Even as the humanitarian and economic crises of the coronavirus pandemic expand, policymakers have been reacting with unprecedented speed and support, and financial markets have begun to envision the contours of a recovery.
Illiquidity and forced selling have already eased in high quality segments of the bond market, such as U.S. Treasuries and U.S. agency mortgage bonds. Over time, other sectors should reliquify and recover, although much will depend on the details and implementation of policy support, further government programs and the trajectory of economic recovery.
In general, we believe the most resilient market sectors will stabilize well ahead of a recovery in the economy. But some segments – such as lower-quality unsecured corporate bonds and senior secured loans – could face real and permanent capital loss.
As detailed in our recent Cyclical Outlook, “From Hurting to Healing,” the global economy and financial markets will likely transition from intense near-term pain to gradual healing over the next six to 12 months. Although substantial risks remain, our base case foresees a global U-shaped recovery (see Figure 1). However, the trajectory
might also resemble a W should the virus come back in a second wave.
As investors, we cannot rely on a modal forecast of a U-shaped recovery. We must stress test and manage against a potentially more nefarious W-shaped trajectory in both the healthcare crisis and financial markets. A second wave could be devastating for downgrades and defaults.
STABILIZING THE CORE
In the U.S., Fed and Treasury policies will go a long way toward distributing capital throughout the financial system, helping markets function and supporting a recovery in the real economy.
In addition to the support for Treasuries, mortgage-backed securities (MBS), investment grade credit markets and money markets previously announced, the Federal Reserve on 9 April announced an additional $2.3 trillion in lending capacity, including several new lending facilities.
Most notably, the Fed broadened access to its corporate primary- and secondary-market lending programs. These no longer exclude companies that were rated investment grade on 23 March (when these programs were announced) but had subsequently been downgraded to high yield. We estimate this could expand eligibility to 100 or more companies with $500 billion in bonds outstanding.
New Fed facilities will support the flow of credit to small- and medium-sized businesses, many of which have been decimated by mandatory business closures, as well as to state and local governments facing a decline in tax receipts.
We believe these measures will help stabilize the “safest” core asset markets – those for Treasuries, agency MBS, high quality corporate bonds, securitized debt and municipal bonds. Since 23 March, when the Fed increased the quantitative easing program, agency MBS spreads have recovered from extreme valuations, Treasury market liquidity has returned, relative value has normalized, and credit markets have reopened for investment grade companies.
Still, markets are by no means back to normal, and the financial system remains fragile and dependent on central bank support. Given the size and scope of economic and financial market disruptions, it will take time to fully restore financial market functioning, and the Fed may be unable to prevent stress in the riskier segments of the market.
CONCENTRIC CIRCLES – MODELING RISK AND RETURN
In times of crisis, a strong framework for assessing risk and return is especially critical. Since the financial crisis of 2008, PIMCO has benefited from a concept of concentric circles (see Figure 2). It places the most liquid, least-risky asset classes at the center, and populates outer rings with increasingly less liquid and riskier segments.
Although the pandemic continues to buffet components of the circles, it’s instructive to review the performance of asset classes over the three phases that have played out so far:
Phase 1 (late February) – Hope and Hedge: Investors uncertain about the outcome and severity of the COVID-19 outbreak held on to risky assets and hedged by purchasing high quality government bonds, driving down yields.
Phase 2 (mid-March) – De-risk, Delever, Liquify: As investors shifted from hoping for a V-shaped recovery to a more realistic U-shaped trajectory, they de-risked portfolios and sold assets – in some cases voluntarily to increase liquidity, but in many cases quickly to meet margin calls. In this second phase many assets normally considered relatively liquid, such as off-the-run U.S. Treasuries and agency MBS, came under significant pressure, which accelerated the de-risking and deleveraging process. It created a vicious cycle that pressured inner-perimeter assets, including commercial paper and securitized products rated AAA, before eventually ravaging credit markets.
As liquidity dried up, credit sectors in March generally suffered their worst month since the financial crisis.
As Figure 3 shows, spreads widened across a wide array of assets as investors sold, and some segments sank to record lows (see Figure 3).
Phase 3 (current) – Opportunistic offense: With the circuit breaker of central bank policy now in place, investors are seeking opportunity from volatility, crisis, and underperformance.
However, we don’t expect markets – nor some of the components of our concentric circles – to return exactly to their pre-crisis positions. Investors may think differently about liquidity, leverage and volatility given the government’s involvement in some markets and not others. Also, the outlook for interest rates, growth, and consumer preferences toward savings and consumption could be forever changed.
As liquidity returns to markets, it will flow and settle in new patterns. While markets remain volatile, here are our current high-level sectoral views on risks and return opportunities, beginning in the heart of the circle and working outward.
The commercial paper (CP) market remains strained. Conditions have improved since March, when the Federal Reserve slashed rates, targeted the fed funds rate to near zero and announced the Commercial Paper Funding Facility1 to support the flow of credit to households and businesses. The secured overnight funding rate rests just above the zero lower bound at 0.01%. Although spreads for top-tier CP rated A1/P1 have tightened, rates remain as wide as 1.5%, while those for lower-quality CP (not included in the program) remain challenged north of 2.5%.2
U.S. Treasuries likely remain the best source of diversification and potential price appreciation in a downside scenario – though clearly less so than in the past given the starting point of yields. Yields on U.S. Treasuries with short- to intermediate-term maturities will likely remain anchored by low policy rates for an extended period of time, even though the yield curve may steepen due to the size of fiscal stimulus programs, budget deficits and supply concerns.
Agency MBS (-3 bps change in spread level since start of health crisis)3
Agency MBS have begun to stabilize and should normalize as one of the most liquid segments of the market. The Fed has provided critical support, stopping the runoff of these securities from its balance sheet and announcing a robust buying program on 9 April. Mortgages will likely continue to perform well in a liquid and high-quality market that remains cheap on a longer-term valuation basis.
U.S. Treasury Inflation-Protected Securities (TIPS) (-42 bps)
TIPS remain attractive in our view. We expect a recovery as liquidity conditions normalize with continuing Fed purchases. Also, the Fed is likely to keep rates low as we believe they want to see an inflation overshoot and stimulate the economy for some time. TIPS also may serve as a cheap hedge in portfolios.
Non-agency MBS (Legacy: +285 bps; senior AAA RPL +130 bps)
Valuations in the broad non-agency mortgage market fell by roughly 10 percentage points in March as spreads widened on all risk assets. However, fundamentals for senior legacy non-agency MBS will likely remain robust over a wide range of economic environments thanks to low loan-to-value ratios, substantial homeowner equity, and affordable debt service levels. Similar fundamentals and opportunity exist in senior reperforming loan securitizations. However, concerns over fundamentals or solvency could weigh on mezzanine or credit risk transfer notes.
Senior AAA commercial mortgage-backed securities (CMBS) (+85 bps)
CMBS are unlikely to suffer losses thanks to cash flows that remain resilient across a wide range of economic scenarios. The widening of spreads likely reflects liquidity and complexity premiums rather than true fundamental credit risk. Notably, no senior CMBS bonds took a loss during the financial crisis.
Senior AAA collateralized loan obligations (CLOs) (+88 bps)
CLOs rated AAA offer similar opportunity as CMBS. Wide spreads likely reflect liquidity and complexity premiums rather than fundamental risks. Senior CLOs embed investor protections, 35%-40% hard credit support, protection through equity and mezzanine tranches, and have excess spreads. The typical CLO can likely withstand losses in the underlying pool of bank loans of 40%-45% before becoming impaired. Clearly, the fundamentals are much more supportive than the underlying bank loan market, so risk-adjusted returns should be much better.
Investment grade credit (+131 bps)
Investment grade credit markets began to normalize after the Federal Reserve took an unprecedented step by creating two programs to buy investment grade corporate credit on 23 March, facilities that were expanded on 9 April to include companies recently downgraded to high yield. One program will buy newly issued bonds and the second will provide liquidity to the secondary market. Both programs will focus on high quality, short- and intermediate-maturity bonds.
However, despite a growing list of attractively priced opportunities, we must caution that only securities that remain under the umbrella of central bank protection could be considered as “safe-spread” assets. There will likely be technical support for the debt of high quality companies and fallen angels (companies rated BBB- downgraded to high yield), but asset purchase programs can only bridge liquidity gaps; they cannot cure flawed fundamentals or over-leveraged capital structures.
U.S. municipal bonds/UST ratio (+99 bps)
U.S. municipal bonds are benefiting from a variety of government support programs – with the exception of longer maturities, although those tenors are also beginning to recover. While beholden to flow cycles, municipal bonds still present a good opportunity as spreads to Treasuries are wide and yields relative to comparable corporates remain competitive.
Emerging markets (EM) external (+275 bps)
EM will likely take time to recover and may rebound fully only once the lasting economic implications of the pandemic are fully understood. However, EM should benefit from abundant liquidity. In the near term, we favor U.S. dollar-denominated high quality sovereign and corporate issuers. We take a cautious stance on lower-quality, oil-exporting countries. As always with EM, fundamental research and security selection will drive results.
High yield corporate bonds (+441 bps)
High yield bond spreads have widened dramatically, yet we believe fundamental challenges have yet to be fully priced in to the bank loan and other high yield markets. We remain cautious due to rising leverage and the potential for high and unpredictable defaults. Stress on many borrowers’ balance sheets is likely to emerge later this year given the high degree of leverage in the bank loan and high yield markets.
NEW CONTOURS, RISKS AND OPPORTUNITIES
Even as unprecedented liquidity and support begins to buoy some markets, significant uncertainties remain. As investors we are constantly reminded in our day-to-day lives that this is first and foremost a public health crisis. The outlook for financial markets largely depends on the outlook for the real economy. How quickly we can return to some form of normal is dependent on treatment and testing.
Our base case is for a deep but short-lived recession and a U-shaped recovery. We cannot, however, dismiss the notion that there will be false starts. The risk of an uneven recovery and permanent capital impairment certainly exists. This is a highly uncertain environment that warrants caution and humility.
With uncertainty comes opportunity. PIMCO’s concentric circle framework provides a strong roadmap to opportunity. Markets will heal from the lowest-risk, most liquid inner-circle assets and improvement can then progress to the riskier areas at the outer perimeter. This environment will certainly favor a coordinated, disciplined and patient approach, which is the main strength of PIMCO’s time-tested investment process.
Please see PIMCO’s “Investing in Uncertain Markets” page for our latest insights into market volatility and the implications for the economy and investors.