The coronavirus spread has continued to play out as many predicted but the market has clearly been disappointed in the policy responses received to date.

The address from President Trump on March 11 night clearly fell short and in Europe, the market was hoping for coordinated fiscal and monetary action but only received the latter. On March 12, the Fed announced a renewed Treasury buying program and expanded repo facilities substantially, but prices fell on almost all fixed income instruments across geographies, maturities, rating categories and sector. Markets recovered strongly on Friday on optimism that governments and central banks will step-up their efforts to protect the global economy from the coronavirus fallout. However, this was sharply reversed by Monday as markets sold off on the back of disjointed policy guidance over the weekend and an emergency Fed cut, which brings rates to near zero. Intraday volatility remains exceptionally high and we do not believe it will dissipate until further clarity is achieved on the virus spread and policy responses.

We believe the worst of the effects of CoVid19 will pass sometime in the 2nd quarter, with an expected rebound in the second half of the year, although the magnitude of which will depend on the course of the virus in the second quarter. In the meantime, the Fed is actively cutting rates and adding sizable liquidity to the markets. Congress took the easy first steps over the weekend of funding healthcare related matters and increasing unemployment insurance and paid sick leave. However, the market is expecting more, and the next step is harder – it involves Congress directing fiscal stimulus and support mechanism to the private sector, i.e. corporations. Importantly, this needs to include small & mid-sized entities (SMEs) too. This could come in the form of subsidized loan programs and temporary payroll tax cut. We are hopeful this works. However, 2Q GDP is likely to be negatively affected and down over 1%.

U.S. High Yield Implications:
Compounding this already unprecedented situation, particularly for high yield, has been the drastic drop in oil prices as high yield has seen significant correlation to oil prices in the past.

On March 9th, we saw the biggest one-day drop in prices in 30 years. After what was supposed to be a coordinated supply cut by OPEC+ to balance markets and keep oil prices high (oil prices had been falling due to decreased demand globally due to the coronavirus), Saudi Arabia and Russia instigated an oil price war. Instead of a coordinated cut, Russia refused to cooperate as they viewed previous OPEC+ cuts as having aided America’s US shale industry. Saudi Arabia, reacted by announcing aggressive plans to boost oil output next month to well above current output levels and slashed prices for crudes sent to Asia, Europe and the U.S. thereby cutting oil prices and enticing refiners to use Saudi crude and instigating a price war. Saudi Arabia’s reaction appears to be aimed at increasing market share, given its cost advantage over other oil-producing economies, as well as enhancing its credibility as key enforcer of the cartel.

A key difference between the oil price drop now versus 2015/2016 shock is that this is potentially a demand (Coronavirus) and supply issue at the same time. If prices remain low, liquidity concerns and bankruptcy risk will rise for oil leveraged E&Ps and Oilfield Services companies. As a result, we think it is reasonable to expect an increase in defaults in the coming months, however this is all dependent on how long prices remain low and how severe this COVID-19 induced downturn is. It will also depend on the nature and duration of the hedges that these energy companies have on. We believe the longer markets remain volatile, the higher the risk of seeing significant defaults.

This price war exacerbated markets already engulfed in the COVID-19 crisis and pushed U.S. high bonds to their most severe sell-off since the financial crisis. High yield spreads widened almost 200bps last week, beginning the week at 581bps and ending Friday at 754bps.¹ Yields increased from 6.36% to 8.27%. Yields and spreads continue to push wider as of Monday, March 16^th.²

Portfolio Positioning:
The MS INVF US Dollar High Yield Fund is underweight energy as a whole, but within the sector, overweight the E&P subsector. During much of 2019, we “high graded” our E&P exposure and our focus has been to own higher quality companies operating in cost-effective basins, with low leverage, and an ability to reduce capital spending. Given the historic moves in oil, we are closely monitoring the energy positioning in the portfolio and are evaluating these companies’ ability to operate for an extended period of time in a low oil price environment.

Looking at the company earnings and future growth, we see a base case of a Q1/Q2 slowdown with the implication of lower earnings leading to higher leverage and consequently, risks of downgrades. We would note that companies have done a good job terming out their debt so near-term maturities are minimal, which is positive.

We are continuing to monitor certain problematic sectors that are more directly impacted from the coronavirus, such as travel and leisure, airlines, restaurants, etc. While we have not avoided all credits that are exposed to a slowdown from the coronavirus, there is little exposure to airlines (0.29%), and zero cruise-related credits. Currently, we are not implementing any large-scale portfolio changes. We have our credit research team focused on assessing liquidity needs of the companies we are currently invested in and will sell credits we deem to be a near-term default risk.

We expect the path forward to be uncertain but as spreads approach 800bps, high yield bonds as represented by the J.P. Morgan US High-Yield.

¹ Source: Bloomberg Barclays U.S. High Yield Corporate Index
² Source: Bloomberg Barclays U.S. High Yield Corporate Index

Index look increasingly attractive. We would note that data has shown when investors bought HY at spreads above 800bp over the past 30 years, total returns were significantly positive over the next 12 and 24 months in all but a few instances.^[1] The median annualized return over the next 12, 24, and 36 months for high yield bonds as spreads cross 800bps is 24.1% 18.7%, and 14.8%.^[2]

The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results.

RISK CONSIDERATIONS

• The value of bonds are likely to decrease if interest rates rise and vice versa.
•  The value of financial derivative instruments are highly sensitive and may result in losses in excess of the amount invested by the Sub-Fund.
• Issuers may not be able to repay their debts, if this happens the value of your investment will decrease. This risk is higher where the fund invests in a bond with a lower credit rating.
•  The fund relies on other parties to fulfill certain services, investments or transactions. If these parties become insolvent, it may expose the fund to financial loss.
• There may be an insufficient number of buyers or sellers which may affect the funds ability to buy or sell securities.
• Past performance is not a reliable indicator of future results. Returns may increase or decrease as a result of currency fluctuations.
• The value of investments and the income from them can go down as well as up and investors may lose all or a substantial portion of his or her investment. The value of the investments and the income from them will vary and there can be no assurance that the Fund will achieve its investment objectives.
• Investments may be in a variety of currencies and therefore changes in rates of exchange between currencies may cause the value of investments to decrease or increase. Furthermore, the value of investments may be adversely affected by fluctuations in exchange rates between the investor’s reference currency and the base currency of the investments

^[1] Source: JPM Credit Research. Data as of March 13, 2020
^[2] Source: JPM Credit Research. Data as of March 13, 2020. Performance in the chart above/below represents the median annualized return of spreads at month end that were above 800bps; this has happened 44 times since the inception of the index on 1/31/1995 through the current month 2/28/2020.