Who wins carnage in the credit markets?

JHIM THE FIRST The rule of investing, according to Warren Buffett, is not to lose money. The second rule is to remember the first. This is only true for bond fund managers, whose job is to protect their clients’ money from volatility while earning the possible returns. The bloodbath in bond markets so far this year – America suffered its worst quarter since 2008 and Europe its biggest plunge ever – should be the ultimate nightmare for such timorous investors. Instead, many are sighing in relief.

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After a brutal but brief crash during the world shutdown in March 2020, and until the end of last year, rule number one was pretty easy to follow. Central banks were pumping $11 billion in new funds into the markets through quantitative easing and keeping interest rates low. Governments have offered unprecedented tax support to businesses to prevent them from going bankrupt.

The corollary was that the best thing for bond investors to do was close their eyes and lend. Asking about trivia like the condition of the borrower’s balance sheet or capital discipline seemed like a quaint tradition. In general, high-risk, high-yield debt securities performed the best. Yet the key feature of the market was “low dispersion”: a tendency for returns across sectors, issuers and credit rating tranches to be unusually similar.

There’s a lot of money to be made in such a market, which a Wall Street bank credit strategist describes as “a rising tide lifting all boats.” But that’s troublesome for active fund managers, whose business it is to use financial acumen to pick particular bonds in the hope that they beat the market in general. Measured by monthly returns between January and October 2021, for example, around 95% of US corporate bonds have outperformed Treasuries, with the lion’s share being clustered. This made it difficult for conservative bond pickers to stand out.

Yet that state of affairs has begun to reverse, and the scatter is back with a vengeance, the strategist says. The successful rollout of covid-19 vaccinations last year had already “squeezed excess juice” from those few sectors, like travel and leisure, whose debt was not already at a high valuation, reducing its potential for further appreciation. Now, headwinds, ranging from inflation and tangled supply chains to recession risk and the withdrawal of easy money, are blowing against borrowers, further clouding the outlook.

These obstacles are so vast that few companies are able to avoid them. But companies differ widely in their ability to cope. Take inflation. Companies with strong brands and unassailable market shares, such as Coca-Cola or Nestlé, have had no trouble raising prices to mitigate rising costs. Other companies, Netflix for example, have suffered.

This variation in pricing power extends well beyond the sectors in direct contact with consumers: producers of raw materials are generally much better placed to face the rise in the prices of energy and metals. than commodity buyers. Commodity producers who are less exposed to Chinese shutdowns — energy companies as opposed to miners, for example — are even better off. At the other end are industries such as auto manufacturing, vulnerable to both supply chain issues and recession-induced damage to consumer sentiment.

This represents a minefield for investors, regardless of their asset class. For bond pickers, divergence will be further fueled by a withdrawal of market liquidity. On June 1, the Federal Reserve will begin to reduce its holdings of $5.8 billion of Treasuries; by September, he intends to cut it by $60 billion a month. This is equivalent to the disappearance of a 3% annual buyer of government bonds, whose yields are therefore likely to rise. As a result, corporate borrowers will have to work harder to convince investors to buy their debt rather than seek the safety of government securities. Such a buyer’s market means increased scrutiny of debt issuers and greater variation in the yields they have to offer.

Active bond investors – or, at least, good ones – will benefit from this renewed focus on fundamentals. But they won’t be the only ones. Financial markets derive their value to society from their ability to allocate capital to those who are best placed to earn a return. A rising tide can lift all boats, but by diluting the incentive to discriminate between borrowers, it reduces the effectiveness of this allocation. A credit market that distinguishes more between winners and losers is a step towards its recovery.

Learn more about Buttonwood, our financial markets columnist:
Slow pain or fast pain? The Implications of Low Investment Returns (April 30)
A Requiem for Negative Government Bond Yields (April 23)
The Complicated Politics of Crypto and the Web3 (April 16)

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