Investors’ search for income is getting tougher and more urgent as the coronavirus pandemic continues to wreak havoc on global markets, says Jason Brady, chief executive of Thornburg Investment Management.
“The fastest ever sell-off in equities and evaporating dividend payouts is a real problem when interest rates globally have been slashed to zero,” he said at Investment Magazine’s Retirement Conference.
Brady’s comments come just as some of the world’s largest companies move to reduce or scrap dividend payments to preserve more cash. In Australia, the pressure on the big four banks will likely see an average 30 per cent dividend cut by the end of financial 2021.
Speaking on the state of the markets, Brady said pricing uncertainty amidst an unfolding health crisis has been worsened by a liquidity shock since market participants may need to raise funds for redemptions or margin calls.
“The volatility is showing extreme stress in the market place and the uncertainty is causing those liquidity challenges,” he said. “This is a major force in the current market.”
Nevertheless, he argued, there is one area where investors can find income – in global public credit markets which have become broader and more robust.
“Prices are a lot lower and the menu of income-producing securities is a lot bigger and more interesting,” Brady said. “It is true in equities certainly, but it is absolutely true for fixed interest.”
“The good news is that there is a lot to do outside high-quality fixed-interest securities,’ he said.
Nevertheless, the Thornburg chief executive warned that while credit globally has gotten very interesting, riding out volatility remains a challenge.
“There are many different kinds of risks to take – some of them terrible – but the benefit today is that prices have fallen dramatically.”
Brady said while it seemed counterintuitive, in a downturn, there are more investment opportunities in public credit than in equities.
He added that coming out of market dislocations, credit tends to be one of the best-performing assets, both through the challenge and into recovery.
“Credit investors are generally very volatility averse and will sell out at any signs of a drop in yield. Therefore, prices in credit are extremely volatile relative to their outcomes.”
He also noted that the collapse in prices is not only valuable from an income perspective but also from a total return perspective.
“While the Fed has backstopped high-quality credit, the lower-quality credit has been left to investors to pick up the pieces,” he noted.
Finding cockroaches
That said, Brady sees a rough road ahead for private credit. He warned that since most of the global stress will hit small and medium businesses, current credit pricing doesn’t reflect reality.
“Comparable public credit securities have seen massive price markdowns. If we see a similar markdown in private credit assets, the pain will be tremendous.”
During the session, Brady warned that, post the GFC, the central banks’ move to cut rates to zero, or sub-zero, by capping long-duration bond yields through asset-buying programs has led to a massive increase in indebtedness for companies around the world.
A decade of ultra-low interest rates and large-scale asset purchases by central banks led to cheap money. Not only did low rates act as an incentive for corporates to raise debt levels at cheap rates, he added, but they pushed investors to the riskier end of the spectrum.
“The reach for income caused a lot of activity in portfolios but also in the lending paradigm,” he said. As institutions heightened their search for yield, companies took on more debt, making themselves riskier and spurring pensions on to invest for yield.”
Brady said global balance sheets are more levered than any time in history including when economies were in recession. “So, as we go into recession, it is a real question as to how ugly things get and how resilient those balance sheets are,” he added.
Ultimately, resolving uncertainty depends on the duration of the health crisis. “But the other issue is what other ‘cockroaches’ are out there – how many liquidations, how many margin calls for instance.”
“Once we know, we can get more comfortable with valuing assets but we are not there yet.”
Correlation Breakdown
Brady also warned that the historical correlation between equities and bonds has broken down and presents the biggest problem for the investing industry for the foreseeable future.
“Over our entire investing lives, we have seen basically global rates go lower with risk asset prices going higher,” he said.
In his view, diversification strategies depend on correlations between assets being low; the broader market is starting to realise that those correlations are not constant. In fact, he went on to say, with global rates at zero, high-quality income has a very different place in investor portfolios relative to riskier assets like equities or long-dated infrastructure.
The multi-asset investment specialist said the chief contributor to the break down in correlations is that global rates have become more than a monetary policy tool, or a cyclical tool, becoming instead a “cycle-of-funding” tool.
Lastly, Brady warned conference delegates not to discount the importance of cash as it provides the greatest optionality in a portfolio. “I can turn cash into anything… but what we have seen in the last month is I can’t turn everything into cash,” he said.
“You can have the greatest portfolio ideas in the world but if you don’t have the cash to execute them you’re hamstrung,” he continued.
“If you can manage liquidity well you can manage excellent returns. If you can be the buyer when everyone has to sell, you can name your price.
“I can’t pick the bottom. I’ve bought the bottom, but I’ve never just bought the bottom.”
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