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Institutional Perspectives

We believe supply/demand imbalances are creating potential opportunities for investors with liquidity.

While the equity markets have experienced historic volatility in recent weeks, investors may have also noticed unusual moves in the short-term credit markets. Supply and demand imbalances have created sharp spikes in credit spreads, even for very short-term, investment-grade securities. These imbalances are generating potential opportunities for investors.

As coronavirus concerns intensified, we’ve observed many companies that have looked to gain additional liquidity and build a war chest of cash on their balance sheets. They borrowed through commercial paper and other markets. At the same time, traditional buyers of commercial paper and other short-term securities took a step back from those markets to build their own cash reserves. That led to a supply/demand imbalance that sparked a widening of spreads in debt markets including commercial paper. The accompanying charts illustrate that imbalance.

 

Chart 1: Commercial Paper Rates Have Spiked
30-day commercial paper trailing 1 year (as of March 16, 2020)

Source: Bloomberg. Data as of March 16, 2020. Based on US Federal Reserve 30 day A2/P2 Nonfinancial Commercial Paper Interest Rate.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

  • The data in Chart 1 displays the average borrowing costs for 30-day commercial paper, which is short-term, unsecured loans for investment-grade rated companies. According to this Federal Reserve (Fed) data set, rates on 30-day commercial paper jumped from under 1.5% to over 3.5% in a matter of days. Recognizing the stress in this market, the Fed acted quickly, reinstating the Commercial Paper Funding Facility to provide additional liquidity in these short-term borrowing markets. 

 

Chart 2: Spreads Jump, Prices Drop for Investment-Grade Corporate Floating Rate Notes

Source: Based on Bloomberg Barclays U.S. Investment Grade Corporate Floating Rate Note Index. Data as of March 20, 2020.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Similar spikes have occurred in the market for short-term investment-grade corporate floating rate notes (FRNs). The FRN Index, which has an average credit quality of A1/A2 and an average maturity of 1.8 years, saw spreads jump by nearly 300 basis points (bps) and the average dollar price drop by over 4% in under a month, as seen in Chart 2. This is index-level data; anecdotally, we have seen even more extreme moves, including 3-month FRNs of an A-rated issuer trade at spreads of 800 bps amid this market dislocation.

 

Chart 3: Corporate Index Spreads Reach Highest in a Decade
1-3 year corporate index spreads, trailing 10 years (as of March 20, 2020)

Source: Bloomberg. All data as of March 20, 2020.
The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Past performance is not a reliable indicator or guarantee of future results.

 

  • Short-term, fixed-rate bond markets were not immune to these extreme moves. As seen in Chart 3, the average spread in the BAML 1-3 Year Investment Grade Corporate Bond Index (“A” average credit quality), soared to 400 bps over U.S. Treasuries, the highest level in more than a decade. The spread had recently been below 50 bps. By comparison, the spread on this index peaked at roughly 200 bps during the U.S. debt crisis of 2011, and peaked under 150 bps during the energy crisis of 2016.

Though the price moves in the short-term credit markets have been modest in comparison to volatility in the equity markets, investors are not used to seeing such price declines in short-term or ultra-short bond strategies. But investors should remember that these price declines likely are being driven primarily by these technical imbalances rather than by significant credit issues. Because these companies have several options to access liquidity in the near term, defaults on short-term investment-grade securities have historically been rare. We believe that will continue to be the case.

While price volatility may stay with us for some time, it’s also creating compelling valuations, in our view. For active managers who have liquidity, these pricing dislocations are creating very attractive opportunities in short-term, investment-grade securities.

 

A Note about Risk: The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. Lower-rated bonds may be subject to greater risk than higher-rated bonds. No investing strategy can overcome all market volatility or guarantee future results.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Glossary of Terms

basis point is one one-hundredth of a percentage point.

The ICE BofAML 1-3 Year Investment Grade U.S. Corporate Bond Index is an unmanaged index comprised of U.S. dollar denominated investment grade corporate debt securities publicly issued in the U.S. domestic market with between one and three year remaining to final maturity.

The Bloomberg Barclays U.S. Investment Grade Corporate Floating Rate Note Index measures the performance of U.S. dollar-denominated, investment-grade, floating-rate notes across corporate sectors. 

Floating rate notes (FRNs) are bonds that have a variable coupon, equal to a money market reference rate, like LIBOR or fed funds rate, plus a quoted spread. The spread is a rate that remains constant. Almost all FRNs have quarterly coupons, i.e. they pay out interest every three months. 

Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.

The credit quality of the securities are assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor's, Moody's, or Fitch, as an indication of an issuer's creditworthiness. Ratings range from 'AAA' (highest) to 'D' (lowest). Bonds rated 'BBB' or above are considered investment grade. Credit ratings 'BB' and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principle on these securities.

The opinions in this commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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