Fixed Income Update: As Market Dislocation Continues, Opportunities Emerge

Matt Toms

Fundamentals drive technicals, and technicals drive price—it’s time to own durable yield for the zero interest rate world ahead.

Higher quality debt has been hit disproportionately hard by the recent market dislocation

  • In times of strain, investors sell what they can sell—not what they want to sell—and the higher liquidity and price transparency of higher rated/quality debt has made these instruments easier to sell, which means they have been more susceptible to the recent technical dislocation in the fixed income markets.

Expect volatility to continue

  • Despite the recent announcement of “unlimited support” from the Federal Reserve, the technical dislocation in the fixed income market will likely persist in the short term and potentially accelerate over the next several trading days, as Asset Allocation investment strategies will be forced to sell fixed income assets and buy equities in order to get back to their target risk weightings at month/quarter end.

Pull to Par: Short-term mark-to-market volatility is painful, but this environment is a buyer’s paradise for long-term investors  

  • Reminder: During the depths of the 2008 crisis spreads for AAA and AA rated CLOs blew out to distressed levels but these instruments ultimately experienced no losses. On the other hand, AAA-rated CDOs backed by one giant pool of subprime junk mortgage debt didn’t fare so well and are almost non-existent today.
  • When market selling is indiscriminate and technical dislocation is extreme, the risk you owned heading into market volatility is just as important as where you choose to capitalize on opportunities created by the dislocation.

We retain our bias towards Securitized Credit

  • Heading into this market shock, fundamentals were generally supportive across the consumer, housing and commercial real estate markets and we entered this recent period of volatility with a bias towards securitized credit because of the sector’s exposure to these strong fundamentals.
  • In the middle of this market storm, we retain this bias in our portfolios as our central case remains that meaningful and forceful monetary and fiscal stimulus will help the U.S. and the world recover from economic fallout.
  • This means accessing these same general risks at meaningfully wider spreads is an extremely attractive starting point for asset allocators. 

Time to own durable yield for the Zero Interest Rate world ahead

  • Going forward, fundamentals are likely to be defined by a sharp global recession followed by a stubbornly low growth world coupled with the odd bedfellows of high debt levels and low risk free interest rates.
  • There is no need to be a hero in the current fixed income environment. Opportunities to earn outsized yields through high-quality investments with high conviction, low risk outcomes are bountiful.

The Current Market Dislocation

Fundamentals are currently defined by an energy price war and by a global pandemic. While there are many other fundamental factors to take into account, these two overarching fundamentals are driving the market’s outlook currently. Clearly, the financial markets are forecasting a global recession, and rightly so as these two factors influence every country and economy in the world concurrently. 

These fundamentals have led to technicals that have been driven by fear and by the GLOBAL need to raise U.S. Dollar funding.  While monetary policy is seeking to deploy cash rapidly, insufficient readily accessible sources of funding have driven market participants to sell U.S. dollar assets with great speed.  The degree of the leverage unwind outside of the banking system is comprehensive and problematic in its scale.

The growth of Private and alternative asset markets has likely exacerbated this impact as private market lock-ups lead to a portion of investor portfolios being largely ignored in time of liquidity needs.  This forces the remaining public stocks and bonds in investor portfolios to provide all of the necessary liquidity in times of stress.

Up is Down? The Technical Dislocation is Hitting Higher Quality Debt Harder than Lower Quality Debt

With this fundamental backdrop, the market technicals in public debt markets have led to massive selling in nearly all types of assets – hunting for cash instead of for yield.  In times of strain, investors sell what they can sell…not what they want to sell. The higher liquidity and price transparency of higher rated/quality debt has been a technical beacon, driving selling into higher quality assets disproportionately relative to lower rated assets. In securitized credit, execution in the grab for cash is further impacted by cusip level valuation components that become overlooked and are inherently less hedge-able, uniquely exacerbating the dislocation. 

Buyer’s Paradise: Technical Volatility Will Likely Accelerate into Month End

This technical force has caused massive price distortions in fixed income markets that will prove unsustainable. Risk is transferring to more appropriate holders, deleveraging is occurring where necessary, monetary policy will take root and panic will ultimately abate. However, in the short-term, despite recent announcements of “unlimited support” from the Federal Reserve, this market pressure will likely continue and technical forces already in play are likely to grow over the next several trading sessions. Bond markets will continue to ready themselves for the collective and autocorrelated rebalancing of Asset Allocation products that are required to sell fixed income assets and buy equities in order to get back to their target risk weightings at month/quarter end. For long-term investors, this environment will create a bounty of opportunities to purchase fundamentally sound investments at steep discounts. Investing into these flows ultimately represent the opportunity in fixed income for this nascent decade.

Certainly, many very dark tail scenarios can be feared, but in our opinion, the central case moving forward sees fundamentals defined by a sharp global recession followed by a stubbornly low growth world coupled with the odd bedfellows of high debt levels and low risk free interest rates.  The lack of a “V” shaped recovery is likely to result in the higher risk areas of the corporate bond market facing a persistent fundamental headwind moving forward. Also, the degree of the increase of the size of these markets over the past 7 years leaves the corporate space more exposed to the crowding out effect to be caused by the massive increase in government borrowing globally that is about to ensue. As this plays out, we expect the factors driving current market dislocation—technical selling pressure (driven by fear), leveraged unwinds, U.S. dollar funding needs, and portfolio rebalancing—will abate. 

As this happens, less distressed and more rational markets will begin to highly value the yield and income opportunities currently available in highly rated fixed income instruments in the Zero Interest Rate Policy world that lies ahead.  Today, there is no need to be a hero in fixed income markets as high quality opportunities with high conviction, low risk outcomes to earn outsized yields are bountiful.  

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This commentary has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults, (5) changes in laws and regulations, and (6) changes in the policies of governments and/or regulatory authorities. Past performance is no guarantee of future results.