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What Next For Bonds After ‘Capitulation Day’

10 March 2020 by Mark Holman

Monday was one of those days investment professionals will remember all their lives, and compare with similar standout days from the past.

Just to recap, the oil markets opened with their biggest drop since 1991, while equities in developed markets hit their circuit-breakers (recording their worst day since the financial crisis) as volatility also hit levels not seen since 2008. In fixed income, the entire US yield curve dropped below 1%, with the 30-year rallying by 20 points since the middle of last week. In credit the market was practically untradeable in any volume. If investors wanted to buy on the dips there was virtually no inventory on offer, and any forced sellers would have found dealer bids for risk assets were materially pulled back. ETFs struggled to function properly and received the brunt of speculators’ attention with HYG (a US high yield ETF) now 7% down on the month and IHYG (a European credit ETF) is down 9% on the month, despite the European indices containing virtually no energy exposure, unlike the US.

We should be wary of making too strong a comparison with 2008 as the underlying rate environment is very different in this post-crisis world, but yesterday certainly felt every bit like 2008 and can only be described as a capitulation day. In the morning, we tried to trim a position in the benchmark 30-year US Treasury bond and were shocked when several dealers were reluctant to show us a firm price, something we can’t remember ever happening before. Normal service resumed shortly afterward, but to us this was a stark illustration of the sheer panic that permeated the market.

So what can we expect from here? We will likely have more disturbing news flow to contend with more lockdowns inevitable and companies triggering business continuity plans in response to the coronavirus. These plans are very prudent, but they are unlikely to improve risk appetite. The economic disruption that authorities will cause in their attempts to curtail the spread of the virus is going to be very sharp and broadly felt, but we think the realistic timeframe for economic pain is one to two quarters, which is very different to the pain felt in the aftermath of the financial crisis. Importantly the health of the banking system is far more robust than it was in 2008, and it is worth reminding ourselves that banks are unlikely to cause a systemic problem this time around. In fact, we expect them to be strongly motivated (and encouraged) to provide lending assistance to companies with short term cash flow problems.

We are also expecting imminent action from both central banks and governments. Central banks will be seeking to boost confidence and offset the sharp tightening of financial conditions that the recent panic has created. The case for fiscal stimulus was very high before the virus outbreak, and it is now impossible to ignore. We could see movement from the US as soon as Tuesday, with President Trump already hinting at bold measures. In an election year, he has every motivation and we expect him to deliver. Other countries will follow suit and this should help bridge the pain that the sharp contraction in economic activity will bring. So the news flow, while still unpredictable, will not all be negative. It is going to be highly challenging to have good visibility on company earnings, and the same goes for GDP growth or contraction at the national level. With authorities’ support though, this period could be transitory.

We think investors will be given opportunities here to improve their portfolios over the coming weeks, but timing will be difficult, so adopting a strategy of scaling-in assets on the weak days like Monday would appear to be a sensible approach. We know it can be difficult for those not active in our market to follow bond prices outside the leading benchmarks, so let’s look at a few examples to demonstrate how far things have fallen in the last couple of weeks.

Starting close to the action, Intesa Sanpaolo issued a 3.75% Additional Tier 1 (AT1) bond callable in 2025 at a cash price of 100.00 on February 20, which is now trading around 84.00 – that is a near 8% yield in euros, 9% in sterling or nearly 10% in US dollars.

Closer to home, a 5.875% AT1 callable in 2024 from Nationwide Building Society was trading at 111.00 a week ago, but on Monday dropped back to an indicated 100.00. In the insurance sector, Rothesay’s 6.875% notes were up at 117.00 in late February but are now down around 102.00, while Aviva’s 6.125% callable June 2021 notes have fallen from over 111 in early February to a bid level as low as 104.50 on Monday. British Telecom’s 1.874% hybrid, issued at par on February 11, was bid at around 93. These are all household names that we see as well-equipped to survive a period of economic downturn better than most.

We will endeavour to keep you updated more than usual over this volatile period, and of course are here to answer your questions.

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