The speed and depth of the crash in risk markets over the last 2-3 weeks has surprised almost all market participants.
This time was indeed different as it was triggered by a health issue, which we are all aware of, but was quickly followed by an oil price shock caused by the decision from Saudi Arabia and Russia not to co-operate and maintain oil prices by limiting supply.
Other differences to the 2008/09 GFC have been the almost immediate drying up of liquidity, and for the first time, this affecting the world’s largest and usually most liquid market, that for US Treasuries.
One of the similarities has been the speed with which spreads over the risk- free government bond have risen, particularly in the riskier end of the bond market, in high yield (that is bonds with a rating of lower than BBB-).
The oil price shock has seen a huge widening in spreads in the Energy sector – more than double that of the next widest sector in Telecoms.
Source: Jefferies/BAML
Overall the market spread is just over 1,000bps, or 10%. The last time we had this level of risk priced into the market was the 26th of September 2008, and spreads went on to widen then to above. 2,150bps in December of 2008
So where are we in the cycle of this event likely coming to a bottom and moving into positive territory?
One of the sets of data we can look at are the PMI surveys, which show general business output and sentiment. Unfortunately, we only have manufacturing data back to pre-2009, when services was introduced to the survey.
This gives us a less powerful indicator this time around, as currently manufacturing seems to be holding up but services has fallen off a cliff as might be imagined given global lockdowns of populations to various degrees mean services are hardest hit, whilst manufacturing can continue to a large extent.
Looking at these surveys, we can use the fall in the equity market and spread data to extrapolate where we might end up, based on the forward-looking surveys.
At a composite PMI of 40, the equivalent fall in the S&P500 from its peak in October 2007 to September 2008 was approximately 24%, and the move from the low point in spreads of 2.41% in June 2007 to 10% in September 2008 took 15 months.
Currently we have had a fall in the S&P500 of 27.7% from the high on the 20th of February and it has taken only 45 days from the 20th of January low in spreads of 3.38% to reach 10%.
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Therefore we are dependent on the next round of PMI data to give us the lead as to where equities and spreads might end up, but it would seem with the lockdowns in Europe and particularly the US only recently having been implemented, these impacts are likely to get worse before they get better.
On the plus side, the rebound in spreads to below 10% by July 2009 was equally speedy, as a result of government and central bank actions, which we have had a huge amount of already during this crisis, and the market reassessment of those credits which were likely to survive and repriced accordingly.
So what to do and where to find value?
Bonds have a crucial difference to equities – they have a maturity date. This is a date in the future where as long as the issuer is solvent, they must pay you back the face value of the bond.
This means that we can, with confidence brought about by fundamental analysis of the issuer’s financial position, be confident in the repayment in a few years.
This in turn means that while the lows in risk assets may be ahead of us, we can look to pick up cheap bonds in these dislocated markets and then ignore the price in the interim and await our repayment at maturity.
It is virtually impossible to pick either tops or bottoms of markets and so we must act accordingly when we see value.
Here is a list of bonds that we think currently offer this value:
AUD:
USD:
Source: FIIG Securities. Prices accurate as at 25 Mar 2020