- U.S. bond valuations are balanced between an uncertain economic outlook and the explicit support of the U.S. Federal Reserve (Fed).
- We believe the Fed will continue to intervene in bond markets to ensure liquidity remains sufficient and is likely to act further to support markets if required. Nevertheless, we expect uncertainty – and volatility – to remain high, amplifying the need for careful security selection.
- We favor identifying areas of the bond markets where the current liquidity premium is high, notably in higher-quality and shorter-dated securities, and likely sufficient to compensate for future liquidity risk.
If necessity is the mother of invention, investment managers have to be creative people. We have a daily necessity to add value for our clients, and a seemingly endless supply of “unexpected” events, even crises, that demand regular reinvention. But investment managers are trained to manage risk, and most managers do it by applying general principles to help tackle each new unknown and its corresponding surge in volatility.
Do you trade the economy or the Fed?
Consider today’s corporate bond market, which is suspended between two competing forces: A highly uncertain macroeconomic outlook and the (almost) limitless support of the U.S. Federal Reserve (Fed). To figure out the fair value of a particular security do you make a macroeconomic call, trusting your forecasts, or rely on the Fed to be a buyer of last resort? In portfolio manager parlance, do you trade the economy or the Fed?
Our answer is: neither, because one of our core principles is that the long-term value is added by understanding investment risk at the security level. A bottom-up approach, if you will. And another core principle is that the closest thing to a free lunch in investment management is the efficiency gained from having a portfolio of risks. Diversifying risk allows the potential to build a portfolio with the same risk as the benchmark, but with a slightly higher return, or the same return as the benchmark, but with slightly less risk. In our view, the choice between trusting the Fed to underwrite the bond market – whatever the macroeconomic data brings – and making a call on what economic havoc the coronavirus could wreak is a false one. Or, more precisely, it is a low-quality question. The higher-quality question is: Given what we do know, can managers create a portfolio of risks that has a greater chance of delivering steady total returns?
Separating the impact of economic contraction from that of illiquid markets
We believe the answer to that question is: yes. The Fed cannot ensure an economic recovery but it can help ensure that the corporate bond market remains functional. By injecting liquidity into markets, the Fed hopes to keep individual quality (and solvent) companies from failing because they either cannot rollover their existing debt or they cannot raise funds to cover the short-term cash shortfall caused by the pandemic. In sum, the Fed has more control over liquidity, and the corresponding premium companies must pay to borrow in volatile, illiquid markets. We think you can separate the question “what is the price impact of the sharpest economic contraction in a lifetime?” from the question “what is the price impact of an illiquid market?”
Going into March 2020, U.S. corporate bond spreads in both the investment-grade and high-yield sectors were relatively close to their historically tightest levels. The shock to markets from the spread of and attempts to contain COVID-19 that hit in March caused those spreads to widen dramatically. Valuations moved to price in both the deteriorating and highly uncertain economic and fundamental pictures, as well as a collapse in liquidity. Then, the Fed’s swift and strong intervention, through a variety of programs, boosted the markets’, and our own, confidence. With the Fed’s help, credit – particularly the higher-rated segments of the corporate and securitized markets – grew more attractive by late March. But the economic outlook remained far from clear.
Targeting liquidity risk
Adding aggregate credit risk to a core portfolio can be effective, if you are right on the direction of the market. Adding high-yield credit risk in volatile times is a particularly high “beta” version of this approach. But in order to diversify risks, we believe it prudent to look at what sectors and securities underperformed the most “per unit of risk” in a volatile period and what kind of risk was being priced into spreads at the time. This helps us identify the sectors and securities where “illiquidity” is responsible for the largest declines.
In March, for example, we knew certain securitized sectors where hard hit because of forced unwinds of levered investors in the asset class, even ones predominately invested in Agency mortgage-backed securities (MBS). And, in our analysis, the higher-quality sectors, such as AAA rated securitized products including asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS), as well as A rated corporate bonds looked to have priced in a comparatively high liquidity risk premium. That premium resulted from investors’ need to raise cash whether from fund withdrawals or, in the case of levered investors, to meet margin calls.
To help perform our analysis, we looked to the Duration Times Spread (DTS) measure to quantify the risk in different securities. The simple multiplication of a security’s duration by its spread creates a metric that accounts for both a security’s term risk and its credit risk. What it doesn’t account for is liquidity risk. But by dividing a security’s DTS by its historical excess return, we can show how it performed “per unit of DTS risk,” or how it performed given its unique combination of duration and spread over Treasuries.
1Q20 EXCESS PERFORMANCE & EXCESS PERFORMANCE PER UNIT OF RISK FROM U.S. CORPORATE CREDIT TENORS
As performance decreases, performance per unit of risk increases.
Source: Bloomberg, Janus Henderson, as of 31 March 2020. Excess returns represent returns above that attributable to falling U.S. Treasury yields of the various maturities of the Bloomberg Barclays U.S. Corporate Bond Index. The Bloomberg Barclays U.S. Corporate Bond Index measures the investment grade, US dollar-denominated, fixed-rate, taxable corporate bond market.
The chart above shows the excess returns (the returns above that attributable to falling U.S. Treasury yields) of the various maturities of the Bloomberg Barclays U.S. Corporate Bond Index, and their return per unit of risk. As would be expected given heightened uncertainty, the longer the bond, the worse its performance during a particularly weak period for the overall market. But the return per unit of risk was exactly the opposite: The shorter the bond, the worse it performed per unit of risk. Why? Because, in a liquidity crisis, shorter and/or high-quality bonds tend to suffer the most because they are the most liquid instruments at the time. When investors need to raise cash, they sell what they can.
By looking at the difference between a bond’s performance and its performance per unit of risk, we can get a sense of just how much liquidity (or lack of it) affected the bond’s performance. This allows us to differentiate the premium offered due to illiquidity from the premium offered for macroeconomic risk. In a sense, we are “trading the Fed,” but with an important difference: We are isolating the ability of the Fed to provide liquidity, not to cure the macroeconomic ills, or even to be a buyer of last resort for companies struggling to cash capital. Instead, we are focusing on the extra yield offered because securities are illiquid – a problem we believe the Fed addressed in March and will ensure does not return.
The excess yield being offered in most shorter-tenor securities may not be a lot when compared to a high-yield bond, or even the average investment-grade corporate bond. But in our view, the slight yield pickup provided by these relatively short securities offers an attractive risk/reward profile due to the lower probability that issuers will have trouble meeting near-term obligations. Particularly in volatile environments when (as redundant as it may sound) the unknowns are large and the potential impacts are even larger, we think it can make sense to buy more securities with a lower risk profile than adding a lesser amount of securities offering a higher risk profile. When you can isolate the premium being offered for one kind of risk and have confidence that this particular risk will be mitigated by the U.S. Federal Reserve, even better.
We do not know the extent of the current recession as its path is dependent on a particularly hard-to-predict set of variables: how well our society both contains and treats COVID-19. We believe uncertainty will remain high, keeping volatility relatively elevated (though we do not expect it to return to the highs of March), which should sustain both a liquidity premium and wider dispersion in security pricing. While it would be nice if the economy recovers and spreads compressed quickly, we are happy to earn the excess return generally gained over time.
During periods when volatility is high, we believe bottom-up security analysis is key to identifying higher-quality risks: Finding pockets of securities with, in our view, either mispriced risk or an excessive liquidity premium, or both. And, should a second wave of the virus wash over the markets, we expect higher-quality assets to suffer less on a return basis as well as, with the continued support of the Fed, on a liquidity basis. We believe a commitment to finding the long-term value added by understanding investment risk at the security level and assembling these risks into portfolios that aim to produce lower-volatility, incremental returns should guide us through the unknowns in the months ahead.