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Q1 2020 can be broken into three distinct parts
- From the beginning of the year until 19 February, we saw normal trading conditions
- Between 20 February and 20 March, there was a deterioration in market liquidity and evaporation of buyers
- From 23 March to 31 March, buyers returned to the market following unprecedented co-ordinated government action
Less panic selling and more of a liquidity squeeze
On Dolfin’s trading desk we saw no panic selling in the last three weeks of March, however markets were severely hit by risk rerating a liquidity squeeze, and the entire industry essentially migrating into a work from home set up.
- Credit risk rerating
The impact of Covid-19 was hard to price outside airlines and hotels. As such any bonds that might be impacted were quoting with very wide spreads. All but the safest investment grade seemed to be impacted and even quality names like Boeing which normally move bp were quoted with several point spreads.
- Liquidity squeeze
Perhaps the largest impact to bond markets was a shortage of USD. This in turn fed into other currencies before the Federal Reserve worked with other central banks to create swap lines. For a few days’, bids for near-term paper with maturities of less than three months were overwhelmed by sellers looking for a fast exit, investment grade paper was trading at a 1-2 point discount to the 100 redemption price.
- Working from home
Business continuity planning was implemented widely across the market by liquidity providers in mid-March. Working from home is difficult for traders used to 10 screens and lots of market data. We found a large number of bonds were simply not quoted as traders focussed on the “core”, in many cases this was less than 25 per cent of normal coverage leaving 75 per cent of bonds simply showing no quotes.
A good metric for looking at the liquidity squeeze is the USD LIBOR-OIS spread, which in effect is premium banks lend to each over the central banks. This has blown out in recent weeks, these high level feed directly into bond markets and goes a long way to explain the exceptionally wide bid/offers we see on a day to day basis.
The week of 16 March was one of the worst we have seen for credit markets. Liquidity simply dropped out of the market and was amplified by the migration to full working-from-home setups. This was broad based, covering all paper and, on 20 March, over 75 per cent of our first 30 trade requests to the market received just one or no response at all. Looking at our data for early 2020, this same metric is about 5-10 per cent. This was reminiscent of trading days back in 2008 although with slightly less panic and we noted many professional counterparties choosing to wait on orders. The response from the Federal Reserve – flooding dollars back into the market – ensured that this was short lived dislocation event.
For our UK-only portfolios, this drying up of liquidity occurred as we were going through our quarterly rebalancing which necessitated working closely with the investment management team on both bond selection, liquidity and pricing to ensure we optimised execution for all of our discretionary UK clients.
The gains on this collaborative approach can be seen below on a trade ticket in GBP. Sterling is very hard to trade in the best of times but with a focussed approach you can see real yield uplift (highlighted in pink).
The flow in the last week has seen buyers coming back into high yield and pushing bonds often points higher. On a global basis, good size sellers of oil and energy remain, and this has been a constant theme. The take up of new bond deals has really kicked into gear in April, and the selling of Government paper often from emerging markets and the Middle East has abated. It was probably linked more to clients raising money in those liquidity squeeze weeks.
Finally, US-related paper is back in focus, across the board: investment grade, high yield and big-cap names. We have been buyers of them all and although the market might be wider, the super-prime investment grade world is now back to similar bid/offer spreads seen in January.
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.
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