Financial conditions have tightened sharply amid the sharp plunge in risk sentiments with evidence of widespread dislocations across markets. Specifically, perceptions of credit quality across a wide range of asset classes have deteriorated with market liquidity drying up. As a result, credit spreads and market measures of corporate and sovereign default risks have widened considerably.
G7 yields are currently reacting to the elasticity of aggressive monetary and fiscal policies. The first and swift response of global authorities was to employ monetary easing to act as buffers to the permeating adverse effects of Covid-19 and the subsequent fall in yields and disruptions to short-term funding. The US Fed has followed up this week with the activation of a commercial paper funding facility (CPFF) that acts as a backstop in times of crises to provide short-term funding to corporates. Technically, the CPFF is a special purpose vehicle that will purchase unsecured and asset-backed commercial paper directly from eligible companies by facilitating new primary issuance. The objective of CPFF is to restore liquidity by heading off any credit squeeze by helping US businesses raise cash to meet payrolls, inventory payments and other short-term liabilities at a time of shrinking cash flows. For instance, even established companies like Boeing are now tapping bank credit lines. There have been concerns among some money market funds who invest in commercial paper (CP) that they will face outflows. The move by the Fed will hence relieve pressures on the CP market.
Elsewhere around the globe, we have also seen leading central banks including the European Central Bank (ECB) stepping up quantitative easing (QE), bond buying programmes as well as slashing rates on currency swaps to raise liquidity by a few notches and ease the impact of Covid-19 on the global banking system.
The credit spread of global investment grade (IG) benchmark index has widened from a low of 97bps at end-Dec 2019 to 262bps as of 18 Mar 2020 with little regard to fundamentals. Secondary market liquidity conditions have sharply deteriorated in the IG market. For instance, illiquidity indicators and bid-ask spreads have soared to levels comparable to those seen at the height of the global financial crisis (GFC). We note that the broker-dealers’ capacity to provide liquidity have since shrunk considerably following post-GFC regulations (i.e. broker-dealers are no longer able to expand their balance sheet and commit principal capital at times of greater demand for liquidity).
Asian & Emerging Market (EM) credits
Asian credit markets went through one of its most difficult times this week entering what seemed to be a liquidity vacuum with bonds encountering problems finding a home. Credit spreads ballooned indiscriminately across sectors regardless of tenors with little regard to fundamentals. The riskier high-yield segment was heavily bashed with the JPM Asian credit non-investment grade bond index widening by 291bps – from 592bps as of end-Feb 2020 to 882bps on 18 Mar 2020; while its IG peers widened by 74bps from 200bps end-Feb 2020 to 274bps as of 18 March.
EM fixed income is currently undergoing a drastic market dislocation with little to no market liquidity. The situation has been exacerbated by outflows and fund redemptions, which has resulted in indiscriminate selling and little regard to fundamentals. That said, in terms of magnitude, oil-related EM sovereigns – such as Angola, Ecuador – are experiencing greater price weakness which has pushed the spread of the JP Morgan EM Global Diversified Index wider by 261bps from end-Feb 2020 to 18 Mar 2020.
Fixed Income Outlook
With the massive negativity, capital markets may possibly remain shuttered in the months to come, adversely impacting funding supply. Concurrently, default risks are set to rise as the sharp drop in consumer demand has caught many corporates off-guard.
As such, we will continue to scrutinize issuers’ profile for adequacy and advocate more defensive positioning, including keeping more cash in the near term. We are maintaining in our base case scenario that the global economy will slow down significantly in 2Q20 and 3Q20 in the wake of current heightened measures taken by governments – including countrywide lockdowns and travel bans – to arrest the onslaught of the Covid-19 with the likelihood of recovery being pushed back to 4Q20.
Having said that, the easing of financial stresses amid the massive QE and hence liquidity injected into the global system will likely be a strong catalyst for a sharp market rebound when the situation turns around with the incentive to put cash back to work and the resumption of hunt for yields. We remain positive over the medium term with a view to capitalise on pick-up in yields from IG credits given the zero rates environment. The key is to stay calm and defensive to ride through this period of illiquidity and be selective in our picks. There will definitely be opportunities for very decent returns on a medium-term investment horizon.
We maintain our preference for EM-Asian IG credits given the relatively higher buffers against fundamental deteriorations. Over a more intermediate time horizon, we will continue to be mindful that the risk-return profile for spreads remain skewed to the downside should global growth weaken more than expected. As such, we advocate defensive carry as the primary return driver until there are sustained positive developments on the Covid-19 front.
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