April is going to be a critical month in assessing the global response to the COVID-19 crisis. My base-case scenario continues to forecast a “V-shaped” economic recovery, in which the coronavirus impact is widespread but short-lived, and we see a quick rebound in economic activity following the market bottom. But there is also the chance of a “U-shaped” recovery, in which the economic slump is prolonged throughout the year, and the recovery takes longer to get off the ground. The continuing global policy response will be instrumental in shaping the path forward.
In the midst of these questions, Invesco’s portfolio managers are positioning their strategies to help mitigate the risks they see ahead, and to take advantage of opportunities as they arise. In this blog, we hear from several investment experts on the road ahead:
- Ronald Zibelli, Senior Portfolio Manager, Mid-Cap and Small-Cap Growth
- Eric Pollackov, Global Head of ETF Capital Markets
- Laurie Brignac, Chief Investment Officer and Head of Invesco Global Liquidity
- Scott Baskind, Chief Investment Officer and Head of Global Private Credit
- Stuart Novick, Senior Equities Analyst, Convertible Securities Team
Small and mid-cap growth stocks: Taking advantage of what’s changed and trends that remain intact
Ronald Zibelli: The market outlook changed substantially during the first quarter of 2020 due to the global outbreak of COVID-19. In the US, the pandemic has led to an abrupt plunge into recessionary economic conditions while equity markets tumbled from historic highs to a bear market in record time. Small-cap companies suffered the most, with the Russell 2000 Index falling more than 40% from the Feb. 19, 2020, peak through the late March low.1 Mid-caps were only marginally better off. While the markets have at least temporarily stabilized due to unprecedented monetary and fiscal stimulus, the magnitude and speed of the recovery remains largely unknown. Despite this heightened uncertainty, we believe it is important to focus on what has changed and what hasn’t changed due to COVID-19 and the opportunities this unique market environment has created.
We are evaluating two primary sets of opportunity in this tumultuous environment, one short-term and the other longer-term. The first results from a heightened level of market inefficiency created by the combination of volatility not seen since 2009 and diverging fundamentals across industries and companies. These circumstances create extra opportunity for skilled active managers to assess and potentially take advantage of. We are asking ourselves about how this macroeconomic situation and its likely aftermath impacts the prospects for companies in our actively researched universe. The range of answers to that question is quite wide. Meanwhile, short-term stock price fluctuations have been running far above normal. This results in an elevated number of mispriced security opportunities that will diminish over coming weeks and months as economic and company specific uncertainty is resolved.
The other opportunity set presented by the current environment involves our belief that the technology driven disruption that has been rapidly transforming the global economy should emerge from this situation with only a temporary setback to growth prospects. We believe the digitization of enterprises, transformation of vehicle architectures and revolutionary advances in life sciences will continue, providing abundant opportunity for future value creation. In some cases, recent events may even accelerate the trends in technology leadership that had already been in place. Many of the companies participating in these areas have suffered serious erosion of their equity prices, creating compelling investment opportunities for portfolios.
ETFs: Bid-ask spreads illustrate an improvement in liquidity
Eric Pollackov: In late February and early March, liquidity dried up in the underlying cash bond market, disrupting a wide range of fixed income securities. Treasury futures liquidity seemingly evaporated day over day, with market depth reaching levels not seen since the financial crisis. The difference this time, however, was the pace of change in liquidity conditions, deteriorating over days rather than months. However, thanks to the various asset purchase programs announced by the US government, liquidity conditions have recently begun to recover.
From Feb. 20 until March 27, volumes for all US-listed exchange-traded funds (ETFs) were 200% higher than they were at the beginning of the sell-off (from Jan. 1 through Feb. 19).2 Liquidity was reduced during this time, with bid-ask spreads widening by 135%.2 But since March 30, in conjunction with the asset purchase programs mentioned previously, bid-ask spreads have begun to normalize. For example, investment grade corporate bond spreads have been reduced by almost half since mid-March, though it’s important to note that they remain almost five times wider than their 2019 average.3
In short, liquidity remains somewhat of a challenge from a historical perspective, but it has continued to get stronger in recent days.
Money market funds: Historic inflows reflect the need for liquidity
Laurie Brignac: The need for liquidity in these uncertain times has its roots in two main areas: 1) corporations need cash on hand to meet payroll and other obligations while their businesses are put on hold, and 2) there has been a flight to quality due to volatility in the fixed income and equity markets. As a result, we’ve seen historic flows into money market funds in March — with about $800 billion pouring into the asset class for the month, according to the Investment Company Institute. The inflows went into government money market funds, well offsetting outflows from prime and tax-exempt funds.
As part of the COVID-19 rapid response, we’ve seen swift action by the global central banks, lowering target rates to zero or near zero. The low interest rate environment combined with the wall of demand for high-quality, short-dated assets from money market funds and individual investors have pushed yields in government securities to below 0.25%.4 Helping to add supply into the market is the US Treasury, which has issued over $650 billion in cash management bills4 and continues to increase the size of its regular auctions, all of which is necessary to pay for the pushback of the tax filing deadline from April 15 to July 15 and the $2 trillion fiscal package passed by Congress.
The US Treasury, along with quick action and liquidity programs created by the Federal Reserve, has created a floor on short-term rates and provided much needed stability to the front end of the yield curve.
Senior secured loans: Strong yield potential with priority status
Scott Baskind: In sympathy with other credit risk assets, senior secured loans traded off sharply during March as concerns surrounding COVID-19 crept into capital markets. Through the first half of March, price declines were indiscriminate across the quality spectrum as liquid, high-quality loans were heavily sold to raise cash to meet redemptions. However, high- and mid-quality loans materially outperformed toward month-end, as buyers emerged and the technical pressure abated. Low-quality loans remained under pressure even as the market rallied due to a focus on fundamentals. We have been defensively positioning our portfolios against loans that are most vulnerable to a broader economic slowdown and potential liquidity risks, and those that could be downgraded to CCC. In our view, March’s volatility has resulted in loans presenting a compelling opportunity from a relative value standpoint.
Senior secured loans offer the potential for a comparable if not greater yield than subordinated credit instruments such as traditional high yield bonds. But, unlike subordinated bonds, senior loans sit at the top of the capital structure and are secured by assets of the company. If a company faces financial hardship, loans have a priority claim on the company’s assets and are to be repaid first.
Historically, senior secured loans’ overall coupon has been the primary driver of returns, contributing to the overall stability of the asset class — dating back to 1992, loans have produced only two years of negative total returns (2008 and 2015) as the asset class’ high coupon more than compensated investors for price declines.5 In both instances of negative returns, senior secured loans produced a strong rally the following year.5 Overall, we believe loans’ return history, and their senior and secured status, may make them particularly attractive in today’s market.
Distressed credit and direct lending: A historic opportunity
Scott Baskind: COVID-19 has had a significant economic impact across the globe. And while we take no joy in finding opportunity in these regrettable circumstances, these events have materially reshaped the opportunity set in both distressed credit and direct lending.
In distressed credit, we are seeing a clear expansion of opportunity in the US and Europe (notably in our focus area of small-cap/middle-market companies which are disproportionately impacted by the circumstances). Moreover, we are seeing a diverse range of fundamentally sound and resilient businesses which go beyond the first wave of coronavirus- impacted industries such as travel, leisure, and gaming, where many large-cap firms are currently focusing. Certainly, this is the most significant level of opportunity our distressed investing team has seen in decades. We estimate that the market opportunity has quadrupled, and we believe we are only in the early innings of an opportunity that will continue to gradually grow over time.
In direct lending, we expect a similarly significant opportunity. Looking back at previous recessions, we saw four key trends that we may see again in this environment: 1) available liquidity to middle market companies became severely constrained, 2) as middle market valuations contracted, private equity sponsor activity increased with its need for financing, 3) deal terms and structures shifted to favor lenders, and 4) return profiles/all-in yields increased. In short, as private equity firms begin deploying their record-high levels of dry powder in this environment, we expect direct lending to be well-positioned to deliver attractive risk-adjusted return profiles.
Convertible securities: A unique tool to help mitigate risk
Stuart Novick: As economic pressure builds in the face of the coronavirus pandemic, US stocks fell significantly in the first quarter — a trend that was punctuated by days of brief spikes. For equity-focused investors concerned about additional pressure on stock prices, but also afraid to miss any potentially sharp gains, convertible securities could help dampen the downside potential of a stock portfolio while still offering exposure to upside moves.
A convertible security is a corporate bond that has the ability to be converted into a fixed number of shares of the issuer’s common stock. Because of the way these securities are structured, we expect them to lag the performance of stocks in a bull market but outperform them on the downside. During major market sell-offs prior to the current correction, convertibles have generally performed the way they were supposed to, with declines less severe than those posted by equities.6 Convertibles exhibited this behavior during the financial crisis6 and are doing so currently. Through the first quarter of 2020, the ICE BofAML US Convertible Index posted a -13.62% return, comparing favorably to their underlying stocks (-24.26%), the S&P 500 Index (-19.6%), and the smaller-cap focused Russell 2000 Index (-30.6%).7
In short, I believe convertible securities can be a worthwhile diversification tool, offering investors the potential for equity upside participation as well as downside support from the fixed income component.
1 Source: Bloomberg, L.P.
2 Source: JP Morgan Research
3 Source: Market Axess
4 Source: Bloomberg, L.P. as of April 8, 2020
5 Source: Based on the Credit Suisse Leveraged Loan Index. The Index returned 44.87% in 2009 and 9.88% in 2016.
6 Source: StyleADVISOR. From November 2007 through March 2009, the ICE BofA US Convertibles Index posted a -28.1% return, comparing favorably to the S&P 500 Index (-35.8%), and the smaller-cap focused Russell 2000 Index (-36.8).2
7 Source: Barclays Research. Jan. 1, 2020, through March 31, 2020
Blog header image: Per Swantesson / Stocksy
Past performance is not a guarantee of future results. An investment cannot be made into an index.
Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.
Senior loans are subject to credit, interest rate and prepayment risk, are typically lower-rated and may be illiquid investments (which may not have a ready market).
Diversification does not guarantee a profit or eliminate the risk of loss.
Credit risk is the risk of loss on an investment due to the deterioration of an issuer’s financial health. Such a deterioration of financial health may result in a reduction of the credit rating of the issuer’s securities and may lead to the issuer’s inability to honor its contractual obligations, including making timely payment of interest and principal.
Convertible securities may be affected by market interest rates, the risk of issuer default, the value of the underlying stock or the issuer’s right to buy back the convertible securities.
The ICE BofAML US Convertible Index is a market-capitalization-weighted index of domestic corporate securities. To be included in the index, bonds and preferred stocks must be convertible only to common stock and have a market value or original par value of at least $50 million.
The S&P 500® Index is an unmanaged index considered representative of the US stock market.
The Russell 2000® Index, a trademark/service mark of the Frank Russell Co.®, is an unmanaged index considered representative of small-cap stocks
The Credit Suisse Leveraged Loan Index represents tradable, senior-secured, US-dollar-denominated, noninvestment-grade loans
Market depth is the market’s ability to sustain relatively large market orders without impacting the price of the security.
The bid-ask spread is the difference between the highest price abuyer is willing to pay for a security and the lowest price that a seller is willing to accept for the same security. In general, the narrower the bid-ask spread, the more liquid the market.
The yield curve plots interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates. The front end of the yield curve refers to bonds with shorter maturity dates.
A credit rating is an assessment provided by a nationally recognized statistical rating organization (NRSRO) of the creditworthiness of an issuer with respect to debt obligations, including specific securities, money market instruments or other debts. Ratings are measured on a scale that generally ranges from AAA/Aaa (highest) to D/C (lowest); ratings are subject to change without notice. For more information on Standard and Poor’s rating methodology, please visit www.standardandpoors.com and select “Understanding Ratings” under Rating Resources on the homepage or Moody’s at www.moodys.com and select “Rating Methodologies” under Research and Ratings on the homepage.
ETF shares are not individually redeemable and owners of the Shares may acquire those Shares from the Fund and tender those Shares for redemption to the Fund in Creation Unit aggregations only, typically consisting of 10,000, 50,000, 75,000, 80,000, 100,000, 150,000 or 200,000 Shares.
The opinions referenced above are those of the author as of April 9, 2020. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.