While there has been a rally in risk-off assets since January over coronavirus fears, credit markets have been largely resilient given strong technical demand, driven by huge inflows for bond funds and the wall of cash sitting on the sidelines.
However, the surge of coronavirus cases in Europe has been a game changer for markets and sentiment. The developments over the last few days, with several towns in Italy on lockdown and new cases in some neighbouring countries, have led to some extreme moves in the markets. While the equity moves are well reported in the news, we wanted to give an update on the impact on fixed income assets.
Firstly, there has been a rush to safety as investors seek protection and as such US Treasuries, the ultimate safe haven for many investors, have seen a significant rally. The bellwether 10-year US Treasury closed on Friday at a yield of 1.47%, but has since reached all-time lows and sits at 1.35% at the time of writing. This is a significant move from the wides at the start of the year of 1.9%, breaking through all resistance levels. The market has also increased its expectations of interest rate cuts from the Federal Reserve, with investors now pricing in two 25bp cuts by September.
In the credit space, the iTraxx Crossover index (a basket of 75 credit default swaps of the most liquid sub-IG European corporates) has widened almost 40bp from a close of 219bp on Friday to 256bp as of this morning, a sign that market participants are buying protection. Other bond markets have reacted similarly, with the US High Yield index asset swap widening 46bp to 375bp, the European HY index widening 33bp to 303bp, and the Coco index currently sitting at 364bp having been as low as 313bp two weeks ago. Sector wise, the biggest underperforming sector in the US has been energy, which comprises a large portion of the sub-IG market, moving from 9.2% to 9.82% on a yield-to-worst basis in just two days.
2020 so far has seen record amounts of supply with new issues being considerably oversubscribed, and while these initially performed well in the secondary market, in many cases they have been the first to react in this volatile market. For example, Unicredit, a Tier 1 Italian bank, issued an AT1 bond on February 12 with orders of €7.2bn for a €1.25bn deal. This deal, with a coupon of 3.875% to a 2027 call date, was priced at 100 but is now trading around 93 at a yield of 5.1% – that is the equivalent of nearly two years of coupons lost in three days. When ING tried to issue an AT1 on February 20 (and subsequently pulled it due to the resignation of its CEO) the Dutch bank found $11bn of orders for a $1bn deal with pricing expected to be inside of 4.625%. When ING came back to the market to print on Monday, it only received $3bn of interest and printed a $750m deal at a yield of 4.875%.
Sometimes in periods of stress, the market sees exacerbated price moves in a vacuum of liquidity. However, in fixed income at the moment we still see pockets of healthy trading volumes; the iTraxx Crossover saw 351% of its average trading volume yesterday and flows in subordinated financials have also been high versus levels observed earlier this year.
The longer and larger the spread of the virus, the less likely we are to see a V-shaped recovery in growth, which much of the market had been expecting; a U-shaped recovery is now looking increasingly probable. We have felt for some time that with low yields, tight credit spreads and an old economic cycle, expensive markets are more vulnerable to shocks, and we have been taking a more defensive approach as a result.
We initially thought that a re-escalation of trade wars was the most likely risk to markets in early 2020, but coronavirus has been the surprise driver. We feel that while markets believed the virus could be contained in Asia, participants were looking for a fairly short lived dip, but the latest spread in to Europe and South Korea seems to have changed mindsets considerably. The chances of the virus becoming a pandemic are materially higher, and we essentially have a race between a vaccine being found and worldwide spread.
From a market standpoint, we would still advocate caution. Naturally there will be buying opportunities created but we feel investors are better rewarded to remain cautious in the short term until there is further clarity.