As many of us speculate on the extent and duration of social distancing (a term we feel may be a contender for Merriam-Webster’s Word of the Year), governments and policy makers have been busy working to soften the substantial blow to the global economy. To combat the damage stemming from skyrocketing unemployment numbers and significantly reduced consumption, many central banks opted to cut interest rates, eased financial conditions to persuade banks to extend loans and reduced the interest rate expenses of businesses and consumers. In addition, central banks have been buying publicly traded fixed income securities, a program commonly referred to as ‘Quantitative Easing’ or simply QE. The most notable action was taken by the U.S. Federal Reserve (the Fed), who extended purchases beyond U.S. Treasuries (government debt) to corporate debt, mortgage-backed securities, and municipal debt.
In a downturn, companies will either issue new debt or sell fixed income assets they hold to generate cash to cover expenses. They need a buyer on the opposite side who has the ability to exchange cash for these securities, and now in this scenario, that purchaser is the Fed. Without a buyer, fixed income securities will trade at lower and lower prices regardless of their intrinsic value resulting in companies running out of cash. This is called a ‘liquidity crisis’. Where an issue now arises is that the Fed has not expressed any intention to purchase High Yield bonds (lower credit quality debt, commonly referred to as “junk bonds”). Many agree that by doing so, you create a moral hazard that compensates companies that spent frivolously and accumulated debt when the economy was booming with no regard to the repercussions of a downturn. We believe many of these companies also used low-interest rate debt to fund share-buybacks to induce higher share prices and inflate executive compensation. Since these companies will not have a significant buyer of their debt, we expect to see a higher number of delinquencies in this space the longer the shutdown extends.
The current crisis in financial markets is unfolding in reverse order to the Great Financial Crisis. In 2008, you had a rising number of delinquencies that resulted in a panic and then a liquidity crisis. Here, a panic is unfolding due to the COVID-19 virus which, in turn, is impacting the economy and earnings, creating the liquidity crisis. As we’ve always said, we’re not in the business of predicting the next crisis but of anticipating it. How we respond to it will dictate our recovery. Our role is to help educate you, to guide you back to your financial plan and to build robust and resilient portfolios to weather the storm. While we are happy with how our portfolios held up during the initial downturn, we’re continuing to learn and adapt to find areas where we can add value to the portfolio and come out of this in a stronger position than we went in.