Bonds Commentary

Credit Where Credit Is Due

April 2020

Investors may have been left perplexed and perhaps disappointed by poor absolute performance across a variety of fixed income sub-asset classes during March. Treasury bonds rallied/yields fell throughout the month as the Federal Open Market Committee (FOMC) announced two emergency cuts to the fed funds rate, taking this key rate down to a range of 0% to 0.25% in the process. Riskier bonds, specifically investment-grade (IG) and high yield corporates, as well as traditional safe-haven securities such as municipal bonds experienced capital outflows, price declines, and shallow or limited liquidity over the back-half of the month as investors sought to raise cash.

To generate liquidity, investors and traders indiscriminately unloaded bonds of all types, finding little appetite and few eager buyers to take the other side of the trade in the process, leading to wide bid/ask spreads and significant price dislocations. Lending facilities announced by the Federal Reserve and Treasury toward the end of March have led to improved liquidity and trading more closely resembling a normal environment in the fixed income market over recent weeks, while boosting demand for and prices of higher quality corporate bonds and agency mortgage-backed securities (MBS). Buying what the Fed/Treasury will be buying will likely prove to be a profitable strategy over coming quarters, and based upon what we know about the programs currently in place, barring changes down the road, purchases will be heavily skewed toward the highest quality instruments available in the marketplace.

We continue to favor high quality investment-grade corporate bonds over their higher yielding, riskier peers over the coming month(s), and the U.S. government beginning to purchase IG corporates over recent weeks bolsters our stance that on a relative basis this is the best place to be in the current environment. With that said, we expect additional, potentially widespread downgrades of investment-grade issuers by credit ratings agencies as the U.S. economic backdrop continues to deteriorate, turning many bonds into ‘fallen angels,’ or bonds previously carrying investment-grade ratings now considered high yield, or junk securities. Many investment-grade issuers won’t be immune from experiencing financial strain during the economic downturn, and ratings downgrades of some borderline issuers could generate forced selling by portfolio managers of investment-grade bond funds as many have a 5% limit on non-investment grade or high yield holdings. We expect performance dispersion in the investment-grade bond category between the best performing managers and those at the opposite end of the spectrum will widen as security selection plays an increasingly bigger role in driving investor outcomes. Those willing to dig in and ‘do the work’ analyzing corporate balance sheets will likely be rewarded.

We feel like a broken record on these points, but a focus on diversification and maintaining a high-quality bias within fixed income portfolios will serve investors well in weathering the current environment, while also affording them the flexibility to tweak around the edges to take advantage of what remains a fluid, albeit potentially improving economic environment at some point in the months to come.

Source: Bloomberg, Factset


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