Fixed income investment opportunities emerge with market volatility
When global financial markets wobbled in reaction to the coronavirus pandemic back in March 2020, there was no way of knowing where or when they would eventually level out. It would take several weeks for the volatility to subside and settle around more typical levels with the arrival of urgent funding relief from the U.S. Federal Reserve (the Fed). Capital markets welcomed the Fed’s liquidity lifeline, which enabled equities to regain their footing in April and helped steer the ongoing health crisis further away from becoming a significant financial crisis.
Since then, many of the restrictions that were implemented to flatten the curve of infections have been lifted, and more sectors of the economy are beginning to reopen with hope of a return to normal, or at least an acceptable new version of it.
Although everything was affected in some way by the same unprecedented events, the benefits of market volatility can come with the discovery of unique investment opportunities that may not have occurred in an otherwise normal environment.
In a recent episode of the Investments Unplugged podcast, Philip Petursson and his guests from Manulife Investment Management’s Capital Markets Strategy team cited some examples of how the market has a way of exposing opportunities to investors with an eye on the fixed income market, including corporate defaults and fallen angels (companies with an investment-grade rating that has been relegated to high-yield due to declining revenue, increasing debt, or negative market conditions).
“Fallen angels can offer unique prospects for a fixed income manager,” Philip said. “There are companies that can be unfairly lumped into this category because of market conditions, and often this is where the opportunity lies. Some fallen angels may be well capitalized and can withstand the market lows, but their debt could be trading at 80 cents on the dollar on the bond market. This represents an attractive position from which you could purchase a five-year bond with a 5-6 per cent coupon—trading at a discount—that if held to maturity, would result in a substantial gain.”
Tom Goggins, Senior Portfolio Manager and Senior Managing Director with Manulife Investment Management, raised another example that emerged during the swings in the bond markets: “The returns that you can get in high-yield in a year or year-and-a-half are exceptional, which is why expanding high-yield and investment-grade corporate bond exposure looked so attractive earlier this year and began to appreciate in value quickly after a broader bond selloff in March,” he said. “Delta Airlines is a good example of a fallen angel that went from a triple-B to a double-B rating and came to market for a five-year bond that could be picked up at 6.75 per cent. This was an extremely compelling investment opportunity for a company that has been hit by hard times in the industry but should return to form as the economy improves.”
Don’t dismiss defaults
While fallen angels can present timely opportunities for keen investors, they can come with an elevated risk of defaults that balloon when the economy dips into a recession.
“In the past year, defaults rose to 4.7%, a level unreached since the height of the financial crisis a decade ago. In the month of April, a one-month record of 19 companies filed for bankruptcy. And the number of defaults by mid-2020 is already the sixth highest amount ever recorded for an entire year¹,” says Kevin Headland, Senior Investment Strategist at Manulife Investment Management.
Not all defaults are created equal, however. They can differ and attract investor interest depending on the nature of the difficulty facing the company, as Philip Petursson explains:
“The circumstances brought into play with the reaction to COVID-19, such as the significant number of defaults that we’re seeing, is that there are always going to be opportunities within the activity — and that goes for any market environment.
Having the expertise, as our portfolio managers do, to know which companies are less likely to default can make for an attractive investment since a higher default rate doesn’t necessarily mean a complete loss of your capital. In fact, if the default ends up being a restructure, you can still end up with most, if not all, of your capital investment.”
Then again, there’s always the possibility that some companies won’t bounce back from a default. As an example, a company could see declining revenues when another brings a superior product to market. If the first company fails to respond effectively enough through innovation, it will more than likely be outsold. A fitting example of this is the transformative evolution of VCR tapes to DVD technology to streaming video services in the home entertainment industry.
According to Headland, “There will be companies that will go bankrupt and never heard from again. We’re seeing this happen and can expect it to happen. Essentially, it all comes down to picking your spots and understanding the risks and relative returns. Right now, we’re seeing most defaults occurring in three main sectors: energy, retail and telecommunications.”
Aside from the obvious role the coronavirus pandemic will continue to play in any economic resurgence, some areas of the global financial markets will inevitably reveal attractive investment opportunities. Whether they will benefit investors over the short or long-term will depend on updated key data. Expect to see statistics, such as unemployment, consumer spending, industrial output, energy usage, and the pace at which the coronavirus spreads or recedes, affect any measurable ability to predict how much the economy will need to regenerate to help the world return to any semblance of pre-pandemic days.
There are reasons to expect more unsettledness with the presence of COVID-19 and markets will adjust accordingly. In the meantime, investors who pay attention to their asset allocation and can balance their risk appetite with a realistic view of returns could view the current state of the markets as a field ripe with opportunity.
Listen to the full conversation. Episode #36 of the Investments Unplugged podcast featuring Philip Petursson is available here. Visit manulifeim.ca for links to more podcasts and information.
1 J.P. Morgan High Yield Market Monitor.
A rise in interest rates typically causes bond prices to fall. The longer the average maturity of the bonds held by a fund, the more sensitive a fund is likely to be to interest-rate changes. The yield earned by a fund will vary with changes in interest rates.
Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a fund’s investments.
The opinions expressed are those of Manulife Investment Management as of the date of this publication, and are subject to change based on market and other conditions. The information and/or analysis contained in this material have been compiled or arrived at from sources believed to be reliable but Manulife Investment Management does not make any representation as to their accuracy, correctness, usefulness or completeness and does not accept liability for any loss arising from the use hereof or the information and/or analysis contained herein. Manulife Investment Management disclaims any responsibility to update such information. Neither Manulife Investment Management or its affiliates, nor any of their directors, officers or employees shall assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained herein.
All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment or legal advice. Clients should seek professional advice for their particular situation. Neither Manulife, Manulife Investment Management Limited, Manulife Investment Management, nor any of their affiliates or representatives is providing tax, investment or legal advice. Past performance does not guarantee future results. This material was prepared solely for informational purposes, does not constitute an offer or an invitation by or on behalf of Manulife Investment Management to any person to buy or sell any security and is no indication of trading intent in any fund or account managed by Manulife Investment Management. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Unless otherwise specified, all data is sourced from Manulife Investment Management.
Manulife, Manulife Investment Management, the Stylized M Design, and Manulife Investment Management & Stylized M Design are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates under license.