Global Head of Fixed Income Jim Cielinski provides his perspective on navigating bond markets through highly illiquid environments and discusses the factors he believes are crucial to shaping the extent of the economic crisis.

Key Takeaways

  • In our view, the key to navigating the current crisis is accurately defining the kind of environment we are in.
  • For example, we do not believe the liquidity event we experienced in bond markets in March constitutes a true liquidity crisis, as unprecedented policy intervention was ultimately able to stave it off. Policy makers have also introduced new tools, such as the direct purchase of corporate bonds.
  • From a broader economic perspective, the duration and severity of the pandemic will determine whether we end up in a full-blown economic crisis. Economies can rebound from relatively short shutdowns, but it will be far more painful and difficult to recover from a shutdown that lasts six months or longer.

Jim Cielinski: Hello, everyone, I am Jim Cielinski. I hope you are all doing well during these testing times. What I wanted to talk about was navigating bond markets through highly illiquid crisis environments. We saw in March some of the worst performance ever for risky parts of the bond market, and there were days when liquidity simply dried up. So if you are like me, you are probably asking what comes next but also what are the sign posts that are going to help me navigate this cycle?

And when I am faced with a crisis environment like we have today, the right starting point is always to ask, “What kind of crisis am I in?” This has been described as a health and humanitarian crisis, and there is no question that COVID-19 would qualify as that. But equally I have heard the words liquidity crisis or solvency crisis, financial crisis. These are not synonymous. And if you are going to have any hope of navigating this cycle, you need to first define what kind of environment you are in but also how far you are through the various cycles.

So, let’s start with liquidity crisis. We had a liquidity event in March. We did not have a liquidity crisis. And a liquidity crisis, to me, has to be defined as when a deserving borrower is not able to access capital markets or obtain capital. That in turn creates a solvency crisis and causes that borrower to default. A liquidity crisis, however, is not when you have prices fall by a big margin. It is certainly not defined as when a bond trader can’t sell their bond at a price today equal to what it was a day ago or a week ago. We saw policy makers step in in an unprecedented way. I do think we were well on our way to seeing a true liquidity crisis, but policy-maker intervention stopped it and staved it off. Policy makers are actually pretty good at this. They have had a lot of experience, they dusted off every tool they used in 2008, but they just turned the volume up a bit, and they can turn it up more. But they have also introduced new tools, such as the direct purchase of corporate bonds.

We saw a global response this time, so QE4 in the U.S., I believe it probably takes the balance sheet of the Fed up by another $4 to $5 trillion, which is bigger than all the other QE [quantitative easing] events combined. But equally, in the UK, in Europe, we have seen aggressive policy action, and it is directly targeting this liquidity event. So I think we have staved off the liquidity crisis that might have been on the horizon.

The next question is the big one, Is this going to be a full-blown economic crisis? And I think a shutdown that lasts for two or three months or, say, one quarter is probably not going to move us into true crisis mentality. It will be extraordinarily painful, because the degree of decline in GDP will be double digit across most developed markets. But economies can recover if the shutdown is short. We see evidence of this in China, but it is extraordinarily painful. What is more difficult is a six-month shutdown. And economies are not like a light switch, you don’t come in the day after you shut them down and just simply turn them back on. The longer they are closed, the more painful it is.

The global economy is like a huge jigsaw puzzle, and if you just let it sit on the table for six months, you are going to start missing some very important pieces. Supply chains break, there will be many defaults if this goes on for six months, and therefore, the duration coupled with the severity to me is really the key thing to watch now. So I think we can avoid the full-blown economic crisis, but only if we can see declines in the number of new virus cases and if we can get some control over COVID-19. This will allow policy makers, I think, through the aggressive fiscal response to at least replace some of the lost income and carry us through what is going to be an extremely deep valley.

So, crisis or no crisis, I don’t think we know every answer yet, but the sign posts to watch are probably those that would dictate the duration of this slowdown. It is going to be volatile. The other lesson from investing in these kinds of environments is to make sure that you elongate your time horizon. We will all make decisions that probably don’t look that wise if we define our time horizon as one week or two weeks. But I think keeping an eye on the right sign post and then elongating that investment horizon is what is going to help you navigate this cycle.