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COVID and credit: One year later

Investments
COVID 19 Coronavirus

By Nimisha Srivastava | April 26, 2021

Finding attractive value and total returns in credit markets today is unequivocally hard, but pockets of opportunity remain.

We look back at the speed and scale of the March 2020 selloff, the subsequent recovery, and where asset owners can look now to find attractive risk-adjusted returns in Credit markets. Private Credit and parts of Securitized continue to offer strong relative value, while we are monitoring other areas for potential rotations. We believe the coming years will favor more alpha-oriented mandates, while diversity across credit risk remains the biggest source of portfolio resiliency against broad macro risks.

March 2020 – a month like no other

Rather than rehash the entire history of the March 2020 shock and its impact on Fixed Income markets, we think it is best summarized by the following two data points: Treasury Market Liquidity and High Yield spread widening.

From March 9 to March 18, the U.S. 10 Year Treasury yield rose by over 60 basis points. This rise occurred at a time where many investors were relying on Treasuries to serve as a downside hedge while equities were selling off aggressively. It was clear that the entire fixed income market was becoming deeply illiquid. Estimates are that the transaction cost on Treasuries jumped nearly 4-5x normal, making them more difficult to transact at any time since 20081.

Within Corporate Credit, the spread widening seen in High Yield markets was extraordinary. In mid-March there were nine consecutive trading days where High Yield spreads widened, ranking among one of the longest “losing streaks” in the last 20 years. However, the severity of the selloff was even more frightening, as the index widened an average of 50+ bps per day during this selloff, far worse than any period in 20082.

Historical High Yield “Losing Streaks” since 2005
Streak end date (# of trading days) Cumulative Widening Widening Per Day
3/23/2020 (9 Days) 474 53
10/10/2008 (14 Days) 517 37
11/21/2008 (11 Days) 359 33
2/28/2020 (8 Days) 159 30
3/9/2009 (8 days) 156 20

chart depicting 5 dates of losing streaks and corresponding cumulative widening.

  1. March 23, 2020, 9 days and cumulative widening of 474 bps
  2. October 10, 2008, 14 days, 517 bps;
  3. November 21, 2008, 11 days, 359 bps;
  4. February 28, 2020, 8 days, 159 bps; and
  5. March 9, 2009, 8 days, 156 bps

On March 23, the Fed unleashed what is affectionately known as “the bazooka” for Credit markets, essentially promising unlimited support to get markets under control. This is typically marked as the bottom of the selloff, with Treasury yields finally stabilizing and risky Credit markets beginning a rally. Subsequent direct support to the High Yield market on April 9 provided an even more favourable backdrop to Corporate credit, with continued accommodative fiscal and monetary policy leading to one of the strongest credit rallies in recent years.

April 2021 –What now?

As of the beginning of April 2021, most developed corporate markets have retraced the vast majority of their March 2020 carnage. High Yield spreads have tightened to near pre-pandemic levels, with the average index price above 100. In addition, yields on the asset class reached all-time lows earlier in the year with the broad High Yield index trading below 4% yield for the first time. Other parts of credit, including Emerging Markets Debt (EMD), Private Credit and Securitized are still recovering. For example, lower quality CMBS spreads remained wide to pre-pandemic levels as the future of some segments of the commercial real estate market remain uncertain in a post-COVID world.

Many investors are now contemplating what moves to take next as the “easy beta” trade has now been all but realized. Asset owners of all types are now searching far and wide to find attractive yield to help achieve their goals and get the most out of their Credit allocation. However, implementation is critical, necessitating asset owners to think outside of traditional market beta exposure.

We continue to believe a diversified portfolio of exposures across “the 3 Cs of Credit” – Corporate, Country, Consumer – can help investors achieve their goals and get the most out of their Credit allocation

As mentioned in our previous paper, Credit and Covid19: Key Considerations, we continue to believe a diversified portfolio of exposures across “the 3 Cs of Credit” – corporate, country, consumer – can help investors achieve their goals and get the most out of their credit allocation. Three themes we find particularly attractive include:

Private Credit

Full retracement from March 2020 has yet to occur in private markets, with attractive illiquidity risk premiums providing a good entry point for those looking to shift exposure from liquid to illiquid. Willis Towers Watson has developed a proprietary “Illiquidity Risk Premium” metric which shows that current levels on offer remain well above pre-pandemic levels. This has improved the attractiveness of more heavily competed asset classes such as Direct Lending where we have seen returns and creditor protections improve. More complex and/or smaller segments within private credit that are less well competed offer even greater illiquidity premia, and pleasingly there are opportunities to invest in attractive segments that offer a direct, positive environmental impact, such as within renewables. We will delve further into our views on Private Credit in an upcoming paper.

Chart tracking Willis Towers Watson illiquidity index from 1998 through 2020 in 2 year increments.
Willis Towers Watson illiquidity premium index

1998: 50 bp

2000: 150bp

2002: 156bp

2004: 50 bp

2006: 0

2008: 350 bp

2010: 82 bp

2012: 148 bp

2014: 78 bp

2016: 68 bp

2018: 8 bp

2020: -150 bp

Lower quality Securitized Credit

As mentioned before, certain parts of Securitized Credit took a disproportionate amount of pain versus other asset classes from the COVID shock. While many areas have fully retraced, on the surface certain areas like CMBS and Niche ABS provide strong relative value versus more vanilla parts of the Corporate Credit market. However, these sectors dislocated significantly for good reason given the uncertainty COVID raised on the future of commercial real estate and ability to repay consumer debt. Nevertheless, we believe skilled active managers can incorporate these risks to identify the right dislocated opportunities to capture value. In addition, these sectors have the added benefit of being less interest rate sensitive, with many parts containing a floating rate feature or just naturally shorter cash flows. This has paid off year to date as the US Treasury curve continues to steepen, signifying optimism by markets on a faster than previously expected economic recovery in the US.

Chart tracking the quarterly spread
Spread per year of duration CMBS vs US Corporates3
  1. commercial mortgage backed securities, rated BBB,
  2. corporate bonds BB, and
  3. corporate bonds BBB, from May 2017 through February 2021. Spreads remained fairly level until March 2020, peaking in May 2020, and then gradually declining until early 2021.

Alpha-Oriented Mandates

In today’s credit market with generally tight spreads and yields near all time lows, strategies that emphasize alpha are arguably more important than ever. We continue to see strong merit in our Focused high yield construct upsizing the impact of each manager’s “best picks” across a wide corporate credit opportunity set. Regional specialists in EMD are also an attractive alpha option, with a large amount of potential value embedded in LatAm Corporates as well as less beta sensitive areas such as African sovereigns, which may offer one of the best combinations of long term real GDP growth prospects and strong fiscal policies in the EM universe. Private market opportunities in developed Asia also look increasingly attractive.

Areas we are monitoring (but not making meaningful moves yet): Broad Emerging Market Hard Currency mandates

Given the recent backup in rates, we have seen longer dated assets such as Hard Currency Emerging Market debt selling off versus shorter dated assets. This is an area of the market we are monitoring for potential value should the rate environment stabilize. We would note that a steepening yield curve is a normal and healthy economic sign following a recession, however US Treasury curve steepness (as measured by 2s to 10s spread) typically peaks in each business cycle between 2.0 - 2.5%, with current levels north of 1.5%4 While we do not typically take directional views on rates, this provides a potential trigger point for investors to consider re-allocating to longer duration assets that could benefit from rolldown. In addition, Emerging Markets Debt can offer attractive diversity given the dispersion in varying phases of economic recoveries globally.

Bank Loans

We continue to prefer allocating to Corporate Credit managers with wider remits than just Bank Loans, allowing skilled managers to find the best opportunities in Loans rather than holding a structural (beta) allocation to the asset class. As noted in our prior paper, The High Yield Problem, the loans market has seen fundamental shifts in quality and investor base in recent years. However, as rates have risen across most of the curve year-to-date, this market has come back into vogue for investors looking to invest in floating rate assets. Rather than making a “rates call”, we believe alpha-oriented managers, with the flexibility to overweight loans based on idiosyncratic reasons, are poised to outperform, particularly in an environment of relatively high dispersion. The outlook on loans is more uncertain, not only due to riskier fundamentals, but also technical nuances in the market such as LIBOR floors, which could make it less clear whether the Bank Loan market will continue to materially outperform High Yield bonds in a rate rising environment. Nevertheless, we continue to examine the loan market as a potential area to add more direct exposure should market dynamics change, though we would note that investors allocating to Securitized credit and Private Debt often get substantial floating rate exposure through these segments

Conclusion

The selloff last March was vicious, and the recovery has been strong, but pockets of opportunity remain. Finding attractive value and total returns in Credit markets today is unequivocally hard, and investors need to look beyond vanilla markets and implementation routes to achieve their goals. Private Credit and Securitized can be two good places to start, as well as tilting mandates away from beta/index oriented exposure to more alpha seeking mandates, particularly within High Yield.

Finding attractive value and total returns in Credit markets today is unequivocally hard, and investors need to look beyond vanilla markets and implementation routes to achieve their goals.

Sources

1 Federal Reserve Bank of New York – Liberty Street Economics. “Treasury Market Liquidity During the COVID-19 Crisis”. April 17, 2020

2 Bloomberg Barclays Capital Indices, Barclays Bank PLC

3 Bloomberg Barclays Capital Indices, Barclays Bank PLC

4 Federal Reserve Bank of St. Louis, 10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity [T10Y2Y], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/T10Y2Y March 21, 2021.

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