Capital Markets Spotlight: A Trip Around the Globe
August 28, 2020
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Title: Spotlight: Investor Insights — Credit Markets
Henry Peabody shares his thoughts around the macro and credit environments.
Hi, my name is Henry Peabody and I am a credit portfolio manager with MFS Investment Management. I wanted to take just a few minutes to share a few thoughts and observations around macro and credit markets and give you a sense of how we're thinking about things on a going forward basis. To do that, I want to take you back to March and talk about Fed policy briefly. It took about 30 days for the market to widen 300 basis points. To put that in perspective, it took over a year to widen that much in the period leading into the credit crisis. The move we saw was unprecedented as was the policy response. Liquidity was the theme here. It wasn't your typical business led recession where companies got over their skis, spent too much, had excess inventory, and needed to correct. This was a different beast.
This was corporate liquidity, and by that I mean both trading liquidity as well as corporations aggressively drawing down bank lines. Consumer liquidity, there was going to be job loss. Consumers needed to have income and liquidity replaced. The authorities addressed these with very, very targeted measures. Fr that, I give them the thumbs up, which I'm typically loath to do. The Fed addressed CP is addressed treasury, mortgages, unis, credit, and dealer liquidity. The number of programs that came forth was aggressive, both in size and timing. From the corporate side, I want to just spend a moment on that. There's a very, very important distinction between the Fed and the ECB. The ECB, their approach was to buy credit broadly to push yields lower to have it impact the broader economy. This is kiwi, this is the portfolio balance channel. This is a more traditional approach.
The Fed, on the other hand, saw the market liquidity and wanted to be liquidity provider of last resort. The two contexts in which these plans were introduced were different, so the approach is different. In this case, the Fed has a stated goal of preventing fire sales. The Fed saw ETFs, bond ETFs trading at 5, 10% discounts to NAV, which shows the cost of that liquidity and the Fed does not want that to happen again. The Fed is there to eliminate tail risk, not suppress spreads. Now, that's a byproduct that encouraged risk-taking so its spreads were suppressed and they may continue. But that's not the express goal of the Fed, and I think that's a very important distinction.
The problem that the Fed found themselves in is that the original condition they stated was that companies must attest that they're eligible for this program to be bought in the secondary market, and this is ignoring the primary market. But their credibility helped the market normalize. First, we had the new issue market clear and then secondary started trading a little bit, and finally, we had a little bit more realistic pricing, new deals that resembled an okay new issue concession and now then they don't exist. The market is normalized at least from a functioning basis. In the context of a fairly uncertain growth environment, upside risk to inflation at some point, balance sheets that are hugely stretched and unprecedented policy in response to unprecedented volatility, what do you do? In my mind, you change nothing.
You fall back on a process, and you think about the levers you can pull at different points in the cycle. A couple of months ago, I think you play the rating and the quality game and you try to get as much return as possible by flexing, probably, a down in quality budget. That strategy probably changes, although, you do probably favor higher quality today. Now you get to pull more of the selection lever. You've more normalized. There's, certainly, there are certainly areas that we can express a positive longterm view that are under a little bit of stress short term, and two that jump out at me are the REIT market and the basic materials market, both challenged for completely different reasons. But both are business models and capital structures that have experienced stress during different cycles.
Both, I think, that if you are honest with yourself and try to think about the post-COVID world, see that they're both part of a normalization. Some retail is going away, but not all. Some restaurants are going away, but not all. I'm fairly certain an infrastructure package is going to be part of some sort of fiscal package at some point. That brings me to the aggregates as well as MELs mining, for example. You also have the inflationary hedge of a commodity base. Those are two things to think about, but from a selection standpoint, now's the time to look different. Now's the time to lean on idiosyncratic risk. Again, systematic risk was March. Today, now we're back to idiosyncratic and item selection. I think there are several important qualities to look for, liquidity, durability of margins, ability to flex variable costs.
I think that this leads us to sectors such as tech, which are helping keep everyone's costs lower, but should keep a lower cost of capital going forward. Medical devices, they were a sector that is hit rather hard when discretionary surgeries were suspended but is in the process of coming back. We've also noticed, over the past few weeks, several of these companies have issued equity and converts. That touches on the need to do some deep research here and focusing on those companies who are being proactive. It's more than likely that the next leg of this cycle, we're going to see credit get challenged and companies need to unwind some of the financial engineering that they've executed in recent years. Look for leaders, look for companies and wise management teams that see their stock at a high multiple, and we'll use that as currency.
Now is not the time to look like the index. The index is populated with some companies that are in really rough shape, and now's the time to look different. I don't want to own a bond just because it's in the new issue market. Right now it feels very frothy to me. It feels as though there's a sense of euphoria. You're seeing new issues, price through final guidance. That doesn't seem right. Deals are multiples oversubscribed. A California utility that came the other day priced 50 basis points through where our analysts liked it. This sort of thing says to me that there is a lot of cash chasing opportunities in credit. To me, especially, with the rise in passive and the rally in the ETFs feels very short-term and I think the key is to think longterm. Think what does the world look like post-COVID? Think how our margin susceptible. Think about owning a company for a year or two if volatility picks up. Think about those businesses that are likely to gain share.
So that sort of item selection is going to come, is going to be an important lever to pull over the next few years. I'm confident that the cycle is not dead. I'm confident that defaults will occur. Moody's is projecting an 8 to 16% default rate, and that maps to credit crisis spreads. We have a position where we have pulled forward a lot of returns, and there is the potential for adverse outcomes in credit. That is where we will shine. That is where our research bench comes into play. It may be a win by not losing scenario over the next few years. But then, again, the volatility does provide opportunity for those willing to look through noise.
I feel excellent about the next near medium and longterm in the credit markets. It's uniquely suited to express an active view for several reasons, not the least of which is behavioral economics. But this is going to be a time where active management hopefully shines. Not that I'm biased or anything, but I think it's going to be an excellent time. I'm enthusiastic, I hope you are too, and please feel free to reach out if we can be helpful in any way. Thanks for your time.
The views expressed are those of the speaker and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor.
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