We hope that you and your family are well as we all adjust to a time of transition in the face of the Covid-19 pandemic.

As governments struggle to address financial uncertainties, central banks have driven interest rates to historical lows on a global basis through quantitative easing and bond buying programs.  The 10 year and 30-year US Treasury interest rates dipped to lows of 0.31% and 0.70% respectively in March. At the current low interest levels, a 1% increase results in 8.8% and 20.2% declines respectively in these bonds. Interest rates have been negative in Europe and Japan since 2014 when their central banks bought bonds in the hopes of spurring economic growth, which did not occur. Instead, governments and corporations alike binged on debt issuance increasing outstanding global debt to $250 trillion.

The first sign of stress in the bond market came in September 2019 when US banks stopped lending to European banks. This caused the overnight lending rate to spike from 2% to 10%. This, in turn, caused the Federal Reserve to increase its overnight lending facility to $1.5 trillion preventing short-term interest rates from rising. 

The second sign of stress developed in March 2020, when high yield exchange traded (ETF) bond funds began to trade at significant discounts to their net asset values. The selloff in high yield bonds was triggered by governments’ orders to “shelter in place”, which effected 75% of the US population. Investors realized that layoffs across multiple sectors meant more defaults on lower grade bonds and mortgages. As some ETFs began trading at 10% discounts to NAV, the Fed started to buy bonds to prevent prices from cascading lower. Investors discovered that the liquidity of their ETFs was only as good as the liquidity of their funds’ holdings. 

Canada faced similar issues prompting its central bank to provide C$500 billion in liquidity to their banks and support for mortgage backed securities.  Europe is now considering central bank digital currencies to prevent bank runs and eliminate the black markets.  The US, Europe and Asia have all announced stimulus programs that are expected to rise to $25 trillion over the next few years, all to be funded in the debt markets. 

Although bond prices are expected fall substantially in the next few years, we believe that investors will come to realize that stocks will be their best investment.  The markets will favor those stocks that are benefitting from the growth of the “at distance” economy, particularly those that are generating strong and rising levels of free cash flow.

In closing, we are aware that coronavirus pandemic is creating unprecedented uncertainties with heightened degrees of stress.  We are happy to share our insights with you and hope that you will feel free to share our thoughts with others who may benefit.