Joint CIO, Jeremy Wharton, provides some comment on our previous positioning regarding credit exposure within our funds, how this is playing out for us and how we might look to change our positioning in the future.
I must start by saying that I write this in the middle of a worldwide market panic. I am not going to try and predict anything but some might find it useful to hear some views on where credit markets were before the coronavirus hit and where we find ourselves now.
Prior to the last couple of weeks of February we were already concerned at the levels of risk assets. US stocks continued to hit record highs and there appeared to be a slightly cavalier approach to the notion of credit risk.
Indeed credit spreads, as measured by the iTraxx CDS indices, continued to trade tighter and tighter and reached levels not seen since mid-2007, which was the start of the credit unwind leading to the Global Financial Crisis of 2008. We expressed that this was a cause for concern several times, but had no clue what the catalyst for a reversal might be - we certainly did not expect it to be a virus.
In primary markets, any new issuance that ‘had a pulse’ was snapped up, issues being hugely oversubscribed, ironing out any New Issue Premium and pricing at levels far away from initial guidance. Realised yields were not helped by underlying benchmark government bond yields being so low.
The riskiest debt in the form of the leveraged loan market saw tremendous levels of issuance into willing hands. We felt that we had potentially seen the low in UK yields in early September and were relieved when the UK general election cleared away the political paralysis of the previous three years, and even more relieved when the Bank of England (BoE) held rates at their January 2020 meeting.
We agreed that to look ahead rather than focusing on pre-election data was logical. We do not think inflation is dead and with almost full employment and subsequent wage growth, a key indicator for the Monetary Policy Committee, we think the path of rates will ultimately be to normalise.
However, with the thinking that credit spreads were too tight, i.e. could potentially only go one way, we de-risked our credit exposure considerably. We upped our AAA allocation in the Investment Grade Fixed Interest Fund (CHIG) to its highest ever at 45% (mainly AAA rated covered floating rate notes (FRN’s)) and the Tenax Absolute Return Strategies Fund’s near cash weighting was at its highest ever at 57%. These AAA FRN’s are issued by financial institutions or SSA’s.
The majority are covered, i.e. secured by an on-balance sheet pool of high grade residential mortgage loans, with dual recourse to the issuer and the cover pool, hence they are regarded so highly from a credit perspective. In both funds we shied away from adding duration (volatility) and we also restricted our exposure to weaker credits.
CHIG cannot invest in high-yield (HY - most of which is not remotely ‘high’), so it has no exposure, and we have very limited exposure to HY in Tenax. We have been concerned at the pace of issuance into the weakest ratings of investment grade (IG), along with others, and the BBB bubble theory has gained some traction as a result.
The stock of BBB credit in dollars now outweighs the rest of the entire rating spectrum. We limited our BBB exposure to almost its lowest ever. Ratings agencies, having previously been fairly benign, have begun to act and we have recently seen downgrades to junk for both Kraft Heinz and Renault, with around $56 billion of outstanding debt between them.
With our current panic, the world has now changed but hopefully only on a temporary basis. The coronavirus has enormous potential to get out of control, the ‘pandemic’, but we have to remain optimistic that measures put in place will contain the worst (and possibly retain a sense of proportion).
As I write, we have nearly 90,000 confirmed cases with nearly 3,000 deaths. We do have to remember that this virus is not as lethal, or as contagious, as the likes of Ebola but things could get an awful lot worse before getting better.
The most vulnerable are the elderly and those with pre-existing conditions but the real worry is that the virus takes over in less developed countries where primitive and limited medical facilities, communication, education and finite governmental resources could lead to a dramatic escalation of the situation - hence we have seen such a profound effect on emerging market assets.
So far the most immediate effects of this situation are on supply and demand, ‘the shock’. We can all cope with waiting to upgrade our iPhone but the closing of an Apple manufacturer in China has not helped Apple’s share price. As of today, the Apple share is actually over the outbreak.
Whether we end up with only temporary effects, the ‘V shaped recovery’, or a longer drawn out recessionary situation, is anybody’s guess. No one knows the answer yet, so enough pontificating from me - let’s look at the effect so far on credit markets.
Central banks to provide support – not necessarily with rate cuts
Whilst equity markets saw a dramatic weekly sell off, credit spreads at first were fairly unchanged. Towards the end of the week, they began to play catch up and the HY index gapped out from 209 to 302 but only back to June 2019 levels. IG spreads moved from their tights of 41 to 64 but so far this again only puts them back to June 2019 levels.
All government yields dropped, especially in the US as markets moved to discount the Federal Reserve cutting, the 10-year has gone from 1.6 to 1.15, and the 30-year from over 2 to 1.68 - an all-time low. However, there is a strong school of thought that cutting rates is pointless in this situation (unless you are President Trump).
Rates are already incredibly low, the Eurozone rate complex structure is already a disastrous morass of negative yields and so far this is not about a financial or liquidity shock - despite the primary market being pretty much firmly shut.
Central banks will, and some already have, make all the right noises about supporting the financial system but this would be more sensible to be mainly in the form of liquidity support, such as the currency swap lines the BoE put in place before last March’s potential ‘Hard Brexit’ deadline.
Governments will need to do the heavy lifting here, starting with controlling the situation but then with fiscal measures, already a necessary direction of travel. In the UK, we have a budget to look forward to as well, this may well contain a commitment to ‘borrow to spend’ which will ultimately reassert upward pressure on yields.
From our funds perspective, we will obviously suffer some volatility in our credit holdings but, hopefully, this is more contained due to our positioning outlined above. Quality is key at the moment but we continually monitor spreads and when some material value is created, we are well placed to embrace opportunities thrown up by the current volatility.
Again, I must stress that this is an evolving situation and the potential fallout is not to be underestimated, so the time to embrace new risk on a wholesale basis is still unknown. However, this does not stop both funds selectively adding credits in a limited way when the correct opportunity arises.