Tim Winstone, credit portfolio manager, comments on the crisis gripping markets and how the Corporate Credit team is responding in terms of positioning within the European Investment Grade Credit strategy.

  Key takeaways

• Coronavirus developments will determine market sentiment. We are in a grey area as the world tries to ascertain whether the virus can be contained without deeper economic disruption, while a sustained oil price war adds further tail risk.
• At the technical level, weak market returns could prompt outflows from corporate bonds. So far, liquidity in the market has deteriorated but is still available in smaller sizes.
• The sharp correction in corporate bond markets means valuations have improved. Spreads could widen in a downside scenario, but a fair amount has already been priced in.

Coronavirus

While we continue to monitor the situation very closely, we have no more insight than the medical experts as to how it will develop from here. The best-case scenario is that new cases globally will slow within the next couple of weeks or months. The worst-case scenario sees further countries in lockdown (similar to Italy), causing a more sustained growth slowdown through disrupting demand and supply chains. It remains to be seen whether countries such as the UK and the US can control the spread better than those that were affected earlier.

OPEC+

The breakdown in talks between Russia and Saudi Arabia is another huge uncertainty for the markets and comes at a time when investor sentiment is already fragile. A sustained price war, meaning oil prices around the $20-$30 a barrel range, has a significant impact on US oil producers but less significance for euro investment grade corporate fundamentals. That said, oil price volatility and market share maximising strategies employed by members of OPEC are impacting sentiment and creating another tail risk for all risk assets to contend with in these uncertain times.

Market dynamics

The main risk here is potential outflows based upon poor total returns from the index. Outflows may cause further underperformance of European investment grade corporates as investors are forced to sell assets.

Valuations

Here’s the bright spot. Valuations have improved post the market volatility. For example, the credit spread on European investment grade bonds, as measured by the ICE BofA Euro Corporate Index, had widened to 171 basis points, the widest it has been since 2012*. Markets are suggesting the chances of a recession this year have increased and therefore it is possible European investment grade credit spreads could go wider in a downside scenario, despite a potential increase in monthly corporate bond purchases from the European Central Bank, but at the same time a fair amount has already been priced in.

*Source: Bloomberg, ICE BofA Euro Corporate Index, spread to worst versus government, at 12 March 2020. The spread to worst represents the additional yield over equivalent government bonds, taking into account possible early redemption calls.

Positioning

We had become more cautious on the European investment grade market last week given the prevalence of the coronavirus and the uncertainty of the near-term outlook given its further spread and potential impact on global growth. Hence, we have been positioning underweight overall credit risk versus the index. Our relatively defensive positioning is focused on issuers with strong fundamentals, with an underweight to more cyclical sectors of the market exposed to a weakening economic landscape such as industrials and basic materials. We are overweight exposure to issuers within the real estate sector, which are fundamentally improving and we believe offer attractive relative valuations versus non-financial sectors, as well as select national champion banks. We also hold select high yield exposure to issuers, reflecting some of the high conviction bottom-up ideas coming from our global credit analyst team. We remain underweight non-financial euro investment grade credit and overweight financial euro investment grade as we believe valuations in financial sectors are more attractive.

In Energy, in particular, we have a small underweight position versus the index. We further reduced risk in some Energy names on Monday 9 March as well as a few core euro investment grade and non-euro investment grade names. We will look to reduce risk at the margin from here in names whose prices or spreads have held in relatively well, or whose fundamentals are more likely to be negatively impacted by a weakening in the economic backdrop.

What else are we doing?

As always, we are sticking with our process and so far this has seen us cutting an energy position by a third as per our stop loss process.

Liquidity in the market has deteriorated but is still available in smaller sizes. We are able to trade, although we are keeping trading activity to a minimum to avoid unnecessary trading costs. There are some dislocations being created between different securities, however with volatility at its current level we are choosing to trade in smaller sizes to limit execution risk.

Outlook

Recent Chinese purchasing manager index (PMI) data releases have illustrated the negative impact coronavirus can have on a country’s economics through disrupting demand and supply chains, and business and consumer sentiment. This leaves us cognisant that global growth in the near term could take a material hit as other countries suffering from the virus undertake actions in an attempt to control its spread.

Developments in Brexit negotiations, US politics and tensions between the US and the rest of the world also continue to linger in the background. While these tail risks have taken a backseat in the past few weeks, we may see negative news flow concerning these topics re-emerge and adversely impact investor sentiment if, and when, fears over coronavirus decline.

The European Central Bank continues to engage in monthly corporate bond purchases and central banks across the globe have shown some willingness to undertake policy actions to support economic conditions and financial markets, but it is far from obvious whether stronger actions such as fiscal policy or the use of helicopter money will be enough to stabilise the backdrop. We believe the prevalence of coronavirus-driven uncertainty is likely to override central bank actions in the near term and result in negative credit performance.

Overall, we remain cautiously positioned. Portfolio activity from this juncture is likely to evolve depending on the balance between the prevalence of coronavirus and oil price volatility, the economic and political landscape and coordinated central bank policy.