Fixed income expert on how COVID-19 has affected liquidity premium and why a recovery is a matter of time
Brian D’Costa is a founding partner and president of Algonquin Capital. In this piece for WP, he explains why investors’ fixed-income holdings have dropped 10-15% in the past few weeks, prompting central banks to re-initiate recovery programs developed in 2008.
Most investors hold diversified portfolios of equities and fixed income. A diversified portfolio minimizes the investor’s exposure to severe market downturns. With COVID-19 wreaking havoc on equity markets, investors have been shocked to see their fixed income holdings also down anywhere from 10% to 15% in the last few weeks.
This is because most fixed income investment products hold corporate bonds. These bonds range from high-quality companies (investment grade) such as banks (RBC, TD etc.) and telecommunications (Bell, Rogers, etc.) to lower credit quality companies (high yield) such as Bombardier or Kraft.
When a corporation borrows money in the form of a bond, they need to pay a higher interest coupon than the Government of Canada. As an example, if the Government of Canada needed to pay 1.5% coupon on a 5-year bond, an investment grade company might have to pay a 2.5% coupon on their 5-year bond. The difference in yield between the investment grade bond and the Government of Canada bond is referred to as “the credit spread.” In this case, the credit spread is 1%, or 100 basis points (bps).
The assumption is that the credit spread reflects the risk premium required to compensate investors for the fact that TD Bank has a higher probability of defaulting than the government does. In reality, only a small portion of the credit spread is intended to compensate investors for the default risk. In the previous example, less than a third of the 100bps spread is compensation for default risk. The remainder of the 100bps is to cover other risks, including one that is rarely discussed – liquidity premium.
Liquidity premium is a measure of the cost involved in buying and selling bonds. The seller of a house can think of the commission paid to the real estate broker as a liquidity premium. The bond market does not trade on an exchange. Instead, it operates in the ‘over-the-counter-market’ which is a loose web of banks and dealers who buy and sell fixed income product from their own inventory i.e. put their own capital at risk. As a result of the nature of this type of market, liquidity premiums in the bond market are normally higher than they are in the equity market.
Within the bond market, different types of bonds have different liquidity premiums. Government bonds have the smallest transaction costs (i.e. they are the most liquid), investment grade corporate bonds are in the middle, while high yield bonds have the highest transaction costs (i.e. they are the least liquid).
Normally the liquidity premium is stable.
Let’s move to what is happening now. The global response to dealing with COVID-19 has been to effectively close businesses and ask people to stay at home. Furthermore, the stock market has dropped approximately 35% as fears of a deep recession have grown. Default probabilities have also risen so credit spreads have widened to reflect that. Unlike many previous downturns, the fact that businesses are being shut has spawned a dramatic increase in the demand for cash. We are seeing large companies immediately drawing down on demand bank lines. Think of this as immediately borrowing on your home equity line of credit. It is not only corporations who are seeking cash, but also portfolio managers who worry about funding redemptions etc.
The dramatic demand for cash has been impossible to meet with cash on hand in the banking system so there has been a rush to raise cash by selling what are commonly referred to as ‘cash proxies.’ Cash proxies are short-dated bonds such as t-bills, commercial paper and government or corporate bonds with a maturity of less than one year. Another reason people look to sell such bonds is because the price is generally close to par ($100). Even at today’s prices, people would be far more willing to sell a short-dated bond with a price of $98 rather than a 10yr bond with a price of $85.
With an overwhelming number of people looking to sell bonds, the few buyers are in control and naturally demand a hefty compensation to part with their cash in return for a security. This extra compensation has little to do with the risk of default and everything to do with the liquidity premium. As an example, four weeks ago a bond issued by National Bank of Canada that matures on June 30, 2020 had a credit spread of 60bps. Today it is 260bps. It is difficult to believe that the risk of National Bank defaulting in the next two months has significantly increased. As such, most of the change in spread is simply the liquidity premium increasing.
Fortunately, help is on the way. Central banks worry about liquidity in the financial system. Clearly the demand for cash is overwhelming the current supply. As a result, central banks around the world have re-initiated the liquidity programs they had developed to deal with the 2008 financial crisis. While these programs were originally designed to provide liquidity to the sovereign bond markets, some have been modified to offer some support to the investment grade corporate bond market as well. Furthermore, new programs are coming to specifically target short maturity investment grade corporate bonds.
There is a time lag from the announcement date to the date that cash starts flowing into banking system, however, we believe that the amount of cash available to the financial system will steadily and dramatically increase in the coming weeks. As a result, we should see liquidity premiums narrow and see improved performance from funds that hold high quality corporate bonds. This can occur even without good news on the COVID19 front.
Investors can take advantage of the liquidity dislocation by putting money to work in funds that hold investment grade bonds. It is not a matter of ‘will my fixed income investments recover.’ It is simply a question of ‘when’.