GlobalCapital: What for you, was the moment it became clear this would not just be a China issue or a limited issue, but a real global crisis?
Mardarovici, Macquarie IM: I'm sure there were some people that had higher conviction around the fact that this was something more than Sars or H1N1, but our approach initially was to monitor it very cautiously. In February our approach was very much about acknowledging the risk, noting the possibility of a virus impact, but for the most part still looking at previous pandemic episodes to give us some indication.
Once it became clear that Italy and Iran were not able to control the spread of the virus, the rest of us took note. By the time New York’s outbreak became a headline it was apparent that this was likely to be a 1918-like event, and then the focus turned to how we handled it.
I think what was interesting early on in terms of the market reaction to the entire episode, is that it became apparent that humanity as a species had exactly no playbook for a global pandemic in the modern world. That was the stunning and jarring bit of information that the markets reacted to initially — the market abhors uncertainty.
On the other hand, the intervention playbook was a heck of a lot more readily available than it had been. We’ve been fortunate, in a peculiar way, that the GFC was still so present in the minds of policymakers, and so much research had been done into the policy mistakes that caused the Great Depression, that the outcome on the intervention side was in many respects vastly better than expected.
What was your playbook once you'd realised that you'd have to navigate markets in this very stressed period?
We were actually in a very fortunate position in that we had derisked significantly in the second half of 2019. Our approach is that we take off risk when risk is poorly compensated, and that was the case in 2019, almost no matter where you looked.
So we had reduced our allocation to high yield to its lowest level in over a decade, and eliminated some exposure to higher beta instruments like converts. We eliminated non-dollar exposure in emerging markets because we didn’t feel the risk reward was compelling, we cut back on investment grade credit, and in securitized products we had traded up into more liquid areas. The net outcome was that we’d built a liquid capital cushion, comprised mainly of Treasuries and agency mortgage-backed securities
If one took a snapshot at the end of February, we were already in a very good position to take on some risk in the market. And the reason we did this was not because we had a crystal ball and were absolutely convinced something Armageddon-like wasn't coming, but simply that the unknown unknowns never disappear.
We wanted to have some deployable capital to spend if something were to happen in one of the market segments we look at. Our assessment in the second half of last year was that the risks of a recession had increased significantly, though we didn’t expect it on a grand scale we have seen.
What we wanted to be able to do is be market makers when everybody else is running for the doors. So from an overall top down perspective we were already in good shape. Then the second thing we did was to go through on a granular level and ask ourselves, what will be the fulcrum of the pandemic impact.
That means cruise lines, that means airlines, that means restaurants, movie theatres and so on. In February, the only significant things that we had done apart from just being very cognisant of liquidity, was to cut back exposure to anything that would have been highly sensitive to this pandemic.
What’s the redemption profile of your funds like?
Fast forward into March, specifically the second half of March. Our funds are daily redemption funds, though we have institutional investors and a variety of other types of vehicle, but many are on daily redemptions.
But one of the reasons why our risk positioning helped so much is that we had enough in US Treasuries, agency MBS and cash to readily fund any outflows without issues, and without needing to liquidate things like CLOs in the middle of the worst of the liquidity conditions.
In the last week of March or so, we started to transition into phase two, which is to identify securities that had the liquidity and the fundamental robustness to withstand even a severe economic impact, but which were sold by investors seeking liquidity at all costs.
How do you rate the functioning of market structure through this crisis period? Have you generally been able to transact when and how you wanted?
In the middle of the worst panic, market functioning was as poor as at any time in modern times, and that included the global financial crisis (GFC). I remember one of our rates traders saying they’d seen better liquidity during the worst of the GFC in the Treasuries market than they did in the worst days of March.
The need for liquidity resulted in selling the most liquid securities, which meant Treasuries, to a certain extent agency MBS, and then very short-dated securities like high quality liquid ABS and high quality investment grade corporates. This created massive dislocations in these sub-segments of the market, so that's the reason you saw the Fed start with these as it sequentially entered to normalise markets.
It started with Treasuries because this is the go-to instrument to address liquidity needs, and then agency mortgage-backed, which is typically of how the Fed views the importance of that market. Then it moved to address the dysfunction in short term instruments, so that has meant purchasing ABS through the TALF programme, and purchasing investment grade corporates, and then expanding that in April quite a bit.
The irony, initially, was that the more liquid the segments were, the more likely it was that they would experience severe dysfunction.
Once the Fed intervened, and made it clear to the market that it wasn’t just bringing the bazooka, but it was busy manufacturing a lot more bazookas in the back room, you saw a return to a fair degree of normalcy in Treasuries, agency MBS and investment grade corporates.
In high yield, liquidity can be strained in the segments most severely affected by the pandemic, but in a lot of areas of the HY market you have fairly typical liquidity now.
How do you rate that overall central bank response in terms of effectiveness and timeliness? You sound pretty positive….
Here are a few reference points to think about and help make it sink in a bit.
During the GFC, the recession started in December of 2007, and TARF wasn’t announced until October 2008, so it took 10 months. Then the large fiscal stimulus bill took until the beginning of 2009. By contrast, as much as there was a lot of political bickering in Washington, it ultimately took days and weeks to adopt unprecedented measures on both the fiscal and the monetary side.
The monetary side was especially impressive, and I’m quite convinced that the fact that the GFC prompted a lot of studies into what went wrong during the Great Depression helped.
One of the things that went wrong during the Depression was that there was just not enough money around. The Fed is a clear student of that period, and so the reason you have quantitative easing to infinity in Treasuries and MBS is because it wanted to ensure people had as much money as they needed.
The second component was really surprising, even to markets. On that famous Thursday in April, when the Fed announced it would purchase investment grade corporates directly, purchase high yield ETFs, fallen angels, CLOs, expand TALF to CMBS — that made it abundantly clear that what it wanted to do is prevent liquidity problems created on Wall Street from becoming additional solvency problems on Main Street.
The Fed clearly cannot address the underlying economic problems, that’s impossible, we still will have near-record defaults caused by the pandemic, but it avoided having a vicious cycle created by unaddressed liquidity needs on Wall Street.
Perhaps the most telling example of how effective it has been has been the reopening of the primary market, particularly in investment grade corporates. We had some $750bn in investment grade supply starting in March, and that was substantially because the markets were kept open by the Fed with its intervention, a move which has made a big difference in addressing the liquidity needs of a lot of these corporations.
Boeing offers a good illustration — it had gone to Washington saying it needed help withstanding the crisis.
But because of the significant intervention we’ve seen from the Fed, Boeing was able to issue $25bn in the open market. Not a single dollar of that was funded by the Fed, and it withdrew its request for government help. Effectively, both Boeing and the government have come out victorious. Government was able to transfer the entire risk of supporting Boeing into private hands, and Boeing was able to fund itself at very attractive levels, despite the fact that it’s facing a clear existential crisis.
Has the Fed got any more bazookas being worked on?
It’s clear that it does, but with one caveat. In chairman Powell’s recent speeches, he made it clear that now is the time for fiscal intervention and Congress is obviously looking at a $3tr additional stimulus package.
What monetary policy can and must do is keep the mechanism lubricated, but in order for the mechanism to work, fiscal policy is the only thing that can make it turn. Without an effective monetary policy you can’t succeed, but monetary policy alone cannot reignite economic growth.
Chairman Powell was also very clear that he wants to make sure the announcement effects aren’t replaced with disappointment, so in that sense, the Fed will deliver when required. We think it’s unlikely they would cut short the programmes they’ve already announced, otherwise the market would punish them quite swiftly.
With that said, at this stage, the market is functioning relatively well. The fact that entities like Delta Airlines, AMC, or Boeing are able to come to market shows that the Fed, for the most, has done its job. It has provided liquidity to those that needed it, and allowed a lot of corporations to access the market at reasonable levels.
Unless we see some significant deterioration in market functioning, illiquidity or some massive piece of new negative information, the Fed is likely to maintain as many tools as it can still in the shed, to avoid being too aggressive and distorting markets.
One very good example is the fact that it’s been pulling back from Treasury and agency MBS purchases, reducing purchases to about $10bn per week in Treasuries and probably into single digit territory in the coming weeks. The Fed does not need to continue to be buyer of last resort in an otherwise reasonably well-functioning market.
So yes they have won, they have demonstrated there’s a lot more they can do, they have shown they can be very creative, and very legally creative, but they will be reluctant to do more unless absolutely necessary.
When you and your team are looking this flood of primary supply, what do you like to see from companies and how do you navigate credit at the moment?
We live in times which have as much uncertainty as we’ve seen in modern times, and that includes the great financial crisis. You can see it in corporate earnings — the percentage of companies that have pulled guidance altogether is the highest it has ever been, so visibility in this environment is about nil.
But the way we approach it is to say “let’s do the homework”. Our goal is not to predict the severity of the crisis, or to predict how long it will last, because it’s very unlikely we would be right.
So we ask, instead, 'what scenarios are plausible?', and 'what are some worst case scenarios?', and everything in between. We stress the cashflows, stress the other metrics. If they are not highly sensitive to us having a crystal ball on the crisis, and if the entity demonstrates the liquidity and business model robustness to get to the other side of the pandemic, then it could potentially be purchased into one of our portfolios.
If it requires financial engineering to determine whether or not the company or the securitized bond makes it through, it’s simply not a compelling investment.
A very good example is the energy markets, which makes up around 70% of defaults at the moment. It’s been an area in distress for some time, and we’d avoided higher yielding energy names prior to the crisis. But something that’s trading at 10c or 7c might well see zero or negative recoveries. It’s not necessarily the case that these are bargains because you have to recover something or because the company has assets.
What are some areas where you do see good opportunities and value?
There are two areas that are compelling. Firstly, sectors that are simply less directly exposed to the negative effects of Covid, so TMT for example, but not necessarily every single entity, and banks. From an equity perspective, that might sound surprising, but from a bond perspective, banks have become the new utilities of this era, substantially because of the post-GFC regulations.
In this environment, money centre banks, unlike during the GFC, are actually in a very good position to withstand a fair degree of distress. So that’s an area we’re comfortable with, subject to their individual exposures to different areas.
Then there are other sectors that are less clear — healthcare names can be very negatively exposed to what's happening now, but at the same time some can potentially benefit.
There are some areas in high yield that have been great opportunities — at the worst of the liquidity vacuum, something like a Bausch, which manufactures contacts lenses, among a variety of medications for rare diseases, was trading in the 80s, and has recovered to well above 100. There are unique names where the fundamental business model itself is not directly exposed, but may be in an industry that’s exposed.
So even within energy, which I know I just said we’re avoiding, there are certain Master Limited Partnerships which are investment grade issuers within energy, and which have traded to quite attractive spread levels, with predominantly fee-based business models. It’s another area where it’s about identifying the babies that have been thrown out with the bathwater.
If you look to the emerging markets debt, one of the things we’ve done is move around the investable universe as the primary markets reopened. Initially it is the strongest issuers that come to market, and they have to offer very significant concessions. So a Qatar or Peru will come to market with dollar-denominated debt, and issue with concessions of 50bp-100bp on top of secondary spread levels that are already at historically wide levels.
When you look at the securitized market, there are some areas likely to be subject to a lot of distress — commercial real estate for example, will see significant long term implications from changes in both business and consumer behaviour that result from the pandemic.
We’ve seen an acceleration in bricks and mortar retailers finally collapsing, and so you’ll see significant distress in retail real estate, as well as leisure. Office buildings, too, might see problems as businesses through the world have discovered that working from home is not just a theory but can be implemented to great success.
So when you look at CMBS, you need to transition from thinking about it top down as a cheap asset class, and instead consider which parts of the structure and which specific bonds with which specific collateral can make a compelling case.
As that market has now reopened with the Fed supporting it, we’re likely to see some opportunities there as investors become cautious around investing in that area.
How do you regard the heavily collateralised rescue deals that have come through from the likes of the airlines and cruise companies? Do you see value there?
One of the key themes that our distressed credit team has mentioned is that secured issuance of this kind is one of the last resort mitigating actions that a company can take. It’s great that some of them are capable of doing it, and they’re attempting to shore up their liquidity, but it’s clearly not a good sign.
The second point is that these secured deals have come at fairly attractive valuations, the presumption being that there are assets backing them, and that these assets are worth something.
But it’s very possible that some of these could be worth nothing. Cruise ships are one of the most obvious examples, because one should first answer the question of whether cruising will be a business of the future or not, and the fundamental value of the assets hinges on that. It’s a binary answer.