Fund manager Q&A with Richard Woolnough and Stefan Isaacs

17/04/2020

The coronavirus pandemic has swept through markets, with most global assets becoming casualties of the collapse in investor sentiment. March 2020 saw one of the most aggressive sell-offs across markets in history. It also saw unprecedented levels of economic stimulus from governments and central banks acting in unison around the world.

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Richard Woolnough and Stefan Isaacs, the fund manager and deputy fund manager of the M&G Optimal Income Fund, discussed their perspectives on the global economy and bond markets in early April 2020.

How has the bond market behaved in this climate?

Woolnough: Governments around the world have reacted understandably to the pandemic by instructing people to curtail day-to-day activity. There is effectively a moratorium on consumption and this has inevitably resulted in a collapse in economic activity. Concerns over the effects of this ‘stay-at-home’ recession on companies have driven the dramatic fluctuations that we’ve seen in corporate bond markets. Levels of price volatility were higher than even during the Global Financial Crisis of 2008/09.

Isaacs: All risk assets were caught up in the sell-off, even investment-grade corporate bonds (those issued by companies seen as less likely to default on their bond repayments). Falling prices having pushed up yields – the prospective annual income from a bond as a proportion of its price – on corporate bonds dramatically. The difference between yields on investment-grade bonds and those on core government bonds, which are perceived as ‘safe-haven’ assets during times of market stress, widened to its highest since the global financial crisis.

The same is true of high yield corporate bonds, which are those issued by companies seen as more likely to default. In fact, given their higher risk profile, high yield bonds suffered harder price falls overall during March. While the high yield market has slowed up, where sellers have been unable to find willing buyers for bonds it has been company-specific, rather than across the board.

Where do you now see opportunities?

Woolnough: When markets are fluctuating like they have been, it can create distortions in the pricing of similar bonds. Where there are anomalies, it can of course create value opportunities for active bond investors. For instance, where companies issue new bonds at a price discount (or yield premium) to comparable bonds of theirs already in circulation, it could offer attractive opportunities for long-term investors.

Isaacs: We have seen opportunities like this in the investment-grade space. If you are confident that a company issuing bonds can make its coupon payments over the life of the bond, and be able to repay the bond’s principal when it matures, being able to buy the company’s debt at a discount could be a rare opportunity.

We need to be mindful of the risks, of course, especially among high yield issuers that may have more debt or be more threatened by the economic downturn. Some companies will become very stressed in this climate, and default rates will undoubtedly rise. Nonetheless, unless we believe that more companies will default on their debt than ever before in history, high yield bonds were oversold to some extent in March.

Woolnough: I think investors should take encouragement too from the support that both central banks and governments have pledged to support economies. Yes, we are seeing an aggressive downturn in economic activity that will hurt businesses, but the damage will be limited by the support.

What impact do you think fiscal and monetary policy will have?

Woolnough: I think central banks and governments are clearly doing everything they can to avert irreversible economic damage being done by the coronavirus pandemic. The huge support from governments, through direct support for businesses and workers, is recognition that they have switched off private consumption – a key pillar of economy activity – to combat the virus. It is also imperative to help ensure a swift economic recovery, as there are clear limits to what monetary policy alone can achieve.

While those central banks, like the US Federal Reserve and the Bank of England, that could cut base interest rates further have done so, not all have had room for manoeuvre. With rates already very close to zero, the European Central Bank has not been able to follow suit. Unlike in the US and UK, where national governments and central banks have been able to act in concert to this crisis, the policy response in Europe has also been complicated by the fact that fiscal policy is set nationally, rather than centrally.

What could be the long-term implications of the crisis?

Woolnough: It will take some time to fully understand the long-term economic implications of the virus, not least because it will ultimately depend on how long and damaging this lockdown period ends up being. There are two important long-term social and political implications in which I believe we can have some confidence, though.

Firstly, we can clearly see the shift towards more caring societies, in developed economies at least. Companies are changing their behaviour, wanting to keep employees rather than lay them off. I believe this shift towards corporate social responsibility will persist long after this crisis, and it is to be welcomed. More socially responsible companies will be positive for economies in the long run.

Secondly, and more troubling, we are seeing a continued rise in isolationism among nations. Even before we entered this period of lockdown around the world, we have witnessed a greater degree of nationalism featuring in the discourse of recent elections, including in the UK and the US. This pandemic gives states the pretext to be nationalistic. Whether isolationism translates into a more permanent shift that shapes the global economy will hinge on the electoral cycle, and the outcomes of upcoming elections, not least in the US later in 2020.

What, in your view, are the prospects for government bonds?

Isaacs: Governments have clearly recognised the need for fiscal spending to lead the policy response. The surge in government spending will be financed by borrowing, of course. With more government bonds being issued, it is possible that the rise in supply will put downward pressure on prices – and therefore upward pressure on yields – for a protracted period. In my view, this supply pressure makes it hard to envisage the yields on developed market government bonds, like those of Germany, the UK and the US, continuing their downward march.

Woolnough: I agree with that. For obvious reasons, it is very difficult for yields to stay negative. After all, it is difficult for investors to make a return on the risk they take – however low that risk – over 30 years on a zero-coupon bond. However, whether or not government bond yields rise in due course will depend on how well the extra supply from new borrowing is absorbed by demand, including purchases made by central banks.

If developed government bond yields are to start rising, I think it would be longer-dated bonds – those that mature decades in the future – that would be most affected. After all, these bonds will look less attractive in an inflationary environment. Inflation may be close to zero today, but is still driven in large part by global oil prices. Given that oil prices have recently fallen to levels that are unsustainably low for producers, there are grounds to believe they will recover, making inflationary pressure a consideration for investors again.

The views expressed in this document should not be taken as a recommendation, advice or forecast.

The value and income from a fund's assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested.