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Fixed-Income Update - 3.19.2020

The wild oscillations in the equity markets have made the headlines recently, but we believe all eyes will soon be on fixed-income markets. As we wrote earlier this week, the Treasury and Agency MBS (mortgage backed securities) markets that underlie much of the financial system were experiencing unprecedented illiquidity. The Federal Reserve has announced a series of programs to mitigate the liquidity issues, although it appears that they may have to increase the size of their purchases at this point.

As you can imagine, if the most liquid assets on the planet are having liquidity issues, then it is even worse in the credit (non-government bond) markets. Indeed, we are witnessing unprecedented illiquidity in credit too. As volatility increases and liquidity declines, it is very difficult to value bonds. Much of the market is frozen, except for forced transactions such as liquidations and distressed sellers. Being forced to sell into an illiquid market with no bids is not something anyone wants to do, but some investors are forced to do it. Imagine a mutual fund or ETF receiving investor redemptions; those funds HAVE to sell. Or a hedge fund that has borrowed to buy more assets than it started with; if the value of those assets start falling, then the lender will liquidate the fund's positions for them. These are some simple examples, but there are much more complex examples that have imploded in this and past cycles.

How is this impacting fixed-income funds? Fixed-income fund "net asset values" (NAV) are typically derived using the "bid" (the price that someone is willing to buy a bond for, rather than the "ask" or what some is willing to sell for). So, what happens when a market is frozen and there are no bids? What happens when nobody wants to buy and everyone knows that there are forced sellers and bids are lowered to fire sale prices? This is what is happening right now. NAVs are all over the place within the fund universe. Within the ETF universe, we are seeing many ETFs trade at deep discounts to NAV which indicates that investors do not trust the ETF's reported NAV.

Regarding investment vehicles and fund selection, this environment highlights a few key points:

  1. As we often counsel, avoid fixed-income index funds and fixed-income ETFs. They do not possess all of the tax benefits often associated with equity index funds and equity ETFs, yet they carry additional risks. We will not dive into the mechanics here, but they are well documented for those who want to do some online research.
  2. If invested in an open-end fund (such as a mutual fund or ETF), evaluate the fund's investor base. Is it retail investors or institutional investors? Does the number of shares outstanding appear stable over time or does it have large moves up and down? Investors should look for a committed investor base that will not flee when prices are falling.

What facts do we know today?

  • Liquidity has evaporated. Even government-backed securities like MBS are having issues.
  • Many funds are having difficulty pricing their portfolios.
  • There are forced sellers driving values down.

We believe much of the selling is warranted, but some of it is not. We believe the key to long-term outperformance to lose less on the downside and really capitalize on the upside.

Although the relative safety of Treasuries and Agency MBS (mortgage backed securities) is being called into question during this latest bout of volatility, the US federal government is the only entity that can create US dollars to pay its debt. Although the prices may move differently than we expected, we view these as having zero credit risk and believe some of these assets are being mispriced.

Many "investment-grade" assets have sold off just as sharply as lower-quality assets in the past few days. Our view is that a lot of the assets that people thought were investment grade are actually below investment grade, including A LOT of "investment grade" corporate credit. However, there are some quality credit assets that are being punished harshly, such as agency CMBS (backed by the government) and other AAA-rated assets (rather than single A or BBB, which are also considered investment grade). Although it is painful to see high-quality assets decline in value (for investors who own them), it is also a great time to buy these assets as we believe that they are selling at deep discounts. This is where investment vehicle selection, investor base, and portfolio management matter, as investors need to be able able to capitalize on these market dislocations. The past two weeks have been a bumpy ride for fixed-income investors and we expect the volatility to continue, but we believe this environment is one of the best opportunities that well-prepared investors will ever see.