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Fat tails

admin | March 13, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The coronavirus story has come to include something for almost everyone: medicine, economics, markets, monetary and fiscal policy. None of these are settled yet and look likely to remain unsettled for months. The continuing swings in rates and spreads reflect a wide set of potential outcomes. The base case still remains containment of the virus, repair of most economic damage, and resetting of policy and markets to more normal conditions. The path there, however, could vary widely.

The range of US 10-year yields through the week of March 9 reflects the range of possibilities in the market. Yields touched 0.31% early on Monday and 1.01% late in the day Friday. The flow of information about the virus through the week reflected slowing outbreaks in China and Korea and accelerating outbreaks in Italy, Iran, the US and elsewhere. Evidence of potential economic damage outside of China became clearer as Russia and Saudi Arabia started an oil price war, some areas imposed or broadened quarantine, schools closed, more organizations canceled events, and travel and retail activity thinned out. Boeing and portfolio companies at Blackstone and Carlyle drew down lines of credit. The Fed on Thursday announced plans to offer $4.6 trillion in added repo funding over four weeks and extend Treasury debt purchases to longer maturities along the yield curve. And the White House announced Friday a series of emergency public health and economic measures, including purchases of oil.

All of these factors will interact for months. Public health officials have already started drawing lessons from the experience of China and Korea, which showed the virus can be contained by a combination of limiting public contact and broad testing. Economic damage arguably is the most difficult to predict, with small businesses, highly leveraged corporate balance sheets and their employees most at risk—none likely having enough liquidity to weather months of depressed earnings, higher costs or both. Policy may be able to fill in the gap.

Despite broadly good prospects for managing the crisis, a more visible, public phase is just about to start outside of China and Korea; it hard to anticipate public response. Cases in the US and other places are likely to rise substantially over the next few months putting severe pressure on healthcare systems. The supply of coronavirus tests in the US, at least, is running well behind demand. The available supply of US hospital beds does not anticipate a surge in cases of the magnitude possible with coronavirus. Market expectations and policy response could still swing significantly.

The sharp steepening in the US Treasury curve also points to the different directions of monetary and fiscal policy. The Fed still looks likely to cut sharply at its meeting on March 18, and fiscal response in the US and Europe looks likely to set a lower bound of economic activity.

Risk assets have gone a long way to pricing in a wide range of outcomes. Spreads in investment grade credit and agency MBS have widened to levels last seen during and shortly after the 2008 financial crisis. Spreads in high yield credit, leveraged loans and CLOs have widened to levels last seen during the energy crash of 2014 through 2016. Investors should buy fundamentally sound cash flows trading at these spreads, recognizing the risk of more market volatility.

Investors should also realize the value of liquidity, not just as an off ramp to safety but for its option value in buying sound cash flows at distressed prices.

In a market with a range of new factors at work, options on outcomes at either end of the range remain valuable.

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The view in rates

The rate on 10-year notes has made a roundtrip from 0.76% on March 6 to 0.31% on March 9 to 0.96% on March 13. It reflects a wide range of shifting opinion on the virus, the economy and monetary and fiscal policy. The market has priced for nearly 100 bp of Fed easing by March 18. Both the Fed and fundamentals are likely to be different in the long run, but global flight to quality is likely to keep rates low until the links between the coronavirus, the economy, the Fed and fiscal policy play out.

The view in spreads

At current spreads, investors should add fundamentally sound cash flows in credit. That includes some higher quality corporate names and investment grade CLOs, which have strong structural protection in even severe scenarios. MBS spreads should remain under pressure from some of the fastest prepayments since 2012. MBS should underperform credit.

The view in credit

The immediate risk in credit is from companies with high fixed costs and a sharp drop in revenue from current efforts to avoid coronavirus infection. Companies with the highest leverage are first in line. As for the consumer, that is a story of generally continued strength with low unemployment, strong income, rising net worth and low debt service as a share of income.

admin
jkillian@apsec.com
john.killian@santander.us 1 (646) 776-7714

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