Tuesday 18 November 2014 by FIIG Securities FIIG Securities Legacy

Stressed bond markets

The most recent, major stress event was the GFC in 2008, which was very much about the banks over extending credit to people and companies who were unable to repay it, not having enough reserves and not being able to refinance short term debt maturities. The combined forces led to a major credit crisis that we’re still trying to recover from

Prices fell across most asset classes, including higher risk bonds. However, high quality bonds such as AAA rated Government and supranational bonds saw the reverse. Investors demanded higher returns for higher risk, which is exactly what you would expect. The higher the risk of the investment, the greater its fall in price. Shares took the greatest tumble with the ASX down around 55 per cent, hybrids fell about 30% and some bond prices also fell, although not across the board. 

High yield bond prices took a hit and, to a lesser extent, so did those in the lower echelons of investment grade, while very low risk fixed rate senior bonds from institutions such as the major Australian banks held their value and the highest rated, lowest risk AAA rated government bonds significantly outperformed with high double digit returns. Investors in effect took a ‘flight to quality’, seeking investments that would preserve their capital. The main aim at that point was not about increasing yield but about avoiding loss.  

Highly geared global financial institutions saw prices across all investments, bonds, hybrids and shares plummet until governments stepped in to protect them with guarantees or orchestrated takeovers by stronger peers.

To give you an example, senior unsecured AUD fixed rate 2019 bonds in GE Capital Corporation (GECC), the financial subsidiary of GE traded at a low of circa $52, a substantial discount to their $100 face value. It was a difficult market to sell into at the low point. GECC incurred significant losses and some investors thought GE would allow the subsidiary to fail. The US government provided GECC with bank status, ensuring its survival and the bond prices rebounded.

Individual, direct bond investors faced a very different scenario to fund managers.

Personal investors had the time to assess their holdings, the market and their needs. If they held a range of low, medium and high risk bonds, they had options. The bonds, unlike many shares at the time, continued to pay interest. Investors didn’t necessarily have to sell holdings, although they may have chosen to do so. High quality fixed rate bonds are countercyclical and outperform in stressed markets and for this reason should be held in all investment portfolios.

Those that employed a hold to maturity strategy may have been concerned about the change in price of their higher risk bonds, some of which fell to $70 to $80, but had the back stop of holding to maturity and, assuming the company survived which the vast majority did, then they would get their $100 face value returned to them upon maturity.

Contrast that position with fund managers. Unit holders in the funds wanted to get their money out and redemption requests were high. They were forced to sell assets in a market with falling prices. Also, the funds were being valued on a monthly basis and the values were coming down fast, compounding the numbers wanting to exit. Losses were high. Fund managers had no choice but to try and salvage as much value as possible.

This was a great time for cashed up investors to get into bonds, as forced selling from funds drove prices down but credit fundamentals in many cases were sound.

History tells us to hold a range of risk assets. If you are worried about another correction then consider reducing your exposure to the highest risk assets such as shares and high yield bonds and adding highly rated, government and low risk corporate bonds. The other strategy to consider is to invest in shorter dated bonds of say up to two years. The closer they get to maturity, the less volatility they will display and the more confidence you can have of them being repaid.