Often, components essential to the functioning of an engine work so smoothly they stay hidden until something breaks. Then again, sometimes we will ourselves to drive on even after being warned about faulty parts.
Over the last six weeks, we’ve experienced a whiplash of selling and buying across bond markets. First, prices dropped with the growing awareness that COVID-19 would stall cash flows for entities beyond China and the travel industry. Then there was the panicked dash for cash that forced bond funds to try to offload mass quantities to non-existent buyers. Psychological and price support followed as the Federal Reserve and the US Government stepped in with unprecedented measures to temporarily backstop the liquidity of municipal and corporate issuers. And most recently, fervent demand returned, with investors falling over themselves to bid up high-yielding new issues from virus-impacted companies such as Carnival Cruise lines.
In this period of very low interest rates – even before the current bond crisis — there were a number of signals that the credit market was off-kilter. For one, investors stretching for yield had driven up bond prices across all maturities and credit qualities, with seemingly indiscriminate buying until spreads between investment grade and high-yield bonds reached a 12-year low.
Low rates, too, have contributed to changes in the investment grade bond universe. In 2001, BBB-rated bonds represented a mere 17% of the market, but this swelled to more than 50% by 2019. Corporations used the easy money to finance acquisitions and stock buybacks, and that masked deteriorating trends in many companies. In 2019, Ruchir Sharma of The New York Times cautioned that “zombie companies” that may have had the cash to cover interest on debt, but not to repay principal, were relying on continued low rates to refinance. His gist was that these companies no longer provided value commensurate with their resource use — and that by staying in business, they were crowding out innovation.
The fallout from COVID-19 is exposing much of the previous folly of highly-leveraged companies. According to CreditSights, one of the leading providers of credit research for the investment industry, as many as 83 investment grade companies could be at risk of a downgrade into high-yield over the next six to 12 months, twice the number projected before the crisis. March provided a chilling preview with three times the usual number of companies suffering some level of credit downgrade. The pricing pressure from these downgrades will likely be exacerbated by bond funds whose mandates forbid high-yield issues.
One upside may be that we are forced to come to terms with reappraising and repricing risk at both the investor and the policy level. There are many high-quality companies out there that continue to provide real value and solve essential problems. These are the companies that we should lend money to, especially as COVID-19 gives us a new set of problems to combat.
The other good news is that for our clients, bonds have continued to do their job of preserving capital even as stocks move up and down. We remain focused on looking for high-quality issuers and continually monitor pricing, credit research and macro conditions for new and existing risks as the situation unfolds.