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DFMs' bond picks grapple with credit questions; Liquidity back to the fore for allocators

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Credit lines

Equity markets are back in freefall mode today despite the overnight safety measures. And as the threats to businesses large and small become existential in nature, credit is also under pressure.

The iTraxx Crossover high-yield index has moved past the 600bps mark this morning: the cost of insuring against junk-rated firms defaulting is rising rapidly. That’s not surprising: wealth managers will be aware that most parts of their portfolios appear to be on fire at the moment. But it’s their bond exposures, as much as anything, on which they rely to provide a measure of protection. 

DFMs have typically balanced that caution with the need to provide some yield to investors. Hence why strategic bond funds, complete with notable high-yield allocations, have been the first port of call for many.

But those preferences look less optimal now. We’ve examined the 20 most popular strategic bond funds among wealth managers. The average exposure to junk or non-rated debt stood at 33 per cent as of the end of January.

For the very riskiest CCC-rated bonds, however, this average falls to just 1.8 per cent. Strat bond managers had been upping their exposure to this part of the market in the run-up to the correction, but not one had more than 8 per cent in such debt. 

For BBB-rated investment grade bonds, themselves back in the spotlight as attention turns to funding pressures, the average strat bond exposure has remained constant at just under 30 per cent of portfolios.

As these figures imply, there were few signs that the go-anywhere bond funds were ending their love affair with credit at the start of this year. One notable exception is Mike Riddell’s Allianz Strategic Bond, which slashed its BBB exposure to just 6 per cent over the winter.

Other managers may now be following suit, on high-yield bonds in particular. But wealth managers may prefer to turn to absolute return bond funds to ride out this particular storm.

Fed up

There might not have been blow-ups just yet, but there have been growing signs of credit market dislocation in recent days. Investment grade and high-yield ETFs in the US have been trading at significant discounts to their net asset value, and for persistent periods, too. 

That suggests an absence of buyers for the underlying assets, and highlights the stresses facing market participants. Federated Hermes international fixed income head Andrew Jackson notes that cash has not yet caught up with indices like the Crossover - with B and CCC-rated credits “yet to find a clearing level”.

But the big worry at the end of last week was not so much credit as the ruptures in the US Treasury market. Those were belated resolved - for now - by the Fed’s liquidity injection

In the short-term, wealth managers will be relieved to note that this intervention has also helped ensure that government bonds and equities are inversely correlated once more.

Unlike last week, safe haven yields have fallen this morning in response to shares’ latest slump. Gold, on the other hand, has maintained its recent status as a thoroughly correlated asset: it and other precious metals are down sharply. 

At this point, DFMs may start to throw their hands up in despair. Some will stick with government bonds and alternatives for now; gold’s fate may be less certain. But inconsistent correlations will also be encouraging more and more allocators to shift to an asset that will at least perform as they expect: cash.

Bailing out

One big reason why the Fed’s big rate cut has failed to calm nerves overnight is that investors are aware that monetary policy can’t do much in the current circumstances. The giant supply and demand shocks facing the global economy are not going to be countered, in the short-term, by ultra-low rates. 

Instead, the stage remains set for the introduction of a major fiscal package to help prop up economies. There are lingering question marks over whether this will be able to get off the ground in the US in particular. But the initiatives required go beyond regular stimulus programmes.

Faced with a shutdown of vast swathes of economic activity, the answer would seem to be to prop up both companies and workers for several months, likely via direct transfers. Even libertarian hedge fund managers have accepted the need for giant state intervention. The question is whether payouts of this kind will materialise in time to limit the damage.

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