315 billion reasons to like high yield bonds?
According to Fidelity International, roughly $215 billion of US debt and €100 billion of European...
“I have never been so sure that we are going to have a recession.”
Those were the first words of Richard Woolnough, manager of M&G Optimal Income, M&G Strategic Corporate Bond and M&G Corporate Bond funds, when he began a webinar on Tuesday 17 March 2020, to give us his updated views on bond markets.
Usually, a recession is caused by an over-heated property market slowing, or a high oil price or a monetary policy mistake. This is not the case today. As Richard says: “It is a ‘stay at home’ recession and will result in a collapse in economic growth.”
Basically, people have been instructed to stay at home – and with good reason: to curtail the spread of the Coronavirus. But it also means we have stopped consuming (with the exception of toilet paper and pasta) and we have stopped manufacturing. And this is worldwide and instantaneous: something that has never happened before.
“We can all observe the dramatic fall in daily activity around us,” he said. “Discretionary spending has been curtailed, and the most expensive discretionary spend, travel and tourism, has been hit the most.”
“Fortunately, we enter this recession with already very accommodative monetary policy from central banks,” Richard continued. “Monetary policy takes about two years before we can see its effect in the economy. For example, we saw a slowdown in 2018 – a couple of years after the US Federal Reserve (Fed) increased interest rates in 2016.
“Today the economy has the lead: the Fed stopped hiking rates in early 2019 and then proceeded to cut them. While the European Central Bank has limited scope to react due to its already rock bottom policy rate, the Fed and the Bank of England do. Monetary and fiscal policy are both options.”
Recessions are also usually described as V or U-shaped – there is a very sharp downturn, followed by a sharp upturn in a V-shaped recovery, while the downturn lasts longer in a U-shaped one.
Richard believes that this recession could be T-shaped: the first leg will resemble the U-shaped form. “It will be vertical and dramatic, and the largest ever collapse in GDP on a weekly and monthly basis in many countries,” he said.
“But we know why this recession is happening and we can even strongly postulate how it comes to an end. Different governments and central banks are therefore working on measures to get us through the short-term GDP ‘flash crash’. This has allowed the authorities to act in a bold and aggressive manner that is in itself different.
“The bounce back will be enormous. As the population is told to get out of the house and consume again, economic data will show a rapid rebound: it will not be a V or a U, rather it will look like an l. It will also be the biggest ever jump in GDP on a weekly and monthly basis in many countries.”
“This dramatic collapse and recovery will cause some longer-term damage to the economic system,” Richard said, “Firstly, from an overall business and personal confidence level, and secondly due to the unprecedented nature of the severe short-term pain of the recession.
“Human behaviour may change, and vulnerable companies relying on short term discretionary spending will have been weakened and potentially permanently impaired. While some consumption will just be deferred (buying a car, for example), much will be lost (going to the cinema). On the positive side, unlike most other recessions, developed economies exhibit very low unemployment and considerable numbers of the population will remain employed and many businesses can remain stable. Hopefully there will be fiscal support for those who struggle more.”
Richard believes that post-recession growth will return to normal, but initially will be unlikely to regain its previous levels. This makes this type of recession t-shaped: a sharp pull down, a sharp rebound and then back to the normal economic cycle, at probably a lower level than before – “Unless the policy response overwhelms the downdraft, in which case we return to where we were before (T not t),” he said. Different countries will have different outcomes.
“For credit investors during this time, it is important as always to differentiate between credit qualities,” Richard said. “While high yield defaults can be expected to rise (previous recessions have seen up to 30% of high yield companies defaulting over five years), investment grade companies are so-called because they should survive (with closer to 2% of companies defaulting over five years in times of stress).”
The M&G Optimal Income fund is a strategic bond, so it can invest in all types of fixed income.
Going into the global healthcare crisis the fund had a good weighting to government bonds (around 36%) and was underweight high yield, which helped. It was overweight investment grade corporate bonds which hurt.
“Our government bond exposure was very high,” Richard said, “not because of COVID-19, but because generally, valuations had got very expensive.
“Over the past week or so we have started buying index-linked bonds as they got very cheap – especially in the US and Europe – relative to conventional bonds. This is because the oil price has fallen from around $60 a barrel to $30 a barrel. If this reverses, there will be a bounce in inflation.
“The weak companies and those with the most debt will be vulnerable,” he continued. “So, where we are invested in high yield companies, it is mainly those that are almost investment grade.”