I'm Dusting Off My Old Playbook for Bonds Right Now

Wednesday was the strongest day yet for fixed-income markets, as almost everything rallied -- from municipals to corporate bonds to asset-backed bonds. This is not only an extremely good sign for bond investors, but a bullish sign for markets generally. Let's unpack what is happening now and how I'm using my 2008 playbook to navigate the volatility ahead and find some great opportunities. Dislocation Vs. Risk Last week, just about everything in bonds was dislocated. But especially acute was selling in totally unrelated areas: municipals and real-estate related bonds. In other areas, like corporate bonds -- and especially high-yield ones -- the selling was aggressive and pretty indiscriminate. But this area has more real economy risk. In other words, the selling was at least in part related to worries about how the Covid-19 recession would hurt earnings. The selling in munis and real estate bonds was forced selling. This is the distinction between a dislocation and fundamental risk. Phase one of the asset price recovery will come from purely dislocated assets. This is how it happened in 2008-2009. It was tempting to buy the assets that had declined in value by the most, but many of those took a very long time to recover, and in some cases never recovered fully. The bonds that were suffering purely out of illiquidity or forced selling or both recovered quickly once the forced selling subsided. Because bonds are over the counter, every seller needs to find an actual buyer. In the muni market, which saw record outflows last week, there were way too few buyers to take on the bonds. In real estate bonds -- such as commercial mortgages or home mortgages -- these were popular holdings of mortgage real estate investment trust, hedge funds and other leveraged players. Some of these have blown up completely. Some are being forced to deleverage as margin calls are coming through. But this has caused acute selling pressure in a narrow segment of the market. Readers may have a hard time playing commercial mortgage bonds, and to be sure, there are some that are probably going to be fundamentally impaired. But municipals remain a very attractive buy. Already munis have started to rip, declining in yield by about 60 basis points Wednesday on the back of about 50bps Tuesday. There's still time to get into that trade, but it may only last a few more days before the value is at more normal conditions. Recession for Losses Next there will be bonds that require a much worse recession to take losses. There is a saying that there's always a bull case and a bear case. As you enter into a recession, there will be people who project it not being so bad, and others project the next Great Depression. This hasn't been any different. There are those who argue the economy can start back up in a few weeks and others saying we'll be locked in our houses deep into 2021. Some think the government assistance will bridge the economy with few bankruptcies or long-term supply disruptions. Others think the whole travel and hospitality sector will go out of business and have a hard time coming back quickly. I honestly don't know which of those is real. I suspect it is somewhere in between this optimistic view and the pessimistic view. But importantly, this is exactly how it played in 2008. There were those who thought the banking sector was going to be nationalized and gross domestic product growth stuck at zero for a decade. And of course, even in the fall of 2008, there were those who weren't even sure we were going to have a recession at all. At some point, the real scope of the recession starts to become clearer. For very high quality bonds, it doesn't have to be that clear. In 2008, there was a period where it wasn't obvious that companies could sell new bonds to roll over debts. Once a few very big name companies did so (PepsiCo was famously the first, bringing an 8% yielding bond), it resulted in people flocking to these very high quality and still high yielding assets. We are probably entering this phase now. Here's the list of some of the biggest new issues that came this week: Pfizer Mastercard Baxter Lowe's Comcast Kimberly Clark Procter & Gamble General Dynamics Thermo Fisher Humana That's a list of household names with very little cyclicality generally and probably very little exposure to Covid-19. Almost all of them are A-rated or better. They mostly came at spreads vs. Treasuries of 250bps to 400bps, which would have been high-yield spreads a month ago. These extremely wide new issues will continue to come to market and continue to be very attractive. It can be tough to participate as an individual investor, but the next best thing is to find very high yielding, high quality, low cyclicality bonds in the secondary market. Distressed May Not Return The last comes the cyclical names, while the distressed may never come back. It is tempting to jump on things that have fallen the most during bear markets. But many names in the heavily stressed sectors, like traditional retail, energy, travel, etc., may not come back. Especially if they have a weak balance sheet and can't roll over their debts during this stressed period, time may just run out. Consider this even if you are primarily an exchange-traded fund or mutual fund investor in bonds. High-yield is full of these highly leveraged, deeply cyclical businesses. It could be that high-yield performs well from here, but it will take a relatively optimistic economic outcome. Be aware of the bet you are making in that case. I'd argue buying stocks of low leverage companies probably makes more sense if you want to get more aggressive. Once the corporate bond market starts to open up and we get more clarity around the duration of the economic downturn, cyclical companies will come back too. By then you'll have more visibility into which ones are probably winners and which ones are losers. Consider this before you dive right into the really beaten up assets.

I'm Dusting Off My Old Playbook for Bonds Right Now

After a strong day for fixed-income markets, let's learn from 2008 how to play this volatility.

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