trying to preserve the status quo, this pandemic may prove to be too much for certain credits. It should come as no surprise therefore, that the default rates will increase, from the 2019 lows of 2.5% of credits to somewhere possibly in the region of 10.0% for 2020, and the high yield market will bear the brunt of this.
In itself, such event is to some extent inevitable given the nature of this recession, and the change in consumer attitudes. It is imperative that investors in the space, invest through active management as to avoid significant downside risk – this is not the time to be passive. Further it is becoming clearer that rather than having a regional or asset class bias, the winners and losers of this pandemic will be determined on a sectorial basis. The adjustment to the ‘new normal’ will occur, and investors within certain sectors, will feel the pinch more than others.
Despite all the adverse implications of this pandemic, I always believe that each cloud, however dark it may be, has its’ silver lining. It is true that investors had become accustomed to flat inflation, low volatility and even lower yields, to some extent. Such event has rekindled the risks that exist in investing, and it is rightly so, that investors are compensated for such risk.
Daniel Gauci is a Financial Advisor at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, views and opinions provided in this article are solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.
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