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Nowhere to hide as credit risk soars

Glenn Freeman  |  19 Mar 2020Text size  Decrease  Increase  |  
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Investors should keep a close eye on default risk in their fixed income portfolios as the coronavirus sell-off punishes those holding high debt companies.

Credit risk looms largest on the radar for investors right now, overshadowing interest rates and the sliding Aussie dollar, says John Likos from BondAdviser.

Bid-ask spreads - the gap between what you pay to buy a bond versus the price of selling - have hit levels not seen since the GFC in 2008. This reflects rising fears that highly indebted companies won't survive the coronavirus contagion, Likos says.

The Vanguard Australian Corporate Fixed Interest Index fund is one of the most prominent examples. On Wednesday, the sell spread hit 1.79 per cent, from 0.15 per cent.

"If you're invested in in credit markets, you're accepting that liquidity has literally disappeared, and you can see that with bid-ask spread having gone from 15 cents to about $1.80.

"That means no one wants to buy; everyone is moving to cash and liquidity has disappeared."

Likos says investors - institutional and retail - now fear this liquidity crisis may turn into a credit default risk environment. Fund managers are feverishly scanning portfolios to weed out smaller or highly exposed companies at higher risk of failing to pay back what they owe.

Hybrid Bid Ask spreads during covid-19 

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credit spreads

Source: BondAdviser

House prices hang in the balance

The threat of job losses as recession looms is ratcheting up the risk of defaults on home loans, Likos says.

"Some are starting to price in a greater probability of a house price correction in Australia as a second-order effect of the coronavirus.

"I'm sure there will be a lot more houses up for sale in the next month."

In sovereign debt, falling interest rates mean the yield on government bonds is rising. "People want liquidity, they want cash, so they’re selling what's liquid: treasuries,” Likos says.

"Globally, there is now an expectation of huge bond issuance all over the world, it will be everywhere.

"The US is going to issue up to its eyeballs as part of this helicopter money. And the expected supply is resulting in a reversal of government bonds that are climbing back up."

Is fixed income a safe haven?

“No” is the short answer currently, given the wild swings in financial markets.

"The only safe haven in this market now is cash, because we're even seeing treasuries selling off," Likos says.

"You're seeing some opportunistic buyers starting to deploy some of that cash, but it's incremental and early stage. The market doesn't know what to expect, so it's only happening around the fringes."

Likos says those investors brave enough to start buying any decent volumes at the moment are only looking to deploy small amounts of their capital, "maybe up to 10 per cent."

What it means for you

Investors are being urged to examine whether the companies they own have any upcoming need to refinance loans.

"Because there are serious questions around whether they can refinance in this market. You don't want to be holding companies that've got refinancing coming up," Likos says.

But at the same time, Likos says now is absolutely the worst time to sell out of companies if you believe in the viability of your holdings. He refers to senior unsecured notes, such as major bank bonds, as an example: "they've been hit, but if I believe they're not going to default I'm not going to sell."

In this context, investors need to hold companies with high quality earnings and low debt.
"Because when there's a resolution on covid-19 those companies will snap back as fast as they've fallen," Likos says.

"Those that won't will be the leveraged ones that have been assigned a greater probability of failing."

Will a rate cut help?

Likos hangs little hope on the out-of-cycle rate cut by the Reserve Bank, as interest rates were dropped to a new historic low of 0.25 per cent on Thursday.

"It didn't have much impact in the US. And I expect it to be a relatively neutral reaction here," he says.

"In other words, if the market goes up one day, it'll go down the next."

Likos says people are concerned about the coronavirus epidemic continuing to swirl out of control, not about interest rates. A rate cut will do little to allay fears that the virus will spread, he says.

"Until there's a solution to the virus, this market is going to continue to be very volatile.

"But when the market is comfortable with the covid-19 situation, there is going to be so much money in this system that the snapback is going to be rapid for the high quality names.”

On the flipside, the lower quality companies can expect severe negative fallout.

Duration plays are tricky

In terms of duration - investing in either shorter-term government bonds of 3- or 5-year or longer term 10- or 30-year duration - "that's a really difficult play," Likos says.

The 3-year bond rate is at 0.5 per cent, having traded at 0.75 per cent in mid-February, and a low of 0.37 in early March.

The 5-year bond rate has also risen 40 per cent since March, to 0.65 per cent from 0.45 per cent, having traded at 0.8 per cent in mid-February.

Australia’s 10-year rate reached 1.22 per cent on Wednesday, and now trades at 1.16 per cent .

"What you're seeing is that short-dated stuff is yielding more than longer-dated," Likos says.

The upshot is that there's a greater risk of uncertainty in the near term than in the longer term, and that's reflected in the pricing of hybrids

is senior editor for Morningstar Australia

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