EDM Ahorro: Well positioned to preserve long-term capital.
April began with half of the global population under quarantine and no clarity about how to accurately predict when the world will return to normal in terms of mobility and economic activity. This prolonged interruption of activity has had—and will continue to have for some time—consequences for all economic players. Firstly, a deep recession is underway in most economies with countless repercussions, such as spiking unemployment rates, reduced spending, strong monetary and fiscal stimulus measures, and the resulting increase in government debt and public deficits.
From a fixed-income management standpoint, the new environment requires us to contend with a trio of key risks in this segment: defaults, illiquidity, and duration. With regard to default risk, the current scenario has nothing to do from the situation at the start of the year. In January, for instance, a default rate of around 2 or 3% was expected for European high-yield credit in 2020. Substantially higher default rates are now expected.
Without intervention we would be facing a default environment only rivalled by the Great Depression. This will be avoided, however, thanks to extraordinary monetary and fiscal measures in 2020 and 2021.
The bailouts in the last financial crisis, coupled with low interest rates and quantitative easing policies, have helped curtail insolvencies in recent years at the cost of keeping alive unprofitable or unproductive companies.
The market is currently pricing a high-yield default rate of 5.2% in Europe and 7.9% in the US. It is worth remembering that during the GFC these rates hit 14% and 16%, respectively (and would have been on the order of 20-25% without intervention).
Analysts’ current forecasts, however, show rates that are somewhat higher than those priced in the HY index spreads. In its base scenario, for example, Deutsche Bank expects default rates of 7% for Europe and 11% for the US—in a context where the effects of the pandemic are not protracted in time and the authorities are able to maintain the necessary monetary and fiscal support. Short of these caveats and in the event of a prolonged recession, default rates could be pushed to 15-25%.
One complication is that we entered this pandemic crisis with stretched valuations in corporate credit. In addition, there is the latent problem of market illiquidity, which became apparent during the deep market correction during March, when the prices of some quality bonds plummeted due to forced selling.
From spread highs in March, high-yield has narrowed 200bps in Europe and 300bps in the US, leaving us to wonder whether spreads are now too narrow for the looming expected insolvency rates or whether defaults will fail to reach levels consistent with the decline in economic activity.
Whatever the case, in EDM Ahorro we remain committed to the fundamental analysis of the companies in whose bonds we invest and, therefore, the natural approach to managing an uptick in default risk is to review the financial situation of these companies, analyse their resistance to the current pandemic, and closely track their evolution. We expect portfolios will suffer from market volatility, but this will also open up opportunities to invest in the debt of some solvent companies that the market has overly punished.
In order to manage illiquidity risk, a portion of the portfolio must be held in highly liquid assets (sovereign debt) as well as have some more cash than usual. We do not want to be forced to sell excessively punished bonds in an episode of market panic, bonds issued by companies that will withstand this crisis and will pay their obligations.
Finally, the third key risk for fixed-income assets is duration or interest rate risk, meaning, the risk of rising sovereign interest rates ( meaning falling debt prices), especially for longer maturities, which are more sensitive to interest rate fluctuations. The risk of rising interest rates, among other factors, is linked to the evolution of the economy and particularly to inflation expectations.
In the short term, for the next two years, inflation is expected to remain contained or grow below current levels. In Europe, inflation (HICP) could reach 0.6% in 2020 and 0.9% in 2021, according to macro analyst estimates for a base scenario wherein the duration of the pandemic is contained. Alternatively, even lower rates are expected. In a base scenario for the US, expected inflation rates are also low, around 1.2% and 1.6% for 2020 and 2021, respectively.
Inflation does not appear to be a risk for fixed-income assets in the short term. However, sharp growth in the debt-to-GDP ratio and large public deficits should keep us alert and attentive to possible inflationary signs going forward and we will accordingly adopt strategies to protect investor capital in real terms. Although it may seem premature, we have already initiated some incipient and gradual movement in this respect in our portfolios.
The future is uncertain but we are confident in our approach to facing these three key risks in our management of fixed income assets and moreover, we believe EDM Ahorro is well positioned to preserve capital in the long term.
Anna Karina Sirkia
Fixed Income Fund Manager