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Mhammed BelfaidaHead of Short Duration - Liquidity @MhammedBelfaida
There are few areas of life that COVID-19 hasn’t impacted and credit markets are no exception. Mhammed Belfaida explains how the flattening of credit curves has revealed a surprising anomaly.
COVID-19 has inflicted an almighty shock to global societies, economies and markets. There is no need to repeat the detail here. Instead, I will merely point to a quirk that has emerged along the credit curve amid all the chaos. As investors fled risk assets and retreated to the relative tranquillity of safe havens, many credit curves become flat and, in some cases, inverted.
Figure 1: Example of the credit curve in the euro market
Figure 1 clearly shows there is little value in extending duration to ten years as investors only currently obtain a 23-basis point premium relative to a two-year bond, whereas the five-year average premium is near double (as of May 13, 2020).
Investors sold down more liquid, short-dated bonds in order to meet redemptions
How did this happen? What exactly caused the price of assets to be dislocated away from fundamentals, particularly in the shorter maturities of the bond market? It is impossible to answer fully, but part of the explanation is that investors sold down more liquid, short-dated bonds in order to meet redemptions – this was done in favour of crystallising losses on longer-dated bonds. Effectively, increased liquidity risk has cascaded through financial markets.
Indiscriminate selling and central bank support
Another quirk of this market rupture is that, so far, selling has been indiscriminate. Even high-quality names such as the ones highlighted in the table below have seen their bond spreads widen dramatically, while their funding rate in the money market space (via commercial deposits) continues to be significantly lower.
Figure 2: Example of premia seen in euro markets
Monetary policy is extremely supportive, too; something that doesn’t look likely to change anytime soon. Having extended their purchasing remit to credit, the next central banking tightening cycle looks a while off.
This, however, should not encourage complacency. The rapid revenue deterioration and funding issues that that have widened credit spreads for many companies will in turn hamper their ability to access liquidity. For those in particularly weak positions, this could prove fatal. Strict credit selection and a robust portfolio construction are therefore paramount to build a resilient portfolio capable of weathering any short-term volatility.
With a typical weighted average life of one year or less, the additional flexibility offered by short duration strategies could be attractive in this environment. Allocations to floating rate notes, short dated bonds as well as highly rated money market instruments can be tweaked to take advantage of opportunities in the market.
For years after the financial crisis, many investors were resigned to earning low or negative returns on their short duration mandates. That is no longer the case. For the first time in decades the front end of the fixed income market looks attractive. In euro markets, for example, the short duration universe (ICE BofA 1-3 Year Euro Broad Market Index) offered a yield of 0.12 per cent relative to a five-year average yield of -0.14 per cent (as of May 13). Investors looking beyond traditional cash management to expand their liquidity toolkits might want to consider opportunities this.
