The crash in credit markets this week was tantamount to the 2008 financial crisis. Spreads widened at unprecedented velocity, in extreme trading volumes. US and EU HY indices were down about -7%, with record outflows. Credit markets were resilient until this week. However, the unexpected oil price war and the accelerating virus expansion in Europe and the US helped credit markets catch up with the rest of the market. The corporate sector is facing a twin supply and demand shock for an unknown period. While US companies’ inventories would give them about 1 to 2 months before disruptions appear, their liquidity situation is more vulnerable after years of releverage and covenant easing. Unsurprisingly, the negative contribution to credit performance from the energy sector, which makes up about 10% of HY indices, was severe.
Market liquidity dried up, as demonstrated by surging bid-ask spreads, extreme credit implied volatility, and falling primary dealer corporate bond balances, reflecting growing concerns about broader financial stability.
Following monetary announcements of rate cuts, asset purchases, and short-term liquidity measures on the one hand and more serious fiscal expansions on the other, markets staged a tentative rebound on Friday. In particular, measures of liquidity stress improved. Credit valuations, now more consistent with a recession, look more attractive if a systemic liquidity squeeze is avoided. However, sentiment remains highly fragile with no signs of virus containment in the West, risk of virus re-acceleration in China, limited clarity on the economic impact from mobility restrictions, and uncertainty about the seasonal nature of the virus.
Over this memorable week, our L/S Credit peer group was down only -1.7% as of March 12. Managers have long held a defensive positioning. After cutting exposure to issuers sensitive to Chinese supply chain disruptions in February, managers further cut positions exposed to weakening tourism, leisure, discretionary retail, or issuers sensitive to South Korea and Italy. Managers adequately used the window in credit markets to reduce exposures when other markets nose-dived. This week, managers reported losses in Italian, energy and some EM issues.
While managers see a strong pipeline of opportunities, the majority expect that the bottoming process will not be over in a night. Pressure remains on leveraged companies, with the news flow from downgrades and defaults expected to remain adverse. They are waiting for stabilization in flows, concerned that downgrades (in the energy sector especially) could inflate the HY supply, potentially triggering further selling. They are also closely monitoring the bank credit segment, a key marker for liquidity.
Managers are rebuilding long exposure to more liquid indices and/or shorts on CDS indices. Their underperformance relative to cash bonds suggests they could lead the recovery. They hold limited shorts on single bonds and steer clear of energy issues, two areas vulnerable to a short-squeeze. Meanwhile, they maintain a high level of cash and favor defensive issues vs. cyclical. Managers are spotting deep dislocations and oversold issues, with high alpha potential amid extreme credit dispersion. However, most managers are focusing on getting the market timing right. They are not yet redeploying thematic and fundamental approaches to buying opportunities; credit issues remain highly correlated with limited room for pure bottom-up alpha.