Avoiding the corporate bond liquidity squeeze
12 March 2019
Edward Park, deputy CIO, Brooks Macdonald, examines asset allocation positioning within current fixed income markets
Since the global financial crisis in 2008, aging developed-world populations, record low deposit interest rates and quantitative easing by the world’s major central banks have driven a global ‘search for yield’ by investors. For many years, this drove asset yields lower across the risk spectrum. However, since the start of 2018 the investment backdrop has shifted, causing us to re-evaluate our asset allocation positioning within fixed income markets.
US government bond yields have risen but remained under control as the Fed has tightened US monetary policy. The Federal Reserve (Fed) began normalising its monetary policy stance in December 2015. As the US economy has performed strongly, it has since raised the Federal Funds Rate target range nine times, with the upper bound increasing from 0.25% to 2.50%. Commensurate with this, ten-year treasury yields have risen since bottoming out in the middle of 2016 (Figure 1), with some investors asserting that the multi-decade bond bull market that began in the early 1980’s may have now ended.
Corporate bonds’ relative performance has been dominated by expectations surrounding the economic and corporate earnings cycles. As treasury yields rose between 2016 and 2017 corporate bonds outperformed and spreads, which represent the additional compensation investors demand for lending to companies rather than governments, tightened to cyclical lows at the start of 2018 (Figure 1). At that time, corporate bonds had reached their most expensive level relative to government bonds in the current cycle. This was largely because of investors’ high expectations for economic growth and corporate performance.
However, since the start of 2018, cyclical headwinds have begun to appear within the US economy and the Fed has started to slowly withdraw liquidity from asset markets by reducing the size of its balance sheet. This combination of weaker growth and lower liquidity caused a shift in sentiment within fixed income markets, with corporate bond spreads beginning to increase amid episodes of heightened volatility.
Figure 1: Bond yields, corporate spreads and US monetary policy
Figure 1: Both treasury yields and corporate credit spreads were suppressed by US monetary policy stimulus following the global financial crisis. However, the backdrop has shifted as the Fed has sought to normalise policy and expectations of slower growth are beginning to weigh on riskier areas of fixed income markets.
Source: Thomson Reuters Datastream
There are reasons to be concerned about liquidity
Structural changes that have taken place in the market since the global financial crisis could exacerbate any liquidity events that might occur.
Since the global financial crisis, regulatory changes have meant that investment banks have reduced their participation in corporate bond markets (via making activity). This has occurred as leverage has risen to record levels among small and mid-cap US companies.
The market effects of this have so far been limited, as bond demand has remained buoyant amid the positive growth and accommodative policy backdrops.
However, we hold concerns that the reduction of a major source of bond demand during times of volatility could exacerbate volatility if (and when) the macroeconomic backdrop deteriorates further.
This is not to say that investor demand for yield producing assets will dry up, but there could be a re-pricing of risk within the market if investors anticipate a liquidity or growth regime change.
At the same time, there has been a decline in the average quality of issuance within corporate bond markets, with over half of the global investment-grade index now rated at BBB or lower. This means that in the event that growth slows, financing costs rise and corporates’ financial positions deteriorate, there is now less room for downgrades before issuers lose their ‘investment grade’ status.
If this occurs, certain constrained fixed income investors will become forced sellers, which could cause a liquidity crunch in riskier areas of the asset class.
Recent developments have presented an attractive adjustment opportunity
Corporate bond markets have rallied since the start of the year as policymakers’ rhetoric has tempered fears about the threat posed by declining liquidity.
Since December 2018, US policymakers have shifted away from a tightening bias to a more data-dependent policy stance. This includes a provision to consider reducing or halting the pace of balance sheet reduction in the event that it is putting unnecessary upward pressure on yields. Together with the perverse fact that the US government shutdown acted to support liquidity by reducing the rate of treasury issuance, this improved the market liquidity backdrop, thereby having a positive effect on risk appetite and causing corporate bond markets to rally.
This has provided us an opportunity to address our fixed income allocations in the context of our longer-term outlook.
The economic cycle is maturing and we expect global growth to slow over the course of 2019. Depending on the effect that this has on corporate performance, it could cause corporate bond markets to underperform later in the year. As such, we are opportunistically using the improvement in sentiment to address our fixed income positioning, particularly in areas where liquidity is lower or could deteriorate, such as smaller companies, sterling investment grade and US high yield.
Convertible bonds: an alternative solution
‘Convertibles’ are corporate bonds that can be converted into the underlying issuer’s equity, under predetermined conditions, usually at the discretion of their holder. As an asset class, they fall between fixed income and equities.
Their characteristics mean that they can offer investors ‘convexity’ of returns, i.e. the chance for equity-like returns in rising markets and bond-like downside protection if markets fall (Figure 2).
As key interest rates have been rising in the US corporate borrowing rates have increased, convertibles have become a more attractive financing option for companies. As such, issuance has begun to rise, presenting investors with a broader range of investment options. It is true that financially-weak companies often turn to convertibles to lower their interest burdens, but this is not always the case and the rise in issuance is beneficial to active investors who are able to apply stock-picking skills to uncover value in what is often an under-researched asset class.
Uncertainty about the sustainability of the US economic expansion and associated policy decisions justifies convertibles exposure.
There are a number of risks to the outlook and we are cognisant that the US economic cycle is maturing. However, there is a possibility that it could extend longer than markets currently anticipate. Significant uncertainty also surrounds the path of US monetary policy and we cannot rule out that the Fed will conclude its balance-sheet reduction programme more quickly than expected in the face of rising government debt issuance and pressure from President Trump. As such, we see potential for asset markets to react to the up or downside in the coming months, depending on developments with these and other key market drivers. This uncertainty creates an ideal environment for the use of convertibles and we currently hold a positive view on active exposure to the asset class.
Figure 2: The return profile of a convertible bond.
Source: Brooks Macdonald
The four return profiles of a convertible bond
Distressed: if there are concerns about the issuer’s ability to repay its debts, the convertible’s value may be less than its par value (the amount at which it was issued), as investors may perceive it unlikely that the issuer will be able to repay the holder in full before failing.
Bond-like: the further the issuer’s shares are trading below the convertible’s conversion price (the price at which the holder can convert the convertible into shares), the less value the implicit equity option has. The lower the option’s value, the more the convertible’s value will be determined by its bond features.
Balanced: when the issuer’s equity trades around the convertible’s conversion price, the convertible’s value will be determined by a combination of bond features and the option’s implicit value. This is when convertible bonds can be of most use in the construction of balanced portfolios.
Equity-like: when the issuer’s shares have performed well and their price exceeds the conversion price, the convertible’s value is determined mainly based on its value as converted to equity.
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