Since the height of the Covid-19 crisis in March 2020, risk assets have seen a significant rebound, with credit spreads reverting to more normalised, albeit still elevated, levels.
We isolate the main reasons for this improved market backdrop and explain why we believe the wides in spreads have been set and expect spreads to continue to grind tighter from here.
Most crises follow a similar path.
Although the catalyst for each is different, the stages tend to be relatively uniform. In the current crisis, the catalyst was clearly the spread of Covid-19 across Asia, into Europe and then the US. What followed was complete panic as investors became concerned not just for their financial assets but also for their health and the health of their loved ones, leading to widespread capitulation. As liquidity evaporated from the system, financial conditions tightened, leading to further panic and fear.
Thankfully, and unlike previous crises, most notably 2008, the responses from those in authoritative positions has been swift and sizeable. Central banks immediately cut rates to their effective lower bound. They followed this by recommencing, or in some cases increasing existing asset purchase programmes. The Federal Reserve and the European Central Bank in particular have been very impressive. For the first time ever, the Fed are buying corporate bonds on both primary and secondary markets, purchasing “fallen angels” (issuers that were previously rated investment grade but have subsequently been downgraded to high yield – down to BB-) and investing in both investment-grade and high-yield ETFs. The ECB have aggressively increased the size of their asset purchases through the Pandemic Emergency Purchase Programme, with amounts being bought today well above historical levels. Both central banks have offered clear guidance that, should the situation deteriorate further, they will respond forcefully.
Governments have also stepped up by introducing record fiscal stimulus. Further measures are expected globally so as to protect citizens as much as possible from the economic ramifications this virus is having.
Notably too, European countries that have long resisted calls for further fiscal integration are now embracing the idea of those who have more helping those who have less. Germany in particular have shown leadership on this by backing the joint-debt issuance programme under the auspices of the European Commission so as to provide grants to the European countries most affected by the impact of Covid-19.
Virus containment measures too appear to be working. Deaths per 100,000 people, in a variety of countries, peaked in April and have since been trending down. Much of this is due to the fact that hygiene measures and social distancing are having a positive impact, especially as countries come out of lockdown. Unfortunately, due to the very fact that this is a pandemic, localised flare-ups will undoubtedly occur. However, given the steps put in place and the understanding politicians now have about the virus, we do not expect the much-feared second-wave to occur.
For financial markets, and credit in particular, we believe the worst is behind us though volatility will remain.
Central banks have effectively backstopped corporate bond markets and, should the outlook worsen, we would expect them to respond forcefully and aggressively. Similarly, though localised virus flare-ups cannot be discounted and are somewhat inevitable, large-scale economic shutdowns, such as we witnessed in March, are improbable. The recovery will take time, however, and rates will remain anchored close to zero in most parts of the world. As a result, and unless there are triggers for further risk-aversion, we expect the hunt for yield to continue as the economic data stabilises. This could ultimately see credit spreads returning to pre-Covid-19 levels.
Christel Rendu de Lint
Head of Fixed Income
Bernard McGrath
Senior Fixed Income Investment Specialist
