The Continued Cost of Credit

Back in January of 2020, I wrote an article pointing out that credit markets were setting themselves up for a potentially dangerous outcome. In no way could I or anyone else have predicted that a global pandemic and worldwide shutdown of entire economies would be the catalyst, but the conditions were ripe for any spark to start the fire.

As the fire started and began to burn, investors rushed to sell any holding related to credit as quickly as possible over fears of potential defaults. This, as noted in my previous article, was after flows and assets in taxable bond funds were at all-time highs.

Finance professionals have been suggesting for some time that illiquid securities, like credit, can be very dangerous when held in fully liquid vehicles such as ETFs and mutual funds. Investors would have been wise to understand the large price being paid for access to that liquidity.   

The following chart from the peak of the selloff shows investment-grade bonds (LQD-orange), high-yield bonds (HYG-white), bank loans (BKLN-yellow), and the S&P 500 (SPX-red) all traded almost identically to each other.

This shows the impact on credit investors who chose to invest through fully liquid vehicles. In a market downturn, not only do all types of liquid credit vehicles become equally correlated regardless of the quality, but the price pressure can be equivalent to equities. This is not the type of stability most investors are looking for within their fixed-income allocations. Investors who do not require immediate access to their capital would be wise to explore other alternatives where they can not only avoid the traps of liquidity, but actually benefit from an illiquidity premium.

The cost of liquidity became so extreme that even the investment-grade corporate bond ETF traded to a 5% discount compared to its net asset value (see the following chart). This means the selling pressure was so extreme that investors were willing to take less than the fund was worth, simply to get out of their position.

Now that this credit/liquidity fire has seemingly calmed down for the time being, where does it leave investors going forward? Hopefully, one would assume, they’ve learned from this liquidity trap and are looking for new ways to allocate to fixed income. Unfortunately, that assumption would be incorrect. Over the first week of June of 2020 alone, a total of $2.8 billion of fresh capital has been invested in just two of these bond funds, HYG and LQD. This is partially a result of investors following the Federal Reserve’s purchases, which will have the unintended consequence of causing them more pain for a few reasons.

Not only are investors setting themselves up to repeat their experience with this credit/liquidity mismatch, but they’re doing so in an environment of elevated pricing.  According to the Investment Company Institute (ICI), as of 31 December 2019, there were $32.3 trillion in US retirement assets, which includes employer-sponsored retirement plans (both defined benefit and defined contribution) plans with private- and public-sector employers), individual retirement accounts, 401(k)s, and annuities.” This is in addition to the recent $750 billion that the Treasury Department awarded the Fed to use for corporate bond purchases.

The combination of these two buyers alone creates an almost infinite demand for fixed-income assets as the investors look to immunize their liabilities and the Fed looks to stabilize markets by suppressing rates. This in turn creates much higher prices for bonds. These elevated prices have caused the Bloomberg Barclays Aggregate Bond Index to trade to a yield-to-worst of 1.34%. Compare that to the 10-year average inflation number of 1.77% and investors are potentially locking in losses, in real terms, for the extent of their fixed income holding period. Mind you, this assumes interest rates stay near all-time lows and there is no inflation from all of the “money printing” done by the Fed—another set of scary circumstances for credit investors.

In light of all this, fixed-income investors are facing an incredibly difficult challenge of where to allocate capital. They are looking anywhere they can for alternative sources of yield. The key is to not simply chase yield, as they chased liquidity, for that will naturally push their portfolios into riskier and riskier investments. A term that might become prominent in allocator conversations going forward is the “yield-to-quality” relationship. Fixed-income investors would be wise to ensure that this term is in the front of their minds during any future decision making.

About the Author 

Alex Knapp, CFA, is a portfolio manager at Thomas J. Herzfeld Advisors, Inc. Before joining the firm, Alex had extensive experience across international banking, asset management, wealth management and alternative investment funds. He was formerly an investment specialist for Aviva Investors covering alternative fixed-income strategies. He also served as a portfolio manager and head of liquid alternatives for Ballentine Partners. Alex is a published contributor to Bloomberg, has been quoted in the Financial Times, and has spoken at industry conferences across the country. He holds FINRA Series 65.

Citations:

https://www.usinflationcalculator.com/inflation/current-inflation-rates/ 

https://www.etf.com/sections/weekly-etf-flows/weekly-etf-flows-2020-05-28-2020-05-22?nopaging=1

https://www.ici.org/faqs/faq/401k/faqs_401k

Important Disclaimers: Alex Knapp is a portfolio manager at Thomas J. Herzfeld Advisors, Inc. (the “Advisor”). This article does not constitute a recommendation to buy or sell any security or asset class discussed herein. The article expresses the views of the author and not of the Advisor. Certain statements reflect the opinions of the author as of the date written, are forward-looking and/or based on current expectations, projections, and/or information currently available. The author cannot assure future results and disclaims any obligation to update or alter any statistical data and/or references thereto, as well as any forward-looking statements, whether as a result of new information, future events, or otherwise. Such statements/information may not be accurate over the long term. The views are those of the author acting in his individual capacity and not as a representative of the Advisor; in no way does this report constitute investment advice on behalf of the Advisor.