In Troubling Times, Shine the Spotlight on Quality ETFs
During periods of economic turbulence and credit stress, investors may wish to consider companies demonstrating financial strength.
Is reduced liquidity the problem?
The roller coaster equity ride has been inescapable in recent weeks, with dramatic moves in both directions now a common occurrence. But what about fixed income, normally considered a safe haven from the equity storm? With the exception of treasuries, bonds have had a surprisingly rough time of late. Is investor behavior predicting a wave of COVID-19 related defaults, or are other factors at work? We believe the latter – current fixed income troubles are due to the evaporation of liquidity.
Central banks on the case
While the economic impact of the pandemic has been unprecedented, so has the response of central banks. In the US, the Federal Reserve (Fed) has implemented over $1 trillion in new quantitative easing while establishing direct purchase programs for almost every class of investment-grade security. This could potentially expand the Fed’s balance sheet by nearly $4 trillion. In addition, we estimate that the US fiscal stimulus already totals around 10% of gross domestic product and could expand to 15%1. Globally, policymakers have cut rates over 60 times so far in 2020, pledged about $12 trillion in fiscal and monetary stimulus, and will be purchasing $7 trillion in assets2. Clearly, central banks are concerned about liquidity.
Their concerns seem to be well-founded. In just the last week of February, high yield spreads blew out 140 basis points3. Even investment grade has also experienced some pain, particularly reflected within the corresponding corporate and municipal ETFs. And of course, certain sectors like energy, retail, restaurants, and autos are being dumped indiscriminately. The chart of widening investment-grade bid-asked spreads below clearly shows the effect of reduced liquidity.
Investment-grade fixed income performs well in recessionary periods.
We believe the evidence supports our belief that most of the price dislocation within investment-grade (IG) corporate and municipal bond ETFs has been due to the lack of liquidity, not (in most cases) because of an increase in default risk. In fact, IG bonds have historically performed quite well if held through high volatility markets and recessionary periods (please see the chart below).
And for munis, the news is also very good. In the 2018 Annual Global Corporate Default and Rating Transitionstudy by Standard & Poor’s, BBB-rated municipal issues defaulted less frequently over the last 50 years (and five recessions) than AAA-rated corporates4.
Liquidity crises that are the result of panic selling and forced liquidation have historically been some of the best buying opportunities. As the Fed (and other global central banks) orchestrate massive campaigns to ease liquidity stress, investment grade corporate sectors are starting to show signs of bouncing back. The evidence suggests that fears of mass defaults in this space may be overdone.
Q2 2020 Global Debt outlook: A quarter unlike any other, Hemant Baijal, Invesco.com, April 10, 2020
Here is a breakdown of the $12 trillion in global stimulus passed this month, Phil Davis, Thestreet.com, March 27, 2020
Will innovation help lead us out of this market downturn? Invesco QQQ Team, Invesco.com.
Advisors offered their concerns about the municipal market. We provided our perspective. Mark Paris, Eddie Bernhardt and Timothy Spitz, Invesco.com, April 9, 2020
A basis point is one hundredth of a percentage point.
A bid-ask spread is the amount by which the ask price exceeds the bid price for an asset in the market. The bid-ask spread for an investment grade bond is the difference between the highest price that a buyer is willing to pay for an asset and the lowest price that a seller is willing to accept. The primary determinant of bid-ask spread size is trading volume. Thinly traded stocks tend to have higher spreads.
Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa.
An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.
The values of junk bonds fluctuate more than those of high-quality bonds and can decline significantly over short time periods.
Municipal securities are subject to the risk that legislative or economic conditions could affect an issuer’s ability to make payments of principal and/or interest.
Credit ratings are assigned by Nationally Recognized Statistical Rating Organizations based on assessment of the credit worthiness of the underlying bond issuers. The ratings range from AAA (highest) to D (lowest) and are subject to change. Not rated indicates the debtor was not rated and should not be interpreted as indicating low quality. Futures and other derivatives are not eligible for assigned credit ratings by any NRSRO and are excluded from quality allocations. For more information on rating methodologies, please visit the following NRSRO websites: standardandpoors.com and select "Understanding Ratings" under Rating Resources and moodys.com and select "Rating Methodologies" under Research and Ratings.