This Multi-Phase Crisis Can Be Navigated if We Join Forces to Thread the Needle: Co-CIO, Head of Fixed Income Strategies Matt Freund

First published: March 20, 2020

In a turbulent period for the markets, Calamos is hosting a CIO Conference Call Series for financial advisors. Below are notes from a call Tuesday, March 24, with Matt Freund, Senior Co-Portfolio Manager of the Calamos Total Return Bond (CTRIX), High Income Opportunities (CIHYX) and Short-Term Bond Funds (CSTIX).

To listen to the call in its entirety, go to www.calamos.com/CIOfixedincome-3-24

Matt’s comments build on what he had to say on a call last Tuesday, March 17. Highlights of that call follow. To listen to the March 17 call, go to www.calamos.com/CIOfixedincome

Matt provides a framework that he and his team use to make sense of the headlines and the price bids flashing on their monitors. His realistic, yet hopeful outlook provides a roadmap for successfully navigating this universal crisis together.

March 24 Update

The COVID-19 Crisis Delivers Three Economic Shocks

• It has been a market of exceptional volatility. Lost in the headlines is the fact that we were at all-time highs in risk assets just three months ago. With the arrival of COVID-19, we have suffered the repercussions of three shocks.
• The first is supply shock, which began with the news out of Wuhan. American businesses have been scrambling and struggling because we could not get all of the parts, supplies and inventory we need from China and emerging Asia. That shock has largely passed, as China starts to ramp up.
• The next shock is the demand shock, which Americans are currently living through as we shelter in place and reduce or cease consumption, which has put many service providers, businesses and jobs in limbo. For example, we saw demand shock hit the oil market, only to be further exacerbated by a price war between Russia and Saudi Arabia.
• These two shocks (supply and demand) culminate in a financial shock, marked by a massive drain on liquidity as everybody rushes for cash. The level of uncertainty and volatility is rather high and comparable to 2008 in several ways.

Financial Shock Warrants Further Discussion

• Because we are talking about fixed income, I want to talk at greater length about the financial shock that has two component phases of its own.
• The first phase involves a liquidity crisis, which history shows follows a somewhat predictable pattern: everyone is grabbing for cash, while investors are selling what they can and not what they should.
• This is hitting all sectors of the market, but is especially hitting the less-liquid sectors. Therefore, it began in credit and high yield, while investment-grade spreads shot up like a rocket. More recently, it struck the non-agency mortgage market. There are headlines that several mortgage REITs will be unable to satisfy mortgage calls.
• We’re actually seeing this liquidity shock occur globally. Indications of non-U.S. stress can be gauged by the U.S. dollar. Despite our dramatic reduction in rates and Fed actions, the dollar is up, though off its highs.

In Rides the Fed

• The good news is the Fed knows how to address a liquidity crisis based on the 2008 GFC playbook with all its acronyms, such as TARP. I have high confidence that the Fed can cure the liquidity problems that we see in the market.
• Fed action started with support for Treasuries, as REPO pressures dogged the market even before the virus grew into a full-blown crisis in the U.S. In turn, this expanded into support for money markets and mortgage bonds.
• The Fed actually started quantitative easing again. To put it into perspective, the Fed is doing more in a day than they did in a month during QEIII and Operation Twist. Therefore, they are injecting massive liquidity into the system.
• Then as recently as Monday, March 23, they announced they were going to accept corporate credit possibly rated as low as BBB.
• They also accepted swap lines because there is a dollar shortage in Europe.

Liquidity Crisis Shows Signs of Abating

• The investment-grade market remains open. The prices aren’t great, but we are seeing transactions take place. We are seeing new issuance.
• The bid-ask spreads in Treasuries have now collapsed to the typical tick, and we see the market becoming much more orderly.
• We have seen discounts on closed-end funds across the market begin to close. We have seen bid-ask spreads in credit and high yield begin to close. I think the good news is the worst of the liquidity crisis is behind us.

The Solvency Phase is not as Resolvable

• So we go to the next solvency phase. The way to think about this is we have just had a giant hand grenade go off. The liquidity problem is resetting prices, but we don’t find out who was hit by the shrapnel until later.
  

  “We have just had a giant hand grenade go off. The liquidity problem is resetting prices, but we don’t find out who was hit by the shrapnel until later.”

• There are all sorts of rumors floating about. Without repeating specifics, they involve everything from a European financial institution to a country to domestic hedge funds.
• Leverage structures present obvious problems in this scenario, specifically these triple-levered ETFs, which as they unwind are forced to dump securities into the market.
• Lastly, we cannot ignore problems in private credit. I think there is a lot of great private credit out there, but by its very name, it is opaque and it’s not clear who the good and bad players are.
• Therefore, we’re watching the solvency phase carefully. So far, there have been some hedge fund implosions but nothing material. We are not seeing the contagion of 2008 when it hit the banks, hedge funds and mortgage providers.
• We’re not out of this solvency phase, and the outcome is going to depend on fiscal responses and how well the Fed responds. I am optimistic here because capitalism is designed to absorb mistakes.
• The problem is we don’t know where the compromised structures are lurking. If there is too much debt out there, the Fed will keep the markets liquid and open, but it won’t be able to cure solvency problems that are beyond help.

Washington’s Fiscal Response Could Be a Mixed Bag

• What could help are fiscal responses coming from Washington. I can tell you that the fiscal package being discussed today is stunning. I am located in Chicago, and our previous mayor Rahm Emanuel once said, “You should never let a good crisis go to waste.” That’s exactly what we are seeing in Washington.
• The House bill is over 1,400 pages and includes things that would never get passed on their own. In other words, they are taking a very broad-brush approach. I think these measures could do good in the short term. However, I’m not sure what the long-term impact will be. My worry here is we are going to be subsidizing and encouraging a lot of reckless behavior.
• Next is the Main Street phase, which is very different from 2008. In 2008 when the subprime market blew up, people in Middle America first read about it in the paper. This go-around, Main Street is being disrupted at the same time as Wall Street.
• As of now, fundamentals have not deteriorated, but there is uncertainty regarding the severity and longevity of the economic contraction. Is it officially going to be a recession? Is it going to be something worse? As of now, we quite honestly don’t know.
• In this type of environment, leverage can have unintended consequences. If a company has no debt and sees its earnings decline, they can say we’re going to see earnings decline but we can certainly see our way through this. The problem is untenable if they have a lot of debt. The bondholders still expect to be paid, so that amplifies the pain that is left on the equity side to support credit, preferreds and risk assets.
• So what are we looking at in this environment? Water always flows downhill. Likewise, liquidity always goes to the place where it is treated the best. Currently, these sweet spots for liquidity include the credit, mortgage and emerging markets. Therefore, we think we are going to see the biggest recoveries there.

What’s Going on with Rates in the Wake of the COVID-19 Crisis?

• I think we’re going to see the Fed keep rates at 0% for quite some time in the short term. We’re going to see 10-year rates continue to fall, and it would not surprise me to see 10-year rates stabilize somewhere between 40 and 60 basis points.
• The longer-term rates, such as 30-year, are not going to fall as much because the fiscal package under discussion (as of March 23) is so breathtaking in scope and ramifications. The 1,400 pages include $10,000 in student loan forgiveness; a jubilee on paying mortgages; worker representation on boards; the banning of stock buybacks to name just a few items.
• There is a lot in that bill, which if adopted into law will generate inflation once we work through the initial phases of this crisis, and I think it’s inevitable that the markets are going to react to these longer-term inflation pressures.
• In the short run, I expect rates 10-year and less to decline. Longer 30-year rates will not decline as much. We’re watching the TIPS market and TIPS break even. If we come out of this, and we’re still a couple of quarters away from doing so, inflation pressures will be rather worrisome.

Liquidity Will Find Its Way Back to Equities

• I absolutely think it does. I think the sequence is going to be interesting. Right now, we’re just in the liquidity phase and we’re seeing exceptional moves in price.
• No one has reported anything significant yet in terms of idiosyncratic company-specific events, but we’re expecting shoes to drop.
• When the liquidity crisis is solved, I think we are going to see new money come to market. However, the idea of using a 60/40 portfolio is not going to work in this environment. Because if 40% of your portfolio is yielding near 0%, you’re going to have to look somewhere else. We’re talking about a rethinking of asset allocation models.
• I do think that equities are going to play an important role. And it is not just equities. We view the bond market on a bond-by-bond basis, and there are tremendous opportunities in preferreds and high yield, though it may be a little early. However, after the preferred market recovers, after the high yield market fixes itself, I would seriously think about going into quality equities, especially growth companies that can compound capital.
• I don’t expect rates to go negative. However, let’s assume rates 10 years and in are going to be lower. That’s going to force investors further out on the risk spectrum.

Summary of Key Views (As of March 17, 2020)

• It is difficult to believe that the market’s all-time high was on February 19, or less than one month ago.
• Our primary concern is the well-being of people around the world and our collective ability to stay ahead of the COVID-19 outbreak.
• Second, we are concerned about the health of global economies, markets and financial systems. Throughout, we must let wisdom be our guide, and not allow fear to drive us.
• To put today’s markets into context, Freund recalled the start of his career in the late 1980s and the many challenges that were faced and overcome. They include a 25% drawdown in the markets on one day (October 22, 1987). We saw volatility spike during Gulf Wars I and II. Obviously, there were the disruptions that swirled about September 11. Of course, there was the Financial Crisis of 2008. So, we’ve had our share of stressful occurrences through the years, though this one is unique given its severity in a relatively short period.
• When it comes to the bond market, one of Freund’s mantras is that “it’s not a bond market but a market of many different bonds,” and we are seeing that play out today with the divergent reactions to the crisis.

Crisis Has Perplexing Effects on Fixed Income Markets

• So, are rates up or down? The answer is: it depends. U.S. rates are down to sideways, while European and Japanese rates are up. In fact, we are seeing a reduction in negative yielding debt globally. That is the opposite of what we would expect to be happening, given the crisis and Fed resources being brought to bear on it.
• At the same time, anything with a risk aspect to it, such as corporate, private and high yield credit, has been falling in price and gaining in yield. So, we are seeing some yields down, but more yields up, and that surprises many people.
• Is there an underlying rhyme and reason to all this? What we think we are seeing is a global margin call. There is a lot of liquidity being drained from the system, and we are seeing that reflected in financial markets around the globe.
• Investment-grade spreads are currently at their wides going all the way back to 2016, but we’re in a very different rate environment because the coupons that we’re seeing for newly issued bonds are still fairly attractive, and investment-grade volumes are robust.
• One of the worries is that more than $600 billion of weak BBBs are currently in danger of downgrades.
• On the positive side, corporations have done a good job of taking advantage of rates over the past year and a half and have extended their maturities. Therefore, the cliff that has been a problem in the past for high yield is not as concerning once we get past all the shocks.

Potential Deflation Spurred the Fed into Action

• We initially thought the 10-Year Treasury rates would drop to 1% or below when the next recession occurred, but really didn’t anticipate the virus and the accompanying downturn. Freund looks at what’s going on with the U.S. dollar, and what’s happening with inflation.
• As oil has collapsed and activity has slowed, we are seeing deflation as opposed to inflationary fears working their way into the market, which is worrisome to the Fed. There is a lot of debt in the system and the nemesis of deflation—even though he doesn’t think it will persist—energized the Fed to take drastic action.

Fed Attempts to Dampen Collateral Financial Damage

• When you think about the virus, there are really three types of shocks. First is the supply shock. That is the one we encountered first, as major disruptions in Chinese production occurred in the wake of the outbreak. The only thing that is going to solve that is time and possibly reducing reliance. The next shock that we’re all experiencing is the demand shock as everything is shut down and cancelled. These first two shocks the Fed cannot do much about.
• The third type of shock is financial shock, and that is one that the Fed is clearly trying to address. We have an integrated global financial system and it’s really not designed to handle everyone trying to take cash out at the same time. We all remember the scene in the film It’s a Wonderful Life of everyone rushing into the savings and loan, demanding their money back. Think about it occurring on a global scale because that’s what we’re seeing. There’s stress in the short-term funding market, in the commercial paper market. Put simply, there is stress in the financial plumbing, which the Fed is taking head-on. They’re buying $40 billion a day in bonds, which is unprecedented.
• We expect that Fed actions will be very positive for the credit markets, the fixed income markets, but perhaps less so for the economy, because the latter is not really what the Fed is designed to help. In times of crisis, their main goal is to lessen financial pressures.

Regarding Calamos Funds, We Never Want to Be Forced into a Bad Trade

• When we look at the markets, the most important thing is never to be a forced seller. The first thing we do across the board is to make sure we have adequate liquidity for all demands placed on the funds. We never want to be forced to make a bad trade.
• That said, we have managed our liquidity very well and have been taking advantage of opportunities out there to increase our yields and return to investors, and we’re doing it in a very risk-managed way.

Forced Market Selling Means Great Buying Opportunities

• In the short term, we’ve seen tremendous opportunities in the front end of the credit curve. The way credit instruments are generally priced, near-term maturities are priced higher than maturities that are further out. However, because of the stress we’ve seen in the credit markets and this global margin call, longer-duration securities are down in some cases 10 and 15 dollar points. And these are money-good loans where the credits are not in question.
• The shorter-term bonds are not down as much but their yields look exceptionally attractive, often yielding 5% or 7% in two-year paper that we consider money-good. And by the way, these are investment grade. These are forced sellers that had to let these loans go. In times of panic, two things generally happen. The first is that many sell what they could—and not what they should. Higher-quality, better instruments are being sold because those are the ones that sell relatively quickly.
• Secondly, correlation tends to be around 1. So in this rush for cash, in this rush for Treasuries, the market isn’t distinguishing between great names, good names and questionable names. Fortunately, we are in a position to be a discriminating buyer and are picking up what we consider to be great names at very attractive prices.

We stand ready to help, let us know what you need. Financial advisors, for more information talk to your Calamos Investment Consultant at 888-571-2567 or caminfo@calamos.com.