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19 March 2020 | GSAM Connect

Taking the Temperature of the Bond Market

Liquidity challenges in the bond market have become another component of the current crisis, adding to existing investor concerns about the economic impact of the coronavirus outbreak and the plunge in oil prices. Taking the temperature of the market, we think fixed income remains in the thick of the crisis, but policymakers have escalated their response and we are beginning to see signs of improvement in liquidity.

To fully stabilize the bond markets, we think the US Federal Reserve (Fed) and other central banks will ultimately need to do much more balance sheet expansion. We also expect fiscal policy to begin taking a much larger role in the policy response, and will be closely watching the interaction between central banks and fiscal policy to gauge the outlook for economic growth and inflation.

The corporate credit markets are at the center of this interaction as valuations will be influenced by central bank policies focused on bond market liquidity as well as fiscal policies focused on the economy. We see potential value in areas of the fixed income market that are most likely to benefit from policy responses but we are being patient and clinical in evaluating risks and opportunities in this uncertain environment.

On March 18, senior members of GSAM’s Global Fixed Income team discussed recent developments in the bond market and the policy response. Here are the key takeaways:

1) Bond market liquidity remains challenged but is beginning to improve

Bond market liquidity remains challenged due to significant selling of fixed income securities. We believe much of this selling is being driven by rebalancing—investors selling fixed income and buying equities to rebalance their portfolios when the stock market sells off—and by investors selling fixed income to raise liquidity. As a result, broker-dealer balance sheets have become clogged with securities, reducing their ability to intermediate between buyers and sellers in the bond market.

Central banks around the world have responded rapidly to the liquidity challenges in the bond market and we see liquidity beginning to improve. The Fed has been particularly aggressive, implementing facilities that were last used after the 2008 financial crisis to relieve the pressure on dealer balance sheets. As a result, liquidity pressures have begun to ease in the US Treasury market, although liquidity remains a significant issue in other areas of the market. To fully stabilize the market, we believe the Fed and other central banks will likely need to do much more to expand their balance sheets, and it will take time for these policies to have their full effect.

2) Fiscal policy is needed to target the economic growth impact of the virus

Global economic activity is experiencing a sudden and unprecedented halt as countries take aggressive measures to slow the spread of the virus. Central banks have already cut interest rates dramatically but appear to be out of room for further cuts. In Europe and Japan, where central bank policy rates are already negative, the European Central Bank (ECB) and Bank of Japan (BoJ) both appear to have decided that cutting rates further into negative territory would be ineffective. We believe the Fed is also unlikely to adopt negative interest rates. As a result, we think central banks are essentially done cutting rates and fiscal measures will be required to target the economic impact of the virus.

The fiscal policy response is now beginning to shift into high gear. The situation is evolving rapidly but we expect large-scale lending programs for businesses as well as measures to support consumers across many countries.

3) The interaction of monetary and fiscal policy will be critical to watch

We will be closely watching the interaction of monetary and fiscal policy. If fiscal policy includes lending programs that are structured so that businesses are required to repay government loans, companies may emerge from the crisis with elevated debt levels. That could slow the eventual economic recovery. Alternatively, governments may elect to inject money directly into the corporate sector with no expectation of repayment. We have not seen this approach in other recent crises, but looking back at history suggests that central banks may end up “monetizing” the debt created by higher fiscal spending. Monetization occurs when governments issue debt to support fiscal spending, and then central banks purchase that debt but do not require the government to repay the debt, which has historically created inflation.

The interaction of fiscal and monetary policy is likely to vary by country, and it is too soon to predict which countries will take which approach and how that could affect inflation. In the near term, we think deflationary risks have increased, but over the longer term, we believe this dynamic will be important for future investment strategy in interest rates and currency exchange rates, and we are closely watching to see how this interaction develops.

4) Corporate and municipal bonds are now at the intersection of monetary and fiscal policy

Corporate and municipal bonds have come under pressure from both the liquidity challenges in the bond market, which monetary policy is working to address, and concerns about economic growth, where fiscal policy is needed. Liquidity remains poor in the credit and municipal bond markets, and it will take time to see how the fiscal response develops.

In investment-grade corporate bonds, we expect to see rating downgrades in sectors directly affected by the virus and lower oil prices, including companies in the energy, travel and leisure sectors. We believe the banking sector is well capitalized and well positioned to navigate near-term volatility. Based on our conservative estimates, around $200-250bn of BBB-rated bonds (the lowest investment-grade rating) could enter the high yield market over the coming year, equal to around 17% of the current US high yield market value. We expect energy to account for around half of these rating migrations, with the auto sector accounting for another one-third and the balance being comprised of issuers from travel and other sectors sensitive to the coronavirus.

Both the high yield and municipal bond markets have experienced significant investor outflows, contributing to the liquidity challenges in these markets. In high yield, we think default risk has increased, although we estimate the market is pricing in a 12-month default rate of about 9%, which is above our expectations. In municipal bonds, we think the impact on the coronavirus of credit quality will be largely muted by structural strengths in various sectors, as well as reserve cushions built up by states and municipalities over the past decade of economic expansion.  

5) We are focused on cash flows and quality

We believe bond markets are currently in the thick of the crisis, but we also note that the policy response has been rapid and we are beginning to see the impact of that response. Our investment strategy is focused on areas of the market that are in the path of that policy response, and bonds that offer the potential for strong cash flows backed by strong assets. Mortgage-backed securities are one example of an asset class in the path of the policy response, as the Fed recently launched quantitative easing purchases of at least $200bn in mortgage-backed securities. We also see value in high-quality, short-term credit, which we expect to benefit from improving liquidity.

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