It seems like every time a sudden and severe shock hits the financial markets, all the fancy hedge fund investment strategies that use monikers like, “Enhanced Return,” or “Alpha Plus” go from being perfectly fine to gone within a month. This has happened in the major market blow-ups in 1998, 2001, 2008, and 2020, with a few notable semi disasters (2002, 2013, 2016) thrown in between. Then, when the dust clears, investors are pulverized, and fund managers close up shop so as not to have to work the next 5 years for free to make up remaining investors’ losses.
Naturally, with 2020 being easily the worst economic disaster to hit in nearly a century, the “Alpha” and “Enhanced” hedge fund story has been no different. Recently, one fund run by a very prominent money manager dropped a cool 75% in March. You almost have to try to lose 75% in a month, kind of like Max Bialystock and Leo Bloom in “The Producers.” Many other hedge funds have followed suit, only losing 25% or so. What we find is the same, old story. We find out that the managers with their rocket scientist degrees were, when it comes down to brass tacks, selling puts and calls on an index like the S&P 500 and collecting premiums every month --which was great until the market blew up. Sure, they may have been trading fancy things like “Skew Vol” vs. “VIX” or some other attributes with Greek letters, and no doubt, there were some cool algorithms, but in the end, it was simply selling volatility that blew them up. We call this, “The Picking up Nickels in Front of the Steamroller” strategy.
So much of the selling volatility strategies are part of “The Fed has my back” approach to market investing. Let’s face it; the Fed has been supportive of risk for far too long. The increase in their support has been parabolic. This is what leads to long periods of declining volatility and price inflation for risk assets like equities and corporate credit. Pressure builds, as the degree of Fed support increases, and each blow-up tends to be more spectacular than the last. That is why, before the Fed and Treasury came in the markets in March with the message of, “Put the sell button down, we’re going to be buying everything!” the most liquid markets in the world, US Treasury and Agency Mortgage-Backed Securities markets were simply broken. Anyone who relied on leverage through borrowing was being margin called out of existence.
Tax-exempt AAA-rated 2-year municipal bonds were trading at 2.80, while the two-year US Treasury note was trading at 0.32%. The spreads on five-year Investment Grade Corporate bonds (as measured by Markit CDX) went from an all-time low of 43 basis points to swaps (set just a month prior) to 152 basis points. Five-year High-Yield Bond spreads (as measured by Markit CDX) went from their all-time low (set two months prior at 274 basis points spread to swaps) to 871 basis points. The S&P Leverage Loan Price Index went from 95 at February month-end to 76.23 (this “price discovery” in high-yield loans was due to a tidal wave of margin calls).
We do not think it was a stretch to say that investors in corporate bonds and loans were, like the volatility trading hedge funds, picking up nickels in front of the steamroller.
Then the Fed came in, along with Treasury with a flurry of both old and new lending and asset purchasing facilities, even going as far as promising to buy “fallen angels,” or investment-grade bonds that were downgraded to junk after March 23, 2020. Suddenly, the cries of “follow the Fed” rose up and corporate loans and bonds furiously recovered as the long asked question, “When the day of reckoning comes who is going to make liquidity for all these loans and bonds?” seemed to be answered, The Fed and Treasury! The Fed nor Treasury ever made such a promise but after including corporate bond ETF’s into the buy mix investors couldn’t be blamed for thinking that there was suddenly a bottomless pool of liquidity for their assets. Investment houses, with large corporate bond and loan inventories were quite happy to repeat the “Follow the Fed” mantra because they had many assets to sell!
However, despite all of the publicized help that the Fed and Treasury will provide to the corporate sector, a look at the Federal Reserve H 4.1 report shows that so far, not much has been done. Here are five of the major programs and how much activity they have generated to date:
Primary Market Corporate Credit Facility – ZERO
Secondary Market Corporate Credit Facility – ZERO
Municipal Liquidity Facility – ZERO
Term Asset Lending Facility – ZERO
Main Street Lending Facility – ZERO
The economic crisis we are in is unparalleled. After all, there were not a lot of bespoke collateralized loan obligations in 1933! Many non-investment grade bonds and loans are practically on a path to failure, and help is not on the way for any of them. Moreover, as this crisis in our economy and society deepens and the White House and Republican Senate push back hard on funding states whose budgets have been ravaged by the economic shutdown and the virus, that ball is going to end up in the Fed’s lap. It’s not going to make a good story if the Fed bails out a bunch of over-leveraged, not vital to the national interest “B”-rated companies and does not bail out municipalities who then have to forgo paying or start laying off vital state employees. Imagine the picture of the Fed and Treasury bailing out some perfume company managed by some private equity fund and letting a few thousand school districts fail. Not a good look.
In our opinion, The Fed does not have your back in the corporate bond sector.
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