Guest Post By: Peter Chiappinelli, CFA, CAIA, Portfolio Strategist, GMO Asset Management
Mr. Chiappinelli is a member of GMO’s Asset Allocation team. Prior to joining GMO in 2010, he was an institutional portfolio manager on the asset allocation team at Pyramis Global Advisors, a subsidiary of Fidelity Investments. Previously, he was the director of institutional investment strategy and research at Putnam Investments. Mr. Chiappinelli earned his MBA from The Wharton School at the University of Pennsylvania and his B.A. from Carleton College. He is a CAIA charterholder, and was the founding President of the CAIA Boston chapter. He is a CFA charterholder.
These are difficult times for investors. With markets gyrating and the news filled with rapidly changing information, advisors themselves are looking for advice on how to best respond to client concerns and the direction to take their investments.
Our guest for this post is Peter Chiappinelli, CFA, CAIA, Portfolio Strategist, GMO Asset Management. We posed these questions to him via email.
In past crisis sell-offs, we have seen a common pattern emerge.
Our advice is the same advice we give all the time. Value wins – in equities, duration, credit, etc. – because the price you pay for an asset matters. This simple statement runs absolutely counter to efficient market theory, which states that price and fair value are identical. They’re not.
The price of an asset can, at times, drift dangerously above fair value. When bubbly markets form, that’s real risk. We would argue valuation risk is the most important risk to worry about — not volatility, not beta, not duration, not tracking error, not VaR, etc.
Conversely, in a panic or crisis, the prices of assets can move alluringly below fair value. That is where we are today. The world is not going to end. Yet many risk markets today are priced as though it’s about to. This the moment to steel your nerves, shut off your normal and very human desire to move away from burning buildings, and instead, put your cash to work. Because there are bargains to be had.
If this feels uncomfortable, if this feels unnatural, if this feels contrary to every survival instinct in your being, it is. Welcome to value investing.
Figure 1 – Comparison of US vs Emerging Markets Performance 2000 – 2003
Fiscal stimulus will be good for the economy. And what’s good for the economy will be good for credit markets. Conversely, fiscal stimulus, assuming it’s successful (and who isn’t hoping that it actually works?), will cause interest rates to rise, which will hurt “safe” nominal bonds.
And because yields are so low, the yield “cushion” from the negative price movement is essentially non-existent. Remember the cruel math of bond duration —- it gets longer as yields go down. The cruel math is that not only are you being paid essentially nothing for holding nominal treasuries, it’s also a riskier portfolio.
We must first make an important distinction between rates markets such as sovereign debt from developed countries and the credit markets which include municipal bonds, emerging market debt, investment grade, high yield, structured credit, distressed, etc.
The COVID-19 crisis had a predictable impact on nominal rates markets. Sovereign bond yields dropped precipitously in the usual flight to safety “risk-off” phase. The yield on the 10-year US Treasury quickly broke its 150-year record low in the early part of the crisis, but it did not stop there. The unbelievable question, “will it go below 1%?” was quickly replaced with “will it go below 0%?” in a matter of days.
Any long duration instrument rallied strongly. That was good news for bond holders – the depression/recession “insurance” role of bonds paid off.
Now for the bad news. From here forward, the expected returns from sovereign debt is miserable. In real terms, bonds are essentially priced to deliver negative returns for the next 30 years, if not longer.
Unfortunately, diversification doesn’t really help as sovereign debt across the planet is even worse off than US bonds. Here is one grim statistic: For a 55 or 60-year-old client who is holding a typical target-date fund in their company’s 401(k) plan, it is highly likely that over half of their assets currently sit in bonds with negative real yields. That is, the expected real return of over half the assets is below zero.
It gets worse. Government response to COVID could exacerbate the problem. Fiscal policy initiatives, all designed to resuscitate the economy and get money into the hands of its citizens will likely increase inflation. Printing money — or borrowing heavily — comes at a cost. With rates this low and duration this long, any reasonable rise in long-term rates could damage the bond portfolio even further.
Finally, sovereign debt investors need to buckle up for a wild ride ahead in terms of volatility because the de-leveraging going on in financial circles (hedge funds, risk-parity funds, etc.) is forcing the liquidation of the “the safe stuff.”
Remember that in any crisis, levered positions create unanticipated losses, margin calls, and client redemptions. Portfolio managers are loathe to (or more likely are unable to) sell their risky or junky holdings, so instead they sell their highest quality most liquid holdings, typically US treasuries. That selling pressure, somewhat counter-intuitive given treasury’s safe haven status, is what has been driving historic levels of volatility in the “boring” bond markets in the last few weeks.
Now let’s talk credit markets. Here, the impact of COVID-19 can be seen in two dimensions. First, credit spreads have widened violently. While the credit crisis of 2008 was one for the ages, credit spreads this week are rapidly reaching those historic levels. Investment grade, high yield, bank loans, structured credit, emerging market – it doesn’t really matter – have all seen a painful re-pricing of risk.
Here the good news/bad news is in reverse. If you owned a ton of credit pre-crisis, you just got punched in the gut. That’s the bad news. But if you have cash to put to work today, credit is now tantalizingly attractive. Time to jump into the ring. Our credit teams are literally salivating over the new opportunity set created by this.
In a panic, people sell what they can, not what they should! And as with all crises, indiscriminate selling meant good-credit “babies” were thrown out in the proverbial bad-credit “bathwater.”
Our team believes that it is possible to put together a portfolio of credit instruments that can easily compete with future equity returns, but with substantially lower downside. We have not been this excited about credit in over 11 years.
The key here is to assess your liquidity requirements, because in the post-GFC world, dealers have been and will continue to be skittish about making markets in credit. One must be willing to give up a bit of liquidity in order to take advantage of these delicious yields.
Sovereign Debt: Expect little to no return, with possibilities for future larger losses (certainly in real terms). Duration is incredibly expensive, and yields are the lowest levels in human history. Fiscal stimulus, depending on how big, how it gets executed, and where it is directed, will be good for the economy but a potential dagger to your “safe” bond portfolio. Own as little as you possibly can.
Credit: It’s the best opportunity in over a decade. If you own some, you just took a hit. But if you don’t own any, it’s time to climb into the ring. Spreads are huge, expected returns are high. Be conscious of decreased liquidity (i.e., make sure you have liquidity elsewhere).
Active management can be key here, as it is important to separate the wheat from the chaff. Tons of solid credit instruments have been sold off indiscriminately. There is money to be made. But it’s important to be selective. Some poor business models, especially those who bloated their balance sheets in the last cycle, are vulnerable.
Disclaimer: The views expressed are the views of Pete Chiappinelli through the period ending March 26, 2020, and are subject to change at any time based on market and other conditions. This is not an offer or solicitation for the purchase or sale of any security and should not be construed as such. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities.
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