Weekly Bond Bulletin

21 May 2020

Patience is a virtue

The risk asset rally does not appear to have differentiated sufficiently between issuers coping with liquidity issues and those facing a more existential threat. As these distinctions emerge more clearly, it makes sense to be patient.

Fundamentals

It is still too early to judge the success of virus mitigation amid the re-opening process, given the nature of the novel coronavirus and the time lag with which new infections materialise. As we await direction on that potential market catalyst, our assessment of the fundamental backdrop remains focused on differentiating between markets (and even individual issuers) that face liquidity issues and those that face solvency issues. Central banks have resolutely addressed the liquidity problems, but many companies and individuals are now entering a solvency crisis, as evidenced by rising bankruptcy filings and heightened unemployment. To resolve this crisis, we will ultimately need further fiscal stimulus, but governments appear to have some fiscal fatigue. That said, positive steps have been taken towards a European recovery fund. The Franco-German proposal on 18 May has some constructive aspects, including offering grants rather than loans, and is meaningful in size at EUR 500 billion, though we expect further progress to be a slow grind.

Quantitative valuations

While the liquidity vs. solvency distinction is apparent from a fundamental perspective, market pricing has been less discerning. In the US, high quality and low quality high yield (as represented by BB-rated and CCC-rated parts of the market) have generated identical returns month to date, up 1.2%. In emerging markets (EM), lower quality countries—which arguably have more solvency issues—have actually outperformed of late: high yield-rated EM hard currency sovereign debt has returned 6.2% month to date, while the investment grade-rated portion of the market is only up 2.6%. This pattern is evidence that the recent positive momentum has been technically, rather than fundamentally, driven. (All data to 19 May 2020.)

Recent market performance has not differentiated issuers facing a solvency crisis

Source: J.P. Morgan, Bank of America Merrill Lynch, Bloomberg Barclays; data as at 19 May 2020. HY: High yield; IG: Investment grade.

Technicals

Investor positioning provides some insight into recent market performance. According to our proprietary peer group beta model, EM debt funds are taking much less risk than at the start of this year. This suggests that investors got overly cautious on the sector, ultimately leading to short covering amid the recent positive market momentum. Meanwhile, supply/demand dynamics have been balanced across fixed income: those sectors with very active primary markets, such as investment grade credit and US high yield, have received strong demand to digest the new issuance, while markets with more muted flows haven’t seen as much supply.

What does this mean for fixed income investors?

Uncertainty continues to dominate the fundamental backdrop. Until we have more clarity on the path of the pandemic, we believe it is prudent to focus on markets where cheapening was driven by liquidity issues, given that central banks have largely addressed this problem, while remaining cautious on those with solvency concerns. The recent rally does not appear to have made this differentiation, so we remain patient as we expect a better entry point ahead for risk assets. That said, with cash yielding essentially zero and central banks continuing to flood the market with liquidity, some risk allocation in portfolios appears warranted.

About the Bond Bulletin

Each week J.P. Morgan Asset Management’s Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.

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21 May 2020
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