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Dolfin’s response to Covid-19

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Fixed income | Core: Rates

Investment outlooks / Q2 2020

As the implications of the Covid-19 crisis developed over the quarter, governments and central banks have acted fast by slashing rates and unleashing large fiscal packages to support their economies. Below is a summary of notable responses:

Monetary

  • US Federal Reserve (Fed): Unlimited quantitative easing (QE) of bonds, mortgages and investment grade (IG) corporate bonds
  • European Central Bank (ECB): €750bn via the Pandemic Emergency Purchase Programme (PEPP), €150bn Asset Purchase Programme (APP), targeted longer-term refinancing operations (TLTRO 3) for SMEs at -75bps

Fiscal

  • US: $2tn (10% of GDP)
  • Germany: €500bn (18% of GDP)
  • France: €300bn (12 %of GDP)
  • Italy: €250bn (12% of GDP)
  • Spain: €200bn (20% of GDP)

The impact of these cuts and stimulus measures has led to a collapse in yields across all major developed markets. It is still unknown exactly how long the lockdown of essential economies will last and this uncertainty means that yields will remain low for some time to come.

In developed markets, there is a case for government bond yields to remain low due to an increased scope for the period of muted economic activity to be extended. This is on top of carry-driven investments concentrated on the low-risk end of the spectrum and quasi-commitment from central banks to keep borrowing costs low to deal with unprecedented spending programs. It is the latter point that may be more poignant in the medium to long-term and ensuring that low yields (we do not see any normalisation of rates any time soon) are here to stay beyond the Covid-19 crisis. From a valuation perspective, no matter how we look at it, government bonds across the board are expensive on the whole.

Click table to expand.

The lack of yield in developed markets means that it is important to consider how the yield of each particular region compares to each other on a cross currency basis. The table below compares the yield in USD equivalent for most of Europe, UK and Japan against their US benchmark. It is significant to see that the Japanese government bonds actually offer a better yield in USD terms, with Italy and Greece of interest to those looking for excess yield. While this is not a factor at the current moment, as investors focus on their base currencies for the time being, it will become a more important factor for some as the situation normalises and we enter a “new normal” of low developed market government bond yields .

Click table to expand.

Over the quarter, as the market re-assessed its outlook on risk assets, there has been a flight to safety. Sentiment in the market has gone from greed to extreme fear and as such, participants have switched to a long government bond positioning to benefit from the perceived safety. The risk is a shift of sentiment where more risk appetite will lead to a sell-off in Treasuries to fund purchases elsewhere, in addition to risk of yields widening due to lack of value perceived in government bonds.

From a technical perspective, we are at all time low yields for developed countries and we have seen large inflows into government bonds. Analysis of mutual funds flows for US markets show that in the past month there has been an 12% increase in government holdings, 6% reduction in investment grade corporate holding and a 9% reduction in high yield. The pronounced flow into government bonds no doubt reflects a flight to safety. Investment grade corporates by the same token saw large outflows, with the focus on short and medium-term maturities. The stress in high yield quickly moved down the credit curve to infect investment grade as the close-down intensified. The drawing of credit line revolvers has been particularly marked in high yield where the stresses are greatest. Not only is there a classic elevation in default risk as economies jump to a recessionary state, but the collapse in the oil price is an additional stress factor in this space. What is also interesting is that there has been a matter of a 5% fall in inflation linked bond holdings, indicating that the market is seeing the Covid-19 event as one with a clear deflationary tint. For the time being, the central banks are the only dedicated buyers right now.

Click chart to expand. Source: EPFR Global, Dolfin.

Click chart to expand. Source: EPFR Global, Dolfin.

Click chart to expand. Source: EPFR Global, Dolfin.

US positioning

While there may be scope for yields to go lower and potentially into negative territory, in the case of the US, we do believe the Fed when it says it has no appetite for negative rates. This should leave interest rates with a credible floor. As such, with 2 years already offering a small 25 bps reward, we do not see great scope for either performance or for carry. In fact, when we perform our carry breakeven analysis (table below), it shows that it only requires a small adverse move in price to wipe out any carry earned over a 1 month or 3 month period especially for the short end of the curve. When we consider the relative value of Treasuries as a whole against inflation, we see that real rates are negative. Should there be a pickup in inflation due to the fiscal measures announced, these negative real rates become even more negative.

Click table to expand.

With T-Bills and Treasuries not providing reward for investors, our positioning for the US government market has had to undergo a re-evaluation. With the Fed now unleashing QE into the IG corporate bond markets via the purchase of IG ETFs, rates will remain range-bound in the short term and IG bonds will weaken due to the equity market sell off. As a result, for better risk/reward, we have decided to position ourselves as follows:

  • Substitution of T-Bills with strong IG names which are either cash rich and able to ride out the storm or have a case for strong national interest (i.e. defense related companies).
  • Locking in wide credit spreads on IG corporates which we believe have low default probability due to their balance sheets. This is the basis of the “Covid-19 resilience” basket that is discussed in greater detail within our credit section.

It is our belief that with yields in the US government market becoming unattractive, in the future it is more prudent to insulate portfolios against the projected future search for yield. Our basis for this is that US IG credit spreads will compress back to pre-crisis levels. In effect, we are potentially seeing the US government and IG credit market following the steps of their European counterparts after the European sovereign crisis.

Europe positioning

After initial missteps, the ECB restated its “whatever it takes” promise with a new quantitative easing program that has averted a death spiral in peripheral yields. The key points of the €750bn injection that has caught our attention in particular, has been the waiving of sovereign limits for programs and the inclusion of Greece as an eligible country. This protection of periphery spreads, which are the only bonds offering any significant positive yield, is particularly important for our portfolios and an are we continue to invest in going forwards. The ECB can absorb huge bond issuance and therefore backstop governments, providing comfort to exposure in periphery government bonds.

Click chart to expand.

Similar to our playbook in the US, we see core European countries as having limited scope for performance. While negative rates are a possibility, we prefer to hold for a combination of carry and potential price appreciation and not purely on price appreciation. As such, our portfolios are positioned not only to benefit from the yield offered by Greece and Italy but also the following;

  • Cash strategy replication by investing in short dated strong investment grade names
  • Investing in our European “Covid-19 resilience” basket

UK positioning

Akin to the US and European rates market, the UK rates market has seen yields fall. At the moment all focus is on the Covid-19 crisis and the other big uncertainty for the UK market remains the conclusion of the transition period to enact Brexit. News flow around this has come to a standstill like the economy, and it is hard to see how any meaningful deal is being worked on in the current environment with focus elsewhere. With time pressing on, it is our base case that the transition period will be extended and the uncertainty will persist beyond the end of the year. As such, we do not see rates moving up any time soon. With UK government yields now offering little value, we are following the same playbook as mentioned earlier for our other core markets:

  • Cash strategy replication by investing in short-term strong investment grade names or supranational organisations
  • Investing in our European “Covid-19 resilience” basket

With fiscal spending on the rise, we prefer to hold the development banks as not only do they have an excess spread over the UK gilts (International Bank for Reconstruction and Development 10-year paper yields 0.84% versus 10-year gilt at 0.34%), but their composition means that shareholders are numerous countries spreading out specific default risk of being exposed to purely UK government risk. A notable example is the EU member states being shareholders of the European Investment Bank.


Past performance is not a reliable indicator of future returns. Forecasts are not a reliable indicator of future returns. If the information is not listed in your base currency, then the result may increase or decrease due to currency fluctuations.

If not otherwise indicated, all graphs are sourced from Dolfin research, April 2020.

For more information please read our disclaimer.

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