Over the last week, I have heard concern that the bond market is dead. The narrative goes that as central banks, especially the Federal Reserve, own larger amounts of the bond market through their large scale asset purchases, they are squeezing out the yield and opportunity for traditional bond investors. I am only partially sympathetic to this view.
I accept that the amount of funding needed to support the global economy through a coordinated shutdown is greater than the private markets can absorb. In the US, the amount of funding required at all levels of government (federal, state, municipal), for all rating categories of corporate borrowers and to the consumer will total trillions of dollars. This funding should only be considered aid and assistance to keep the economy alive, not economic stimulus. The cost of this debt needs to be affordable or a recovery will struggle to take hold. The Federal Reserve is needed to help absorb that amount of funding and to control its cost. It’s a return to financial repression - deal with it.
Consequently, we view investing in the bond markets as a set of choices which must balance safety of principal with opportunistic return. Here are the three themes we are emphasizing:
- Co-invest with the central banks across a range of markets. This includes government bonds in the US, Australia, Canada and Europe. It also includes some of peripheral Europe where issuers have come under pressure. It also includes investment grade credit in the US and Europe, securitizations (US agency mortgages, AAA-rated collateralized loan obligations and commercial mortgage-backed securities), and US state/large municipality general obligations.
- Research and find specific issuers that are outside of the central banks safety nets. There are large parts of the non-investment grade corporate market and the non-agency mortgage market that are cheap. But, it is essential to do the research to avoid potential problems. For corporate credit, we are emphasizing strong balance sheets, access to capital and the ability to withstand a prolonged economic shut down. In securitized credit, we are stressing issuers based on their underlying loan origination process, the integrity of the securitization structure and the strength of the credit enhancement.
- Avoid potentially “obvious” opportunities/problems. Inflation expectations loom as a tempting trap. While the amount of borrowing by Treasuries and money-printing by central banks are often considered inflationary, history tells us quite the opposite. The sheer volume of debt forces borrowers to use all their economic efforts to service their debt and to pay it back rather than invest in growth. Japan and Europe have highlighted the disinflationary consequences of excessive debt. Illiquidity is another potential trap. While valuations look cheaper than they were coming into 2020, the reality is that we are only at the early stages of borrowers struggling to make payments. There will be plenty of delinquencies and defaults across bond markets which will be ripe to pick through into 2021. Finally, the reckoning for leveraged loans and private credit with all their covenant-lite structures has hardly begun. For now, resist the temptation.
Like everyone else, I’m surprised we’re facing a downturn of similar magnitude to the Great Financial Crisis of 2008. I don’t know how long the Federal Reserve will support markets, but after the Great Financial Crisis, they left their unconventional tools in place for seven years (2008-2015) before normalizing interest rates and the size of their balance sheet. The bond market isn’t dead, but to generate a reasonable return we will all need to balance the safety of co-investment alongside central banks with the opportunistic hunt for higher yield and return.