Over the course of the last month, equity markets across the globe have sold off relentlessly. More recently, that selloff has “spilled over” into the fixed income and credit markets. With the exception of US Government bonds, nearly all fixed income asset classes have seen repricing. (see chart below)
So what has happened to credit in the last few weeks? Why have we seen investments that exhibited remarkable stability over years suddenly fall double-digits in a few days? In a word, liquidity! As is true of equities, a bond is priced at what it can be sold for. Unlike stocks, however, bonds don’t trade on an exchange. The typical bond trades much less often than a stock. In fact, it’s not unusual for a specific bond not to trade for days or even weeks at a time. After all, most bond owners aren’t buying for a trade, but rather to own for the long-term.
In the last couple of weeks, some large investors (hedge funds and mutual funds among them) have been forced to meet liquidity needs by selling bonds. Given the environment and the high value being placed upon having cash on hand, the number of buyers for these bonds has shrunk. Furthermore, the buyer has immense bargaining power in a “forced sell” scenario (consider the parallel of an asset sale during a divorce settlement).
And therein lies the primary source of the recent repricing. The price of the bonds a portfolio owns is marked to market based on the last trade of a similar bond. If that sale was done under non-ideal circumstances, it will have a temporarily adverse effect on all who own that security (and similar securities). That doesn’t mean that a bond is ultimately “worth” where it’s priced, but rather in that moment that’s what it is expected to sell for.
No different than was the case a month ago, the ultimate ability of a credit/bond to perform is a function of the credit itself. Whether one speaks of a AAA rated municipal bond, a BB rated RRMBS (residential mortgage) or a corporate bond, the ultimate value to an investor is determined by the underlying collateral and the repayment of the bond. Can the borrower repay the obligation? If not, what can be sold to partially repay?
For example, one of the hardest hit areas of the fixed income space in the last couple of weeks has been RMBS (residential mortgages). Some securities in this space have seen their price decline by over 50% in the last 2 weeks. In this space, the underlying asset is people’s homes. Specifically, in the case of Braddock, the average FICO rating is in the mid-700’s and they were underwritten with the stricter underwriting standards imposed after the Financial Crisis. The portfolio is diversified geographically across the country.
Coming into the recent period, the US consumer was incredibly strong (savings rate over 8% and household debt at multi-decade lows). Unemployment rates were well below 4%. Recent legislation has created a way for affected households to gain relief from Covid-19 impact (similar to what was done during Hurricanes Katrina and Harvey) through a 6-12 month relief from mortgage obligations. Loan-tovalue ratios were below 70%. Refinancing simply pays off the loan early (which effectively returns full principal on the bond).
We cannot say with certainty that there will not be bond defaults caused by the Covid-19 virus and the actions taken to combat it. We cannot say that there are not credits that are still subject to further downgrade and repricing lower. These are possibilities that always exist and must be evaluated when fully assessing risk in the fixed income space today.
On the other hand, we do believe that the prices we see today are reflective of even more extreme selling pressure than we saw in 2008-09. We do believe that government intervention will mitigate the potential default by many borrowers. We also believe there could ultimately be further action to support the consumer.
We believe there are many bonds that have been repriced lower that will bounce back quickly. We believe that the managers running our fixed income portfolios are being diligent and acting in the best interest of shareholders. We believe there is opportunity for both an attractive yield and appreciation potential in many areas of fixed income.
For some investors, this update may be a call to action to consider an increased allocation to some of these “beaten-up” portfolios. For others, it may simply serve as a reinforcement of why we invested as we did in the portfolios we own. For those who aren’t yet clients, consider a 15-minute call with us to discuss where we see opportunity.
Through these challenging times, we greatly appreciate the words of encouragement and kindness our clients have shown. We welcome your call or e-mail any time.