Our core Fixed Income managers invest in high credit quality sectors such as investment grade municipal and corporate bonds, U.S. Treasury securities, and Government Agency Mortgage Back Securities (MBS). However, many additional fixed income securities exist, primarily of lower credit quality. We call these securities and the managers that invest in them “satellite” fixed income. Two of the largest and best known of these satellite fixed income sectors include High Yield bonds and Bank Loans (aka Leveraged or Senior Loans). The first graph below shows the Yield on the High Yield Index vs. U.S. Treasuries, the “spread”. Please note that the higher the graph, the higher the spread and the more risk averse market participants are.
The second graph shows the average price of loans in the Bank Loan Index [note the prices are normalized to 100 and the lower the graph, the lower the average loan price, and thus the more risk averse the market]. Both are showing a level of risk aversion only surpassed during the Global Financial Crisis.
Make no mistake, high yield bonds and bank loans are borrowings from lower credit quality companies, and we have internal guidelines to limit how much risk we want in these satellite fixed income markets. Some of the larger holdings in the high credit quality indices would be mega-cap companies. The larger borrowers in the high yield or leveraged loan market could be companies that are recognizable brand names that are going through a turnaround or are lower rated because of higher debt levels. Unlike investment grade corporate and municipal bonds where defaults are rare, these markets not only experience defaults routinely, but expect them and reflect these expectations into the market prices. The language of these markets revolves around a) “the probability of default” and b) “loss given a default”. So, the math of any realized loss for a lender is a * b. If a lender via a high yield bond or bank loan expects that 5% of the borrowers are going to default on average and expects to lose 40% on such defaults on average, their expected loss is 2% (5% default * 40% loss given default).
The levels of stress in these markets are implying realized losses given default multiples of what was actually experienced during the Global Financial Crisis. We can look at history to see how these markets have performed at various initial Spreads (for High Yield bonds) or Loan Prices (for Bank Loans).
What the above data shows is that when these markets price in increased defaults, losses, and stress in these lower credit quality markets, they typically overshoot, such that subsequent returns are some of the best realized in the asset classes. Perhaps surprisingly, returns are not maximized when everything appears calm, but rather when things look bleak. Many of our active fixed income managers believe these levels are significant opportunities and offer risk/reward tradeoffs.
Of course, the old adage applies here that past performance is not indicative of future performance and the credit stress from the COVID-19 virus may give way to different markets this time.