Low-duration impacts at a high-risk time
Q: What’s been happening in short-term credit markets?
In response to the Covid-19 situation, virtually all market players, whether corporations, institutions or individuals, are seeking cash to weather both market volatility and provide a buffer in the event a recovery from this pandemic takes longer than expected. With equity markets in virtual freefall, investors want an asset class that provides the lowest-cost way of obtaining cash from their investments.
Investors sold bonds, but particularly short-term bonds because such sales generate a smaller dollar loss than a longer-dated security. These sales have caused the yield spread over risk-free assets (i.e., Treasuries) to widen more relative to longer-dated securities, causing their prices to fall.
Q: How does this compare to the 2008 financial crisis?
In 2008, the market seized because there was a credit crisis, which created a liquidity crisis. This time, it is the anticipated curtailment of economic activity that has impaired liquidity. But regardless of the length of any virus-induced slowdown, the slowdown will end, and it will end much more quickly than the time it took to resolve the factors at the root of the financial crisis.
Furthermore, the U.S. economy is in much better shape heading into this period than it was in 2008, with reasonable economic growth, full employment, a banking system in far better condition, and a consumer with lower debt levels and healthier balance sheets than was the case prior to the 2008 market decline. Moreover, the Fed already has gone all-in to address this crisis, slashing its benchmark rate to a range of 0% to 0.25% and taking a series of other extraordinary measures even before the worst of the virus impacts hits the global economy.
Important points to keep in mind:
- This is a liquidity event, not a credit event. With the exception of certain lower-quality oil and gas related credits, a few months of slower economic growth will not bring borrowers to their knees.
- The actions currently being initiated/contemplated on both the fiscal and monetary sides are and will be very significant in scope. As was the case in 2008, big actions helped to place the markets back on their feet, and this time there is no mortgage crisis to deal with.
- Once the aforementioned policy initiatives fully make their way into the market, short-term credit spreads should once again tighten, providing the opportunity to recapture at least some of the decline brought on by the recent dislocation. Investors who are inclined to just ‘‘go to cash’’ in this environment will be moving into an investment with a significantly lower yield, as well as missing the potential opportunity to recoup some of the value erosion we have seen over the past few weeks.
While current levels of volatility are unlikely to end quickly, staying the course during this turbulence makes sense from a yield standpoint. It also presents the opportunity to once again derive incremental returns from prudent strategies.