Active allocation to fixed income amidst the Corona-crisis
At the start of the year, many asset managers were positioned for a late cycle re-acceleration. Investors were concerned about high valuations, leverage, and poor profit fundamentals, but the economy was expected to grow, albeit moderately, and corporate earnings along with it.
Enter COVID-19, and companies were suddenly forced to consider zero revenue for several weeks, possibly months, and potentially weak growth thereafter. As a result, we’ve seen major dislocations across asset classes.
Has it been enough to reset our expectations in fixed income?
In a word – not yet. The trajectory of the U.S. economy is highly uncertain. A wave of defaults in corporate credit is a matter of when and how high, not if. In a mild scenario, we expect default rates to rise to 7-8%. In a more severe recession, default rates of 15% or more would be likely. Federal Reserve and U.S. government policies have restored liquidity and eased credit concerns for the near term, but do not stave off the risk of a broader economic dislocation.
Adding to our concern is the fact that an uptick in defaults may not be enough to reset the economic cycle. Surviving companies may still be inefficient and over-levered, while profit fundamentals look likely to be poor for the foreseeable future.
On balance, these pre-existing and COVID-related vulnerabilities lead us to remain cautious in credit, particularly where default risks persist. High levels of market volatility amplify active risk taken in an investment portfolio. Credit spreads have widened significantly in March, but we still do not find the cushion built into lower-rated credit names sufficient to compensate for the risk of cash flow shortfalls.
High yield spread and default rate
Sources: New York Life Investments Multi-Asset Solutions team, Bloomberg Finance LP, 4/1/20.
Where do the opportunities lie?
While it is far too early to think about the end of this crisis period, opportunities will arise from near-term dislocations. For example, despite our caution in the asset class, pricing in high-yield credit is beginning to look attractive for investors who are willing to accept the volatility and higher default rates that will come in the months ahead.
We hold an underweight credit position in our portfolios, but anticipate that investors with a longer time horizon and more risk appetite could find good opportunities here. Where those opportunities exist, prudence will be essential. Extensive cash flow analysis should equip managers with the information they need to select higher-quality opportunities.
We have stronger conviction where policy action will spill over into investment opportunities. For the duration of this economic shutdown, the U.S. Federal Reserve will do whatever it takes to keep financial markets functioning in impacted sectors. This includes investment-grade credit and municipal bonds – asset classes where the Fed has not previously played.
This does not mean that the Fed will support these asset classes forever. Investors should act with careful attention to security selection and to suit their strategic goals. However, it is difficult to say that these asset classes would perform poorly with the Fed so active in the market, as the Fed will help many viable companies avoid suffering severe damage form an acute liquidity shortage. A floor has been put in place.
This is a good time for active management.
As the Corona-crisis continues, it will take time to sort winners from losers. Powerful cross-currents – pre-crisis vulnerabilities, more attractive valuations, higher volatility – will obscure investment risks and opportunities. Assessing securities for their long-term potential to add value to a portfolio will be essential. With market volatility nearly certain to persist, active management is likely prudent for many investors.
Active management is the use of a human element, such as a single manager, co-managers or a team of managers, to actively manage a fund’s portfolio. Active managers rely on analytical research, forecasts, and their own judgment and experience in making investment decisions on what securities to buy, hold and sell.
High yield securities (junk bonds) have speculative characteristics and present a greater risk of loss than higher quality debt securities. These securities can also be subject to greater price volatility.
Funds that invest in bonds are subject to interest rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk which is the possibility that the bond issuer may fail to pay interest and principal in a timely manner.
Municipal securities risks include the ability of the issuer to repay the obligation, the relative lack of
information about certain issuers, and the possibility of future tax and legislative changes which could
affect the market for and value of municipal securities. Such uncertainties could cause increased
volatility in the municipal securities market and could negatively impact the Fund’s net asset value
and/or the distributions paid by the Fund. Securities purchased by the Fund that are liquid at the time
of purchase may subsequently become illiquid due to events relating to the issuer of the securities,
market events, economic conditions, or investor perceptions.
This material represents an assessment of the market environment as at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.
The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.
This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.
“New York Life Investments” is both a service mark, and the common trade name, of certain investment advisors affiliated with New York Life Insurance Company. Securities distributed by NYLIFE Distributors LLC, 30 Hudson St. Jersey City, NJ 07302.