On t’Mark – COVID-19 Concerns, Flying Blind, Tackling Diversification and Liquidity

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On t’Mark – COVID-19 Concerns, Flying Blind, Tackling Diversification and Liquidity

It wasn’t that busy in financial markets, as the US kicked back for the 4 July holiday and there was light trading in Europe. The big focus remains on the uptick in new COVID-19 cases both in the US and elsewhere, and domestically.

The focus will be on Melbourne and how it handles the increasing number of new cases.  Suburbs have already been locked down and there is a real risk that the CBD could be next. That will have a flow-on impact to the Victorian – and more broadly the Australian – economy as residents, shops and offices have to recalibrate again.

That combined with a complete lack of visibility on corporate earnings means that investors are flying blind on a wing and a prayer.

Over the weekend, there was quite a bit of chatter on the so-called myths about the benefits of diversification in fixed income that got my attention. You definitely need diversification in any fixed income (or other asset classes’) portfolios, so that you reduce idiosyncratic risk as much as possible.  Sure, when the proverbial hits the fan, correlation tends towards 1, and all corporate bond prices move lower (spreads wider), as do equities.

However, in time, rationality (and fundamentals) emerge as the key driver for prices and spreads. Bonds will stop trading on fear. One of the great positives of holding bonds is that you don’t need to have the market to prove you correct. By that I mean, if you hold a bond to maturity and the company is still solvent then you will get paid par, i.e. exactly what you are owed. At maturity, it is irrelevant what other investors and the market believe the worth of those bonds to be. The same cannot be said of equities.

Now liquidity is another matter and that can get patchy in bonds, especially in Australia.  But in times of market stress that is a global phenomenon, not just in fixed income but in all asset classes. I believe that liquidity on the bond side has been reduced since the GFC, as the sell-side brokers have reduced risk capital allocated to trading.

Any self-respecting portfolio manager will adjust portfolios to account for the illiquidity of the underlying assets class. Furthermore, in times of truly heightened stress and liquidity completely evaporates, in my opinion, the correct approach is to either prevent or limit redemptions, as the portfolio manager has an obligation to ensure all unit holders are treated equally and fairly.  If the portfolio manager can only sell the better-quality, more liquid assets then that will leave lower-quality, less liquid assets for those unit holders that remain invested.

On Friday, European bourses closed down 0.3-1.3%.

ACGB 10yr yields closed at 0.90% (-2bp). The Aussie dollar was 0.1c higher at USD69.4c.

Credit was offered: In European credit, IG closed at 64 (unch.) and XO was at 373 (+5).  Aussie iTRAXX was at 83 (-1).

Elsewhere, oil was down 0.8%. Iron ore was up 1.2%.

Tin hats on!

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