by Kevin Strauss
The economic upheaval triggered by efforts to mitigate COVID-19’s spread is disrupting not only equity markets, but also the fixed income world in ways that have surprised many investors. Volatility has jumped in a market where investors thought they were shielded. But the news is not all bad. The source of the erratic moves in bonds and preferreds seems to be lack of liquidity. Our prior positioning gives us the chance to step in and satisfy some of that demand for liquidity in a way that allows us to take advantage of the situation.
Over the last two weeks, we have witnessed prices and yields on bonds and preferreds move sharply away from fundamentals; the amplitude of those moves indicates a severe shortage of willing buyers in this market. It now appears likely that this has been partly caused by forced liquidations by leveraged hedge funds. Their efforts to raise cash to cover margin positions appear to be impacting all parts of the fixed income markets – high yield, investment-grade, corporates, munis, preferreds and Treasuries. The 10-Year Treasury yield jumped from below 0.5% to more than 1.25% in the course of just this past week. This caused a number of dislocations in the broader fixed income markets, especially on the short end. In many cases, shorter maturity bonds are yielding more than longer maturity bonds, which does not make sense in an environment where investors are seeking safety.
What are we doing about this at ACM? First of all, we have a Taxable Fixed Income strategy that is currently constructed of less than 20% high yield corporates (and unrated preferred stocks) and more than 80% investment grade corporate bonds. Fortunately, we had reduced our energy exposure ahead of the recent crash in oil prices. We have also been maintaining a relatively short duration (4-4.5 years) in the strategy since interest rates have been near historic lows for some time and credit spreads had been very tight. This gave us some protection from the recent widening in those credit spreads. Over the past couple of weeks as others rushed to raise cash, we have been able to provide liquidity to take advantage of extremely attractive opportunities. Specifically, we have been offering to buy certain corporate bonds on the shorter end of the yield curve as those yields have risen. This is allowing us to upgrade the quality of clients’ portfolios even further and to reduce duration modestly.
A couple of examples of opportunities illustrate our strategy: We found an A-rated drug company, working on a therapy for the coronavirus, with a bond maturing in 6 months that, prior to the past two weeks, was yielding approximately 1%. We were able to win a bid for these bonds at a price that delivered to clients a yield of approximately 4.5%. We purchased another bond this past week issued by a financial technology company with an unusually solid balance sheet including $5 billion in net cash. We were able to pick up this 2-year maturity bond with a yield of approximately 5.5%.
We hope to continue to be able find opportunities like these over the next couple of weeks. We have also been pouring over the balance sheets of each and every credit we own in the existing portfolios to ensure that we continue to be comfortable that these companies will remain well positioned to service their debts as economic stress increases.
We also manage an Investment-Grade Municipal Bond strategy which is designed primarily with an eye toward quality. Each bond we purchase has an underlying credit rating of A- or higher, regardless of insurance coverage, and must include only General Obligation Bonds or Essential Service Revenue Bonds. We have deliberately excluded Non-Essential Service Revenue Bonds such as Airports Hospital, Housing, and Sports & Convention Center Bonds because these four areas account for the majority of the historical defaults in the Municipal Bond market. This is critical in today’s environment because airports, hospitals, and sports and convention centers are going to face either sharply lower revenue for an indefinite length of time or unusually high expenses (hospitals). This has resulted in the ACM Municipal Bond strategy performing significantly better than benchmarks during this turbulent period.
We are finding opportunities from the market dislocation in the municipal bond market just as we have in the taxable bond market. We have been able to purchase A-rated or higher short maturity bonds that were trading below 1% yield as recently as two weeks ago and are now trading at yields of 2.5% – 3.0%. These short-term yields are higher than the yields available for 7-10-year municipal bonds. On Friday, the Federal Reserve, recognizing that a shortage of buyers was causing the dramatic moves in muni prices and yields, announced that it will step in to provide liquidity (become a buyer) in the muni market. Specifically, it will accept short-term Municipal bonds as collateral for loans. While we expect this to help stabilize these markets in the weeks ahead, we should still be able to find some more bargains even during these very troubled times.
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