Investment-Grade Corporate Bonds: Liquidity’s Worth
Complacent markets learned a valuable lesson in December as panicked investors found buyers had vanished.
Investment-grade credit was drowning in complacency as third-quarter 2018 earnings announcements contained few surprises. Credit fundamentals were steady, and gloomy macro headlines surrounding geopolitics and trade wars were omnipresent, but largely ignored. After a meaningful move wider in the Bloomberg Barclays U.S. Corporate Index from the tights of 2018 of 85 basis points to late August’s 113 basis points, the fourth quarter appeared poised to follow the "Christmas rally" script of the prior two years. Instead, a spike in volatility driven by news on tech, FAANG, Huawei, and FOMC posturing exposed how poorly corporate credit can trade during a period of heightened illiquidity. December illiquidity is not uncommon, but fund flows, supply technicals, and constrained dealer inventories amplified it to extraordinary levels.
The Typical Christmas Rally Failed to Materialize in 2018
Cumulative Change in Inv. Grade Index Spreads from 9.30 of Each Year
After a meaningful move wider in the Bloomberg Barclays U.S. Corporate Index from 2018 tights of 85 basis points to late August’s 113 basis points, the fourth quarter appeared poised to follow the "Christmas rally" script of the prior two years. Instead, a spike in volatility driven by news on tech, FAANG, Huawei, and FOMC posturing exposed how poorly corporate credit can trade during a period of heightened illiquidity.
Source: Guggenheim Investments, Bloomberg Barclays. Data as of 12.31.2018.
The stage for December’s liquidity event was set earlier in the quarter as the outflows from investment-grade funds accelerated. Fourth quarter outflows ultimately reached $29.9 billion, erasing a third of prior year-to-date net inflows. Corporate bond trading volumes fell 8 percent from October to November and 23 percent from November to December, according to TRACE data. The result was a rout of corporate bonds spreads of 46 basis points in the fourth quarter, or 43 percent spread widening. The weakness in the credit markets caused a dearth of new-issue supply in December, as the primary market produced a mere $9 billion of investment-grade supply. This represents the lowest December issuance for 18 years, and far below the $42 billion average. Low issuance levels are typically considered a positive technical for the market, but the lack of price verification in the primary market gave rise to an inability to price risk in the secondary market. Dealers cleaning up their balance sheets and reducing risk heading into year-end only exacerbated the move.
Investment-Grade December Trading Volume Declined to Below Summer Lows
Corporate bond trading volumes fell 8 percent from October to November and 23 percent from November to December. The result was a rout of corporate bonds spreads of 46 percent in the fourth quarter.
Source: Guggenheim Investments, Bloomberg, FINRA TRACE. Data as of 12.31.2018.
Confirming our Global CIO and Macroeconomic and Investment Group’s expectations, we experienced an Indian Summer in the investment-grade corporate bond market in the early weeks of 2019. Spreads rebounded, tightening from the recent peak. Looking forward, we will continue to move up in quality, as higher quality credits should better weather a cyclical downturn. Identifying strong and/or improving balance sheet stories will be key, as BBB financing costs have become elevated alongside wider corporate spreads. In addition to the up-in-quality trade, we will focus on reducing exposure to industries and credits we think will underperform in an illiquid and recessionary environment. The dramatic selloff in December reminds us to be mindful of the true cost of liquidity.
—Jeffrey Carefoot, CFA, Senior Managing Director; Justin Takata, Managing Director
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