April 17, 2020Institutional Investment Management

Recommendations

It seems a bit trivial to discuss economics and investment strategy in the middle of a pandemic.  What’s really important anyway?  Where interest rates are headed or how to remain healthy while this invisible killer terrorizes the globe?  One thing we can do is explain what we see happening in the financial markets and how can we capitalize on these disruptions.  Having lived through the 2008-2009 recession, we have some history to draw on as well as what we did or should have done during that time.  At this point in the crisis there are some similarities we want to discuss.   

The virus will undoubtedly cause a very severe slowdown at the end of the 1st quarter and a catastrophic drop in the 2nd quarter.  Trying to use an econometric model to forecast how bad GDP will be is a crapshoot at best.  Does it matter if GDP falls 10% or 15%?  Either one is devastating financially and emotionally.  The Fed acted very quickly to provide the liquidity to make markets function.  The Administration and legislators passed a massive stimulus package to provide assistance for businesses and individuals.  Some interest rates fell sharply.  U.S. Treasury yields fell 100 basis points on longer maturity government bonds and 150 basis points on T-Bills.  The Fed lowered the Fed funds rate to 0%.  Many economic indicators will reach levels we may have never seen.  How long this lasts is a function of the length and depth of the virus crisis.

The first observation is financial markets are not behaving in a normal fashion.  Trading desks at brokerage firms have been told to not add positions.  Doing so exasperates the illiquidity.  When we ask a firm to provide a fair bid or offer, they give a number that is laughable.  Here’s an example.  We asked for a bid on $500,000 AAA rated asset-backed security that will be fully paid out between July and October 2020.  The first firm said, “we cannot buy anything.”  They offered to take it to other firms and see what they could get.  The best bid was $89.  That equates to a 36% yield on a 6-month security.  Now admittedly this is an extreme example, but it gives the reader a glimpse into the disfunction we have been experiencing.

"The first observation is financial markets are not behaving in a normal fashion."

The corporate bond market is an excellent gauge of fear in the fixed-income markets.  It’s measured by the credit spread which is the additional yield the investor receives for buying corporate bonds versus risk-free Treasury securities.  That spread was 105 basis points for the investment grade corporate bond index prior to the COVID pandemic (Feb. 24th).  It spiked to 400 basis points on March 23rd and declined to 305 basis points on March 31st.  Companies trying to issue new debt to take advantage of very low Treasury yields found themselves paying “through the nose.”  Intel, a very solid credit, issued a 30-year maturity security at $99.90.  The yield spread over the 30-year Treasury was 310 basis points.  Investors received a yield of 4.75%.  On March 31st this same bond was trading at $135.4 to yield 2.95%.  Underwriters are pricing new issues so cheaply in order to make sure the bonds have orders that are a multiple of the amount issued.  The issuer, Intel, ends up paying an interest rate that is too high which is exactly why the yield dropped to 2.95% from 4.75% in less than two weeks.  Most investors are generally not able to buy new issues as it is believed underwriters allocate them to the larger orders and their most lucrative clients.      

Other markets are disrupted currently, and the municipal bond market is another prime example.  A large percentage of the municipals outstanding are owned by individual investors.  They tend to get very nervous in times of crisis.  When that occurs their first reaction is to sell.  A tsunami of sellers overwhelms the market and yield spreads widen dramatically.  Tax-exempt municipal yields have risen roughly 80% of the increase in the corporate bond market.  Taxable municipals have moved by nearly the same amount as corporate bonds.  There have been, and will continue to be, some excellent values for astute investors.  These types of disruptions create opportunities that may occur once in 10 years or even once in 30 years.  

Let’s look at an example of the disruption in the municipal market.  Tax exempt municipals maturing in 10 years have traded at 89% of the yield for a 10-year Treasury note on average for the past 12 months.  This means a 10-year Treasury trading at 2.00% implies a 10-year tax-exempt municipal yield of 1.78%.  Today we have a 10-year T-Note yield of 0.66% and 10-year tax-exempt yield of 1.81% or a ratio of 274%! Keep in mind this is the tax-exempt yield before it gets grossed-up for the investor’s tax rate. In addition, there have been wild swings in this ratio on a daily and weekly basis. We expect demand will increase and take advantage of this dislocation.

We have shared some of our observations with respect to the economy, the reaction from the brokerage industry, the corporate bond market and the municipal bond market.  What should or what can investors do?  In situations where uncertainty is very high, we recommend investors focus on quality and liquidity.  This means higher rated corporate bonds, higher rated general obligation municipals, essential purpose revenue bonds, and bonds backed by the government like agency-backed mortgage-backed securities.  We don’t know how long this will last or how severe it will get.  There is hope looking at the data from other countries that have been dealing with this crisis longer than has been the case in the U.S. 

"There is hope looking at the data from other countries that have been dealing with this crisis longer than has been the case in the U.S."

Our recommendation in the corporate bond market is to buy highly rated single A credits or AA rated credits.  Avoid sectors under great stress such as energy.  We also prefer AA rated general obligation municipals issued by municipalities in states considered to be well-managed.  Avoid Illinois.  The mortgage-backed market (MBS) will experience a rapid rise in prepayments due to very low interest rates.  This will be partially offset by homeowners who are unable to refinance for economic reasons.  In any event the entire market is trading at prices over $100, so seasoned MBS with consistent prepayment speeds would be our preference at this time.  Brokers are currently not offering private MBS (RMBS) so we are not able to source them.  Liquidity has been negatively impacted and executing trades has been challenging at best.

Economic and Interest Rate Outlook – Fall, Stall, and a Surge   

The Plague (1347 AD -1400 AD) killed between 25 million to 50 million people.  A smallpox outbreak in the 19th century is estimated to have killed 300 million to 500 million people.  The 1918 (Spanish) Flu is believed to have caused between 20 million to 50 million fatalities.  A 1930’s outbreak of Whooping Cough saw 200,000 cases per year and was especially deadly for infants and young children.  The Polio epidemic of the late 1940’s and early 1950’s paralyzed 16,000 people a year and killed roughly 2,000 per year (it also was met with an inadequate supply of “iron lungs”).  The 1968 (Hong Kong) Flu, is said to have killed between 1 million to 4 million.  As of the time of the writing of this piece, we have had roughly 1.5 million cases of COVID-19 and just over 100,000 fatalities, with a bit over 26,000 in the U.S.  The current moment feels both scary and bad, but it seems to be a case where people’s view of health risks, especially communicable diseases, is skewed by a lack of understanding of our history.  We may also be overconfident in the “safety” that modern sanitation methods, hygiene practices, and access to medical care afford us.  Perhaps all those advancements reduce the frequency of this particular risk, but the hypermobility and general openness of our world likely amplifies the speed and spread of pandemics. 

The point is that although it feels different this time, we have seen healthcare crises on this scale, but we have not had the ability to have large numbers of people working in their homes while distancing.  There are still large segments of the population who can’t work from home and they are either essential to keeping social order (and are still working) or they are now unemployed (along with 22 million of their fellow Americans).  Beyond all the central bank and political solutions designed to shoulder much of the pain of this challenge, people have a “hard wired” desire to return to normalcy.  As an example of this drive, a friend is a senior person at the Bureau of Criminal Apprehension.  He has had the duty of putting the handcuffs on some of the worst criminals (he calls them “clients”) and he says that the almost dutiful desire to maintain a routine is how the “clients” are caught most of the time.  We are creatures of habit.  The other side of this event is no different.  The end of the world as we know it is not the end of the world.  Life will resume to be mostly like the world as we knew it – although there will be fewer handshakes and more sanitization. 

This desire to resume our routine is why we expect much of the broader economy to mirror the stock market behavior.  It can best be described as a fall, a stall, and then a surge.  The stock market is generally made up of the most well-capitalized, best-managed, and competitive companies and the valuations are magnified by the risk appetite emotions of the moment.  The nail salon on the corner is in a different league and is easily substituted by a bottle of nail polish.  It will take more time for consumers to feel good about elective expenditures, but it will happen.  We anticipate that “main street” will see a delayed and muted version of what “Wall Street” has seen.  The “surge” may be of the variety demonstrated by a college student bouncing back from a hangover.  We too will eventually rally.   

"We anticipate that “main street” will see a delayed and muted version of what “Wall Street” has seen."

Entrepreneurs will adapt, government solutions will use the credit card to manage the pain, heroes in the medical profession will save lives now and work tirelessly to address delayed procedures for many months, and the scientists and researchers will get us out of this mess.  So, where does this leave us?  This should look more like a sharp recession, followed by a multi-year Great Regression (to lackluster levels of growth) rather than being an economic depression.  We think there is a scenario where the inefficiencies in the numerous programs (some would call it waste or bailout candy) could offer a short-term “bounce” to the economy, especially if it coincided with a sooner-than-expected scientific breakthrough that led people to believe we were heading back to “normal.”  Stock values could see small losses on a year-to-date basis and Treasury yields would climb.  We continue to think that euphoria will be short lived as global growth will continue to pull us down and segments of the economy will struggle under the weight of shifts in preferences and buying habits.  We forecast that the second quarter of the year will be sobering and sad, the third quarter will be optimistic, and the fourth quarter will be realistic.  In the end, we expect Treasury yields will end the year at current levels or modestly higher (but significantly lower than where we started 2020).  Plan on significant levels of volatility in the interim.  A likelihood exists that recovery expectations could drive the 10-year Treasury yield somewhere between 1.0% and 1.50% mid-year. Municipal bond yields, relative to Treasuries, are once again quite appealing and we would be a buyer as “AA” rated bond yields reach a level that is 200% of the comparable Treasury, or if you can buy 10-year munis at yields of 2.0% or better.

Nobody knows what will happen to the markets.  This situation has so many variables.  What we can observe is that humans tend to be creatures of habit.  The desire to return to normal, financed by future generations, will likely cause the U.S. to start this economic engine as fast as is both possible and sustainable.  As is often the case, we tend to extrapolate the current trajectory of our experience.  That will likely result in an overconfidence in the ability to achieve meaningful economic growth.  Yields will rise and long-term buying opportunities should result.  Be patient, volatility breeds opportunity. 

Special Section - The Fed Gone Wild

Although it is nearly impossible to keep up with the almost daily announcement of a new program rolled out by the Fed to prop up the economy, it is worth discussing the Fed’s unconventional approach to expanding its reach.  Historically, the Fed has only been allowed to purchase, or lend against, securities that have a government guarantee.  Recently Fed Chairman Powell has verbally normalized the idea that the Fed is only using its lending power to assist solvent entities.  So how has the Fed become a dominant buyer in the corporate, municipal and junk bond sectors? The Fed set up and finances a special purpose vehicle (SPV) for each of their programs where the US Treasury makes an equity investment in the SPV and assumes a “first loss” position.  The US Treasury is effectively buying the related securities and the Fed is just providing the financing to leverage the US Treasury investment (and Blackrock has been hired by the Fed to purchase the related securities and run the SPVs for the true owner, the US Treasury).  A genuine concern is that this degree of coordination blurs the lines between and independent central bank and the Treasury.  To date, the Fed has roughly nine different lending programs designed to support orderly functioning in commercial paper and corporate bond markets, asset-backed securities, municipal bonds, and small and medium businesses.  With plans to buy $625 billion in securities a week, it wouldn’t take long before the Fed (or the Fed/Treasury joint ventures) would be the financers of the nation.

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