How central bank emergency measures have obscured looming bond market risks

Key takeaways

• As the novel coronavirus spread, the lockdowns that became a standard part of the policy response playbook ravaged both markets and economies with startling speed.
• Central banks around the world reacted swiftly and aggressively, intending to restore much-needed liquidity, especially within the fixed-income markets.
• Policy success has come with an uncertain cost, as many traditional mechanisms for assessing risk in the fixed-income markets are now broadcasting distortions.
• Going forward, we believe prudent fixed-income investors will need to rely much more heavily on portfolios that can be both dynamic and active in terms of country, sector, and security selection, as passive allocations appear more vulnerable to shocks than they have in years.

Not since the global financial crisis—and not even then—has so much about the global economy changed so dramatically or so quickly as it has this year. On December 31, 2019, as the world prepared to ring in the new year, officials in Wuhan, China, confirmed dozens of cases of patients suffering from pneumonia-like symptoms. Within the next 30 days, cases of the novel coronavirus—and the disease it causes, COVID-19—were confirmed in at least half a dozen more countries, the entire city of Wuhan and its 11 million residents were locked down, and the World Health Organization declared a global health emergency. Deaths mounted around the world in February, and by March 13, President Trump joined a number of other world leaders, declaring a national emergency in the United States. But by then, panic had already taken hold of the markets.¹

It would be difficult to overstate the speed of change in the early days of the coronavirus pandemic. Between February 19—which marked the all-time high for the S&P 500 Index—and March 23, the bellwether index lost more than a third of its value.² With the market collapsing and economic contagion of the global financial crisis still fresh in policymakers’ minds, the reaction from central banks came swiftly. By the middle of March, the U.S. Federal Reserve (Fed) had cut interest rates to effectively zero, down from a target range of 1.50% to 1.75% just a few weeks earlier.³ The Bank of Canada (BoC) did the same, slashing rates three times and 150 basis points in March before settling at 0.25%.⁴ And the moves in monetary policy were just the beginning.

The Fed immediately revived its decade-old quantitative easing (QE) program, announcing plans to purchase $80 billion worth of bonds over a two-day period, with additional purchases of $700 billion or more in the coming months. It also created a commercial paper funding facility, a primary dealer credit facility, and a money market liquidity facility. In essence, as investors and institutions liquidated holdings in favor of cash, the Fed was willing to buy virtually anything.⁵ The BoC also rolled out a series of programs to ease borrowing costs, including its first foray into its own QE program.⁶

It's often said that the stock market—and risk assets in general—are a leading indicator. What investors feared in early March wasn’t necessarily the spread of the virus and the potential toll to public health. What was more concerning from an economic perspective was the government response to attempt to contain the virus. From China to South Korea, Italy, much of Europe, and finally North America, governments around the world implemented quarantine and lockdown measures—by necessity, hastily formed and untested—each with varying degrees of stringency, but all unified by a common goal: slowing the spread of the virus.

The typical signals for gauging risk in the fixed-income markets have become distorted and unreliable—and investors who take their healthy function for granted could be in for a rude awakening.

This isn’t news to our readers, but it’s worth highlighting just how quickly the economic consequences of the lockdowns came home to roost. The week of March 20—a mere seven days after President Trump declared a state of emergency—U.S. unemployment claims hit a new all-time high: 2.9 million, ten times what they were the week prior. The following week they doubled with more than 6 million new claims filed.⁷

The speed and severity of the economic collapse had many market watchers speculating whether the developed world might be heading into an economic depression. While that dire possibility now appears unlikely, it’s still true that the unprecedented collapse of first the markets and then global economies required unprecedented action from central banks around the world. But central bank intervention is no free lunch. Beyond the new complexities central banks face if they ever intend to unwind their balance sheets to pre-2008 levels, investors also face new challenges. The typical signals for gauging risk—particularly in the fixed-income markets—have become distorted and unreliable and investors who take their healthy function for granted could be in for a rude awakening.

Government debt in many parts of the world has essentially become a yield-free investment. The income offered on U.S. Treasury debt is significantly less than 1% for nearly all maturities.⁸ This fact alone presents a number of challenges. Many fixed-income investors are, naturally, income seeking and portfolios geared toward producing even modest streams of income must now take additional incremental risk—specifically, by investing in less liquid securities or securities that represent greater credit risks, or both. In some ways, the challenge of low yields isn’t new, but the severity of the problem has increased dramatically. Consider that the 30-year U.S. Treasury bond today offers less income than the 1-month T-bill did at the beginning of the year.⁸

Not only have yields dropped, but the curve itself remains extremely flat. When the yield curve has a textbook upward slope, investors are compensated for taking increased duration risk: A rise in rates is more easily absorbed thanks to the incremental income a longer-dated bond offers. But that dynamic has been broken for years. The yield curve in the post financial crisis world essentially reflects a slow to no-growth outlook in perpetuity, an outlook in which sharp increases in inflation, rates, and economic growth is viewed essentially as a tail risk.

The combination of these two forces makes much of the world’s developed government debt, in many ways, less attractive than it’s ever been. Some investment mandates must own it, of course, but any investment policy that offers a modicum of flexibility should think twice about large allocations to high duration government bonds that offer neither meaningful opportunity for price appreciation nor current income.

While rates on North American government debt have fallen dramatically, we do believe there is a limit to how low they’ll go—and it’s zero. In the wake of Southern Europe’s fiscal struggles, in 2014 the European Central Bank (ECB) introduced negative short-term interest rates in an attempt to stimulate the economy.⁹ In theory, negative interest rates work by penalizing financial institutions for parking money with the central bank, with the intent of driving investment and lending—which would presumably be preferable to recording an otherwise inevitable loss on capital. The results of the ECB’s experiment haven’t been a runaway success. While it’s possible that economic conditions could have been worse without negative rates, it’s also true that Europe’s economic conditions generally languished with them. Plenty of financial institutions decided to voluntarily destroy capital, which isn’t much of a recipe for growth.

For those reasons, we don’t foresee negative rates in North America. The Fed has stated outright that it has no plans to attempt them, and the BoC has indicated it feels inclined to do the same. Moreover, negative rates impair monetary policy transmission mechanisms: Making banks less profitable, which is a frequent by-product of negative rates, does little to stimulate prudent risk-taking and economic growth through either retail or commercial lending channels.

The corporate bond market has also experienced a significant increase in latent risks, some of which have been years in the making. The clearest shift has to do with market composition. Partly due to easy access to cheap funding, lower-quality companies have become ever larger segments of the market; in both the United States and Canada, BBB-rated companies have now come to represent the largest plurality in investment-grade corporate debt indexes. The change in Canada has been especially pronounced, with the BBB-rated component of the index more than doubling in size over the past 10 years.¹⁰

The risks are material. Already this year, there have been more credit downgrades than in all of 2019; the first quarter was the most active quarter for negative rating activity in over a decade. The chances that this year will eclipse 2015—a year of significant challenges in the energy sector—are high.¹¹

Credit rating downgrades have, to date, been concentrated on those sectors most directly affected by COVID-19 lockdowns and the plunge in oil prices: transportation, autos, discretionary retail, and oil and gas. So far, rating agencies appear more willing to “rate through the cycle” for those sectors likely to be affected indirectly, including real estate, banks, insurance, and pipelines. Given the magnitude of the economic downturn, however, we expect many more downgrades are in store.

This prospect of a wave of downgrades, particularly within the BBB segment of the market, could create an unappealing domino effect if it comes to pass. Many investment mandates holding BBB securities—which, in addition to plenty of actively managed strategies, includes all passively managed investment-grade portfolios—would be forced to sell as issues migrate from the investment-grade universe into high yield. The forced selling would lead to further price erosion and, as is often the case in the retail asset management space, those price declines would trigger waves of redemptions. Asset managers would be forced to raise cash to meet redemptions—and the cycle continues.

It’s possible the Fed or the BoC would intervene to help provide a backstop if there were waves of forced selling in the corporate bond market, but it’s unclear whether either central bank would be comfortable further disrupting the mechanisms of price discovery that make gauging risk possible. If the customary moves in prices and yields that reflect a commensurate change in the level of risk fail to send reliable signals, investors—particularly those in passive strategies—will be relying almost exclusively on the ratings agencies to identify emerging risks. That fact alone may represent more of a dependency than some investors are willing to sign up for.

It’s an old adage that markets hate uncertainty and today there’s no shortage of it. That said, we think the worst is likely behind us ...

Much like the yield curves of government debt, the credit curves in both Canada and the United States flattened dramatically in the depths of the crisis. The long/short credit spread—the difference in yield between corporate bonds at either end of the maturity spectrum—declined to a low of just 20 basis points (bps), down from a more normal level of 90bps to 100bps.¹² At peak market stress, the banking sector, the most liquid part of the corporate debt market, showed an inverted credit curve, with short-term debt offering higher yields than long-term bonds. Since then, the tsunami of emergency monetary and fiscal measures has allowed the credit curve to inch toward normalization, with the long/short spread now up to around 60bps.¹² But the return hasn’t been uniform, as demonstrated by the BBB segment, where credit curves remain unappealingly flat from a risk/return perspective.

If it’s true that the magnitude of the economic consequences created by the lockdowns was hard to predict, the same is true of the recovery. As lockdowns ease and the world starts reopening, the rosiest scenario calls for a “V-shaped” recovery, where the bounce back is just as steep as the decline. While we’re not economists—and although the May employment report in the United States vastly exceeded expectations—the prospect of a speedy return to normal feels to us like wishful thinking. The base case many economists envision is more of a check-mark shaped recovery, where the economy notches slow and steady gains over the course of several quarters. This feels more probable to us given the variety of risks still facing the markets and the global economy. Certain parts of the world have seen marked declines in cases and deaths from COVID-19, while many locations—especially those that experienced more mild outbreaks in the spring—have seen new diagnoses continue to climb; the possibility of a second wave of infections can’t be ruled out. It’s also worth noting the groundswell of social unrest, mainly in the United States, and the presidential election looming in November. It’s an old adage that markets hate uncertainty and today there’s no shortage of it. That said, we think the worst is likely behind us for both the bond markets and the global developed economy, and slow improvement is more likely than continued deterioration.

In such a scenario (and in many others), the role central banks will continue to play in ensuring liquid, functioning markets is unlikely to fade any time soon. While that’s certainly preferable to an illiquid, dysfunctional market, the traditional mechanisms by which market participants assess risk (price discovery) and by which central banks influence risk-taking (monetary policy) are likely to be unreliable for the foreseeable future. And when the Fed does decide to begin unwinding the more than $7 trillion in assets on its balance sheet, it’ll no doubt be writing the playbook as it goes.³

In such an environment, we believe the best prescription for investors is a dynamic portfolio built on active security selection. It may be an old solution to a new problem, but we believe it’s a vital one. The risks within various segments of the market are starkly different and many of the mechanisms for gauging them aren’t sending clear signals. The flatness of the yield curve shouldn’t be interpreted to mean a long-duration position represents only marginally more risk than a short one; the flatness of the credit curve shouldn’t be viewed as suggesting a bullish outlook for unstable companies.

Many investors still need their fixed-income allocations to provide a reasonably steady income stream, a high degree of liquidity, and some defense against downside risk. We believe these goals remain achievable, but they require a much more nuanced scrutinization of risk on all fronts. In our view, today’s uncertain macro environment warrants an approach that is diversified across the full range of risk exposures, including interest rates, credit, currency positioning, and liquidity until there is some degree of clarity on the horizon. If sunlight is indeed the best disinfectant, we believe an active approach to investing—one that sheds light on the risks lurking in the shadows—remains the best antidote to volatile markets.

1 “A Timeline of the Coronavirus Pandemic,” the New York Times, as of June 30, 2020. 2 The Wall Street Journal, as of June 30, 2020. 3 Federal Reserve Bank of St. Louis, as of June 30, 2020. 4 Bank of Canada, as of June 30, 2020. 5 “Timeline: The Federal Reserve Responds to the Threat of Coronavirus,” the American Action Forum, June 29, 2020. 6 “Bank of Canada expected to buy C$200 billion of debt as it embraces QE,” Reuters, March 31, 2020. 7 U.S. Department of Labor, as of June 30, 2020. 8 U.S. Department of the Treasury, as of June 30, 2020. 9 “Explainer: How does negative interest rates policy work?” Reuters, September 13, 2019. 10 ICE Data Services, as of June 30, 2020. 11 Moody’s, Standard and Poor’s, Fitch, and DBRS Morningstar, as of June 30, 2020. 12 bloomberg.com, as of June 30, 2020.