Pandemic takes massive toll on bond markets

These are extraordinary times for all financial markets, with the corona pandemic driving exceptional levels of movements and stress, in some cases worse than the Global Financial Crisis.

Although focus has been on the stock market, the impact on credit and bond markets has been just as dramatic and even more surprising.

We’ve seen a rush for liquidity. Offloading assets has pushed corporate bond prices to the point where there appears to be a massive disconnect between the fundamental value of corporate bonds and the values trading in the market, assuming we don’t get a severe recession and a multi-year default cycle.

Participants scrambling for cash are selling them at prices far below what they would normally be worth. Changes to allow those in hardship to access their super means superannuation funds are also being driven to cash up.

Lower risk “investment grade” corporate bonds and higher risk “high yield” corporate bonds have seen their prices plunge over the past six weeks. Even riskless assets like Government bonds have come under stress at times.

Aside from a potential investment opportunity, current corporate bond pricing may have significant economic implications, making it very difficult for companies to efficiently raise funds with the cost of capital very high. This means companies may make fewer investments and there will be less economic growth.

Current bond pricing is in many cases is implying a very dire future. If you take current bond valuations as a direct sign of what the market expects in terms of defaults, it says we are heading for a very deep recession, with a large number of corporate defaults.

This pessimistic scenario is not the base case of most in the market and, looking at other markets, is not reflected in the value of equities.

The bonds from major banks like NAB, and indeed a large portion of the investment grade universe (bonds rated BBB and higher), are most often very large, well-capitalised investments – there is a high degree of confidence within the market they will be paid back.

The level of defaults and losses in investment grade bonds has traditionally been very low, even under the most extreme of events including 9/11, the GFC, and the 2000 recession, but now sellers appear to be putting valuation approaches out the window.

Investment grade bonds like NAB, which might have been trading at 100 cents in the dollar in February, were sold down to 95 cents in March – which doesn’t sound like a big move, but it is for bonds.

High yield corporate bonds have been particularly hard hit. Some high yield company bonds, which normally trade around 89 cents in the dollar, are trading in the 50 cent in the dollar range.
This disconnect gets wider with less secure and more complex bonds. The more “credit heavy” the investment, the bigger the market punishment. Some of these bonds are trading in the 40 cent range.

We’ve seen wild price fluctuations in even government bonds, faster and further than even those movements seen in the GFC. There was a mini “flash crash” in Australian Government bonds in mid-March, with prices falling (yields higher) by 100 basis points in 60 seconds. That’s an enormous move, never seen before.

This disconnect between fundamental value and what is trading in the market is wider than we saw even in the GFC, which was a major shock to the financial system which had material and long-lasting implications for the global economy.

We hope the current situation is a temporary, virus-induced crisis and we could be back to something approaching normality in 12 months, but, particularly in high yield corporate bonds, market pricing implies close to depression-level defaults.

For those comfortable with some risk and complexity, with a long-term investment horizon and willing to tolerate potentially more volatility over the short to medium term, there appears to be significant opportunities. Levels of return in many sectors of credit are higher than you would traditionally get in equities.

Credit looks cheap provided we don’t get a multi-year default cycle. While that is not our base case, in the uncertainty of the current world, you can’t completely rule that out.

We can’t predict the future and be assured a deep recession won’t come, but the current credit market is pricing in a very pessimistic scenario, and does not reflect the recovery in recent weeks of equities.