During the worst first quarter in 124 years for equities, credit markets were not immune to the unprecedented volatility in capital markets due to the coronavirus outbreak. With a yield of 1.92% at the beginning of the year, the benchmark 10-year U.S. Treasury bond ended the first quarter at 0.70% – a stunning 64% drop. 10-year Treasuries yielded a record closing low 0.54% (after briefly touching 0.318% in overnight trading) in the depths of the panic selling in equity markets on March 9th, followed by a spike to 1.12% only 10 days later as investors panicked out of Treasuries along with risk assets. Investors then moved back into Treasuries as the quarter came to a close and markets settled down a bit.
High-yield or junk bonds were the focus of much press during the quarter. Given their low credit quality, investors sold these bonds en masse due to concerns about the ability for companies issuing these bonds to survive the inevitable economic contraction from the abrupt halt of the U.S. and global economies. The Option-Adjusted Spread (OAS) for high-yield bonds (a more accurate measure versus simply comparing the Yield-to-Maturity) versus Treasuries widened dramatically beginning in mid-February, as fears began to grow about the coronavirus contagion. Given the inverse relationship between bond yields and prices, high-yield bond prices (and corporate bond prices generally) plummeted, while rates spiked.
As corporate bonds sold off and liquidity began to dry up, the Federal Reserve stepped in with two interest rate cuts – the most recent being an emergency cut on Sunday, March 15th to a range of 0-0.25% for the Fed Funds rate. The Fed also announced a $700 billion quantitative easing program at the same time, indicating they would begin buying nearly all types of credit instruments to maintain liquidity in credit markets in response to the growing threat from the coronavirus on the U.S. economy. Neel Kashkari, the President of the Federal Reserve Bank of Minneapolis (who I know well as he was a prep school classmate of mine), was quoted on 60 Minutes on Sunday, March 15th as saying “There is no end to [the Fed’s] ability to do that”- he was referring to continuing to flood the system with cash.
Where appropriate, we took advantage of this volatility to add exposure to corporate bonds, in the form of convertible bonds. Convertible bonds are corporate bonds that can be converted into a set number of shares of the issuing company’s common stock. With both bond and stock prices under pressure, we saw this as an opportunity to put some portfolio cash to work at significantly discounted prices, without taking the full risk of buying stock.
As the coronavirus contagion continues, we expect to see continued volatility in the credit and equity markets. It is during times of volatility like this, for investors with reasonable time horizons, that we are able to make investments with extremely attractive return/risk profiles. We believe these purchases made during panicked times will perform very well over the next couple of years.
