April 14, 2020
The “Once in a Lifetime” (European Fixed Income) Opportunities (Fund)
April 14, 2020
The “Once in a Lifetime” (European Fixed Income) Opportunities (Fund)
April 14, 2020
“Once in a lifetime” opportunities do not come along that often, and so when they do, it is important to take advantage of them. Over the past two decades, the European fixed income market has offered three “once in a lifetime” opportunities. In each case, investors who took advantage of them generated significant excess returns.
We believe that the current environment offers one of these opportunities. The markets have undergone a traumatic month due to the COVID-19 pandemic, with all financial assets suffering through extremely high volatility. Whilst this has resulted in negative total returns for nearly all financial assets, it has also created significant opportunities for investors who are willing, and able, to search through the broad opportunity set and invest in an active and flexible manner. The European Fixed Income Opportunities fund has these important characteristics, able to allocate dynamically to different sectors as the opportunity set shifts. These changes will happen as the virus evolves, and as the fiscal and monetary responses take effect.
Monetary and Fiscal Policy Response Created Tactical Opportunities
The initial volatility shock from the pandemic was followed by a liquidity shock, as risk takers unwound positions, prompting fiscal and monetary policy makers into action. It has been fortunate that the financial crisis of 2008 and 2009 resulted in the creation of many policy tools. The crisis taught policy makers the virtues of acting quickly and aggressively, and the need to intervene again if initial measures fail to achieve the desired result. These tools were quickly dusted off and reactivated in a size many times that of their previous use (Display 1).
The G4 central bank balance sheet should expand to 15% of GDP
Change in Central Bank Balance Sheets – Percent G4 GDP, 12-month change
Source: Morgan Stanley, Haver Analytics, Morgan Stanley Research estimate. Note that the Fed balance sheet size is as of April 1, 2020, ECB's balance sheet as of 27 March 2020, BoJ and BoE's balance sheet as of March 2020 per Morgan Stanley estimate
The first assets to recover have been those closest to the policy response. The largest and most impressive response in Europe so far has been the ECB’s Pandemic Emergency Purchase Plan (PEPP), which allows the ECB to purchase all the asset types included in its other Asset Purchase Programmes, with some notable additions. On paper, the plan might not look that different from the existing APP (i.e. QE) purchase programme, but it is being implemented with more flexibility and aggression, and is of sufficient size to convince market participants that the ECB has systemic risks under control. Slowly but surely, national governments have been rolling out their response to the crisis to provide support to their citizens and the companies that employ them.
In Europe, the first action policy makers took was to ensure that the integrity of the Euro Area was maintained. This was at risk because of widening credit spreads for some of the more indebted sovereigns, with Italy and Greece particularly affected. Yields on 10-year Greek government bonds (GGB) spiked to nearly 4% in mid-March, whilst the yield of the BTP rose to 2.5%, nearly 3.0% higher than German government bonds. Yields at these levels, particularly if left unchecked, make the cost and ability of refinancing the large debt burdens of many European countries unsustainable. To ensure the integrity of the Euro Area financial system, the ECB removed several of its self-imposed restrictions on the QE programme: (1) the 33% ISIN limit, (2) the need to follow the EC’s capital key, and (3) the investment grade limit, allowing the ECB to buy Greek government bonds. These actions quickly restored the functioning of the European government bond market.
Yields fell sharply across the eurozone, and opportunistic and flexible investors were able to take advantage of this situation, benefitting from a 20% return on the 10-year GGB in the second half of March. The ECB has been so successful that Spain, Portugal and Italy were all able to access the bond markets in significant size in late March and early April. These bonds were priced with a reasonable discount, allowing investors to buy bonds at attractive levels and monetise the liquidity premium.
The other major policy response has been to ensure the effective transition of monetary easing to the real economy. The ECB has looked to ensure that major European corporations can have access to reasonably priced funding in the bond capital markets. The ECB will use its balance sheet to buy corporate bonds at new issue and in the secondary market, thereby restoring confidence to the corporate credit market. The primary market for high quality issuers has reopened, and secondary market liquidity has improved. This has allowed the credit market to reprice and much of the unusual discount seen in the middle of March has now reversed. For example, prices of Corporate bond ETFs have now recovered over 50% of their losses mid-month. Nevertheless, opportunities remain, particularly in the primary market, where bonds are often brought at a discount to the secondary market to ensure they are successfully placed (Display 2).
Source: Bloomberg Barclays indices, data as of 31 March 2020
Identifying Strategic Asset Allocation Opportunities
From here on, it is important for investors to look across all asset classes in order to capture each of the opportunities that the current market conditions offer. We continue to believe that there are many attractive opportunities for an active investor to capture (Display 3).
After the Selloff Comes the Rebound
Source: Bloomberg Barclays indices, data as of 6 April 2020
Short-Term Opportunity: Investment Grade Credit
Whilst the short-term, liquidity-driven dislocation in the market has largely been worked through, with help from the central bank policies, the investment grade (IG) credit market still appears to offer attractive value relative to all but the most stressed historic experience. The default rates implied by credit spreads are extremely high, and we believe unlikely to materialise. The elevated risk premiums reflect the price of liquidity rather than materially higher default risk, particularly in the primary markets, and we have allocated to this part of the market to make the most of this opportunity.
Short-Term Opportunity: Agency and Supranational Bonds
At the lower end of the risk spectrum, the Agency and Supranational markets have seen their spreads to government bonds widen appreciably, reflecting the higher liquidity premium and expectations of higher issuance as these entities will be in the front line in the fight against
COVID-19. Many of these bonds also have excellent ESG credentials as the proceeds are being used for social requirements. As market stresses start to fade, we anticipate the spreads will tighten, helping to boost returns.
Medium-Term Opportunity: European High Yield
For investors with a stronger risk appetite, the European high yield market may offer considerable value. Whilst not directly benefitting from the ECB’s policy actions, many of the companies are set to gain from the fiscal support for their local economies. The French President has explicitly stated that no French company, no matter how large or small, will face insolvency due to the crisis. The German development bank KFW has been looking to support various high yield issuers through direct loans to issuers at attractive levels, providing liquidity to viable businesses.
We think that attractive value can be found in this market. Historically, index spreads approaching 900 bps have proven to be an attractive entry point for an investor with a medium-term investment horizon. While it seems likely we will face a pickup in defaults, the very high level of carry offsets negative price action from further spread widening and default losses, whilst offering the potential for very attractive total returns should risk appetite recover, and spreads tighten from today’s elevated levels. It is quite difficult to identify the bottom of a market, but we are confident that today’s levels will be an attractive entry point in retrospect.
However, one should remember that high yield is not a uniform asset class. There will be winners and losers, and it is important to have an active approach to issuer selection, aided by a large team of experienced analysts to assess potential investments to avoid the failed business models.
Medium-Term Opportunity: Securitised Credit
We think that securitised credit may offer attractive returns. There is a negative market perception of ABS given its role in the financial crisis of 2008/09, and investors have reacted to the recent volatility by selling into a difficult market. We have not yet seen investors return to this market, and the asset class continues to trade around the lows.
Like high yield, it is important to do your homework and avoid the sectors and individual bonds which are going to perform poorly (such hotels and retail CMBS), but we anticipate that we can benefit from the reversal of the supply-demand mismatch. The experience of the financial crisis is that the structures are generally robust and can withstand the stresses of a deep recession. These periods of excess supply and limited demand often create misallocations of capital, and taking advantage of this can generate outsized capital returns.
Tactical Opportunity: Fallen Angels
There is another potential opportunity in the corporate credit market: the arrival of the long-heralded Fallen Angels. Corporate balance sheets have expanded significantly over the past few years, particularly for issuers domiciled in the U.S. There has been material growth in the absolute and relative size of BBB-rated corporate bond issuance. The economic shock from COVID-19 containment will put pressure on the cash flows of many of these companies. Having been criticised for being slow to react during the financial crisis, the ratings agencies are taking a more aggressive approach this time. It seems likely that a number of these highly leveraged issuers will be downgraded to sub investment grade. Although many investment grade investors have flexibility to hold these downgraded securities, there are inevitably a number of forced sellers, and given the lack of liquidity in the secondary market, this often results in sharp, temporary downward price action. On average, the average price of a Fallen Angel on the day of downgrade is around 70c, below the average price of a high yield bond, giving substantial upside when the forced selling stops and fundamentals reassert themselves. Our opportunistic funds, which are not constrained by rating, can take advantage of this potential market dislocation.
Tactical Opportunity: Corporate Bond Cash Basis
Given the demand for liquidity, funded cash debt instruments are trading very wide relative to their synthetic counterparts. This situation enables investors with liquidity to lock in this risk premium, without bearing the market beta and higher default risk. The ECB is likely to buy a large part of the investment grade corporate market in the coming months, hence this basis (the difference between cash bond risk premiums and CDS) may fall from today’s elevated levels. This is an attractive way to take advantage of the market dislocation, possibly even better than taking an outright long position.
Not (Yet) an Opportunity: Emerging Market Debt
One area that remains under pressure is Emerging Market (EM) debt. In order to become comfortable that EM offers value, one needs to believe that oil will not remain at current levels forever. If oil prices remain depressed, a large number of EM issuers will have problems. Without clarity on the direction of crude oil prices, we are not inclined to increase risk in this sector. However, even at these lower oil prices, some countries may do less badly, and these are where the opportunities lie. Asian countries, which are typically oil importers, and were the first countries to suffer from the coronavirus, may be the first to recover. There will be a time to increase exposure to EM, but that time is not here yet.
Dynamic Asset Allocation: More Important Than Ever
In these unprecedented times, it is crucial not to cling to historic positioning, but to seek opportunities across all markets, and reposition when mispricing occurs. Whilst it is vital to retain a perspective as these devastating events unfold, it is also important that as an experienced investor you work to find some value in these “once in a lifetime” opportunities.
Fixed income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In the current rising interest rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Certain U.S. government securities purchased by the strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. High-yield securities (junk bonds) are lower-rated securities that may have a higher degree of credit and liquidity risk. Sovereign debt securities are subject to default risk. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default, and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. The currency market is highly volatile. Prices in these markets are influenced by, among other things, changing supply and demand for a particular currency; trade; fiscal, money and domestic or foreign exchange control programs and policies; and changes in domestic and foreign interest rates. Investments in foreign markets entail special risks such as currency, political, economic and market risks. The risks of investing in emerging market countries are greater than the risks generally associated with foreign investments. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). Due to the possibility that prepayments will alter the cash flows on collateralized mortgage obligations (CMOs), it is not possible to determine in advance their final maturity date or average life. In addition, if the collateral securing the CMOs or any third-party guarantees are insufficient to make payments, the portfolio could sustain a loss.
Effective 30th August 2019, the Morgan Stanley Investment Funds Absolute Return Fixed Income Fund was renamed to Morgan Stanley Investment Funds European Fixed Income Opportunities Fund. Please refer to the fund’s prospectus for further information on these changes.
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