Why long-term value is created by avoiding the losers, rather than trying to pick a few heroic winners
The covid-19 crisis has caused some very sharp market movements, most notably a very steep fall in equity prices and a large rise in volatility indices. The initial reaction in the bond markets sent government bond yields sharply down – with the 10-year UK gilt yield falling below 0.2% – and credit spreads wider. In the following ten days, the widening in credit spreads accelerated. However, we also saw gilt prices fall and the 10-year gilt yield climbed all the way back to around 0.8%, pretty much where it had started the year.
This high correlation between different asset classes was indicative of two things. Firstly, liquidity had dried up as traders and market makers were told to cut positions. Secondly, certain investors were scrambling to cash in and were selling what they could to do so – we even saw gold – a traditional safe haven asset – fall at that time. In the investment grade market, this dynamic saw many highly rated credits widen significantly, often in line with more cyclical or lower rated credits, which provided an opportunity for long-term investors with plenty of liquidity. In the last fortnight of March, we saw some of these moves reverse, with gilt yields back down and credit spreads recovering somewhat.
The previous crisis of 2008/9 was fought through the central banks with huge injections of liquidity into the banking system and real interest rates held below zero for a prolonged period. Central banks have duly responded to the covid-19 crisis with interest rate cuts (where possible) and fresh rounds of quantitative easing (QE) and/or other measures to inject liquidity into the banking system. However, we are starting from a point where monetary policy was already very loose; over the last ten years we have seen diminishing impact to successive bouts of QE, so it seems we cannot rely on central banks to pull the world economy out of this hole. Indeed, this crisis is not a financial sector crisis, meaning we are more reliant on governments and fiscal policies to help ameliorate the economic pain of the pandemic.
We have seen a number of governments announcing packages of support for businesses and individuals who have been affected by the shutdowns and social distancing measures. There is still much uncertainty as to how fast the money will reach those in need, whether it will go to the right places, and if it will be enough to prevent mass unemployment and business failures. One thing we can say for certain is that it will not be possible for governments to bail out every company. Going forward, it will be more important than ever to be able to do in-depth analysis on the companies you invest in.
For credit investors, this will not be like the aftermath of the financial crisis where indiscriminate central bank buying lifted all bonds. Many bonds may look very cheap over the next few months but that does not necessarily make them a buy if their business stands to be disrupted to the point that they suffer huge losses or will see their debt obligations balloon sending them into “junk” bond territory. As ever in credit investing, long-term value is created by avoiding the losers, rather than trying to pick a few heroic winners!
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CLI01594 Expiry 31/03/2021