Credit markets have been hit hard across the board. ‘Exiting at normal prices is now virtually impossible because there is hardly any liquidity.’ Only ETFs can still be easily sold, resulting in dramatic price declines. Can the ECB’s latest support package restore calm?
‘Bond trackers, such as the iShares Core € Corp Bond ETF, have fallen much faster than the indices they are supposed to follow over the past month due to the huge outflow they have been facing. We’re seeing a big discrepancy between the prices of iShares bond ETFs and the underlying securities’, says Martijn Hesterman, portfolio manager credits at Dutch pension investor Achmea IM. ‘This means the actual market prices should be even lower. In addition, many investors are so eager for liquidity that the price at which they sell makes little difference to them. And the only things they can sell are ETFs, because it’s very difficult to sell individual bonds right now.’
David Lafferty, market strategist at Natixis IM, has realised bond markets have changed dramatically almost overnight. The rally in spreads and the huge rise in interest rates in recent weeks has made the bond market ‘a very difficult place’, he says. ‘There is now both more interest rate risk and credit risk than before the coronavirus.’
But not everything is lost. ‘Credit spreads have now reached such a level that a recession is now more or less priced in. This is the perfect environment for active bond investors. There’s a lot of uncertainty in the market, and the price mechanism in the market isn’t working properly.’
However, to make use of these opportunities there must be liquidity in the market. After all, unless they have a pile of cash at their disposal, bond investors can’t do much right now.
Government measures must restore calm
Central banks have been trying to restore calm in the markets over the past few months by cutting rates (the Fed and the Bank of England) and other stimulus measures, but these had little success until this week.
‘We were somewhat surprised by the Fed’s emergency rate cuts. You’re not going to solve this crisis with interest rate cuts. Government measures are more effective now because there is an acute drop in demand,’ says Scott Freedman, portfolio manager fixed income at Newton. ‘Cash handouts for citizens and businesses like Hong Kong, and helping banks to guarantee lending to affected businesses, will work better than interest rate cuts.’
‘Better crisis management in Europe than in the US’
Central banks seem to have made an error of judgement by applying the medicine against the previous crisis, interest rate cuts, again this time. To make matters worse, the Fed’s interest rate cuts were not directly accompanied by government stimulus measures.
Gilles Moëc, chief economist at AXA Investment Managers, is therefore beginning to have some concerns about the situation in the US. ‘The Fed’s hands are more tied than those of the ECB, because the Fed cannot buy corporate bonds,’ he says. ‘Combined with the lack of action by the federal government, that’s a problem’.
‘The stress on the American credit markets is, if possible, even greater than in Europe,’ Hesterman of Achmea IM points out. ‘In the credit markets, dollar spreads have increased by 192% since the start of the crisis, compared to 138% in the euro market. This is partly because the weighting to the energy sector [which has been hit hard by the fall in oil prices] is somewhat larger in the US, but an important difference is that in Europe there is still a buyer from Frankfurt. I think the ECB is almost the only buyer at the moment, and those purchases will continue in the near future’.
Fed President Powell should openly call for fiscal measures because of the lack of effective instruments in his monetary toolbox, according to Moëc. ‘But the question is whether he dares to do so. Powell is under enormous pressure from President Trump. If he tries to put Trump under pressure with a call for fiscal stimulus, their relationship could deteriorate even further. In short, Powell is under enormous political pressure, but he can hardly take measures that will have a direct effect on the markets.’
The ECB is much better equipped to fight the current crisis. ‘The ECB’s new buy-back programme is flexible, which means that the ECB can, for example, buy up a lot of Italian government bonds in one go if necessary’. Moëc calls the extra purchase programme that was announced on Thursday night ‘a very good package’.
‘In addition to the impressive amount of €750 billion, it is especially important that the ECB no longer has to strictly adhere to the buy-back limits for various types of bonds, and now also starts buying up short-term debt,’ he adds.
The ECB’s additional stimulus comes on top of the announcement of unprecedented stimulus packages to help affected citizens and businesses by several European countries, including the Netherlands, France, Germany and the UK. ‘Ideally though, European governments would have coordinated their fiscal response better. But you have to give them credit for the fact that they reacted very quickly. That is not a fact of life in Europe. Normally the US reacts faster, but this time it’s the other way around.’