Published on Mar. 20, 2020
Current Income Portfolio Update
A key economic impact of the Covid-19 pandemic is the heightened near-term probability of U.S. and global recession. Investors appear to be pricing this new reality into financial markets. It is most visible for us in the unusually volatile equity market selloff. In the fixed income markets, which primarily trade over-the-counter rather than on exchanges, the ongoing repricing of credit risk has been accompanied by a significant decline in liquidity.
In order to fulfill its mandate of promoting maximum employment, stable pricing and moderate long-term interest rates, the Federal Reserve needs U.S. fixed income markets to fully function with sufficient liquidity to act as a transmission mechanism for monetary policy. For this reason, in recent days the U.S. central bank directly intervened to attempt to restore proper market functioning. It began by offering secured lending against Treasury bills, and it then escalated into $700 billion of direct purchases of Treasury and agency mortgage-backed securities, and most recently it also purchased three-month commercial paper from highly-rated issuers, with up to $10 billion of credit losses to be covered by the U.S. Treasury. We believe these efforts will likely continue, with additional expansions if necessary, until liquidity returns to the fixed income markets.
Our management of the Current Income Portfolio (“CIP”) is affected by the present lack of liquidity in the investment-grade corporate fixed income market. We believe bid-ask levels are not reliable at this time of historical dislocation. As the Federal Reserve’s actions propagate across fixed income markets, we expect liquidity will return, with corporate bonds repricing to incorporate a higher level of credit risk, consistent with a heightened probability of a recession in the wake of the pandemic.
Our approach to purchasing and selling investment grade corporate bonds within CIP is to evaluate transactions individually. We will generally seek to trade only when the price reflects option-adjusted spreads that are consistent with historical levels and in our view appropriate for the individual corporate credit profile and security structure.
Historically there have been other episodes of credit market dislocations following rapid changes in the economic outlook, with market liquidity returning once investors gain comfort that the environment is properly incorporated into security prices. We expect this time will prove no different.