Credit & Fixed Income Markets
High yield and lower quality investment grade spreads have contracted precipitously over the past few weeks as a result of the Fed. This is seen in the graph below. The magnitude of these spread contractions imply that default risks have dropped by an extraordinary amount over that same period. Is that an accurate assessment? As investors we need to be compensated for accepting risk. Has default risk really decreased so dramatically over that period? Or, is it because the Fed has inserted itself so impactfully that they have artificially distorted the markets? You know where we lie on this issue, but it bears repeating. The Fed is impacting the capital markets in ways that has dramatically perverted fundamentals and in so doing has made it impossible for the markets to clear and function properly. No informed fixed income investor can possibly defend this reduction in risk in terms of the probability of economic contraction and thus defaults. Investors and savers continuously lose all opportunity to be rewarded for the risks inherent throughout the fixed income markets disallowing them to generate meaningful income. The Fed is responsible for this outcome. By using massive liquidity insertions and market intrusions they have effectively destroyed these markets. For anyone buying these bonds, you will not be compensated for the significant likelihood of defaults and bankruptcies that are going to happen over the coming quarters. Again, we preach patience.
CFOs will certainly be tempted to issue new paper to exploit the Fed’s foolishness. Why not stack up on cheap financing and build up cash knowing that the coming quarters are going to be very challenging for the real economy? After all, the Fed is signaling economic apocalypse by their actions so best to prepare for the worst. This leads to higher leverage and far less attractive fundamentals for the foreseeable future. This will certainly lead to more downgrades and meaningful turnover across bond portfolios. Moreover, it will make security selection throughout the credit markets more difficult and thus credit markets will become more speculative and volatile. How can the Fed exit then? They are setting up an impossible scenario for themselves. I doubt any of the Fed governors have even bothered to consider this outcome. They are about today with little regard for tomorrow. This treadmill of short termism is leading to the accumulation of higher and higher pressures that eventually must be released. Will it be gradual or sudden? We are certain that the continued destruction of one asset class (bonds) for the benefit of another (equity) can not last forever. Ironically, the Fed’s attempt to help markets in the short term may be ruining them in the long term.
Levels and Slopes
Another striking dynamic is the rate of change of the US Treasury level and slope over the same period. This is illustrated in our exhibit below. The 10-year US Treasury yield has collapsed over the past several months with about half of this collapse happening since the onset of the pandemic. This is a combination of a flight to quality along with massive purchases by the Federal Reserve both pushing up valuations. Simultaneously, the slope of the Treasury curve as measured by the difference between the 10Y and the 2Y Treasury yields has increased five-fold over the recent period. This is a result of monetary policy on the front end of the curve. As the Fed returned to a zero-funding rate, the entire front end of the curve was essentially forced to zero. So even with a massive reduction in the 10Y yield, the 2Y yield fell even faster and more dramatically resulting in a slope increase. Notice that the slope had turned negative (downward sloping curve) last year. The only way for that to happen at these levels is for the 2Y yield to increase and that will be difficult given monetary policy and what the Fed has stated off late.
Questions that we deliberate on daily include: Can the 10Y continue at these all-time lows as profligate monetary policy continues? At what point does the Debt/GDP tradeoff begin to influence UST yields? And when does the dollar begin to suffer? The answer to these questions must be managed with proper duration and yield risk management. Investment strategies must be deployed with a significant eye on liquidity and within a range of the term structure that enables an optimal duration to yield tradeoff.
Our final graph illustrates the level of monetary supply M2 over the same overall period. This clearly shows the insane impact monetary policy has had on the supply of money. The Fed has been purchasing all these assets while tendering the dollar in exchange. The result is a bloated Fed balance sheet, increase in the supply of money, and in the short-term lower Treasury levels and corporate spreads. The demand side has been dominated by the Fed. A major concern of bond managers, or risk managers, is how long can this dynamic last? As economic growth continues to be challenged, do spreads begin to reflect true default risk? Does the Fed insert itself again to suppress these price changes and continue to bloat M2 and their balance sheet? At what point do UST yields reflect M2 supply and inflation?
As portfolio and risk managers we manage our duration exposures with all these issues in mind. Currently, we feel that yields are extremely expensive per unit of duration. We therefore prefer the front end of the high yield curve and the lower quality IG curves. In assessing our exposures, we balance liquidity with income as a function of duration risk. We believe that we can more effectively manage our risk this way and ensure that we can nimbly alter allocations as opportunities present themselves. These opportunities may take place discretely and with proper management we will be able to move exposures profitably. As with the equity markets, the 800-pound gorilla is the Fed. Such exogenous influences make duration risk management less about fundamentals and more about watching monetary liquidity insertions. Either way, we are very confident in our current credit/fixed income strategies.