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Posted by Purpose Investments on Apr 5th, 2020

2008 vs. 2020: What the Bond and Credit Markets In Past Crises Can Teach Us Today

As people and the markets absorb the news that the COVID-19 crisis will have us potentially in isolation for months, experience in past financial crises can give us a lot of insight into what to do today.

In this conversation, Purpose founder and CEO, Som Seif, talks with expert stock and credit analyst and Purpose portfolio manager, Sandy Liang, about:

  • The differences and similarities between the 2008 crisis and today
  • The valuable information we can learn from what’s happening in the bond and credit markets
  • Data and research on why advisors and investors should stay focused on the long-term now more than ever
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Read the transcript:

Hi everyone. This is Som, founder and CEO of Purpose Financial and Purpose Investments.

Once again, I’m here isolating at home with my family and like always hoping everyone is safe and secure wherever they are. You know, the news this week coming out of the government and from cities is our social distancing and self-isolation programs will be in place a lot longer than what we originally had hoped. What was weeks is now turning into a messaging of several months.

Now of course, no one knows exactly, but as I articulated to our teams at Purpose this week, we have to get used to this for a little bit longer than we hoped. That said, I am amazed as I am sure many of you are in the ways people are working together, communicating together and ensuring that despite our physical separations, we can still be socially and emotionally together. Remember, we’re all in this together and we will solve this together.

As we think about the world, lots of people are focused every day on, of course, the social pandemic and its numbers, the impact economically that it will have and, of course, the daily impact that we’re seeing in the stock market and its volatility.

In my day, I try to look beyond the surface and think about what are the challenges that we have yet to calculate or that are hidden in plain sight. You know, often this info can be uncovered by paying attention to what’s happening in the bond and the credit markets. So today, I asked my partner Sandy Liang, who is a portfolio manager at Purpose Investment and also leads all of our credit strategies, to join me. Sandy is an expert on all types of corporate debt and has almost 30 years of experience as both a stock and credit analyst. He worked in New York for 12 of those years as a high-yield debt analyst and was partner at Bear Stearns, and straddled his time over the period of the financial crisis.

One of the things Sandy works on that I’m most proud of, and I think he is, too, is the Purpose Credit Opportunities Fund that he manages and it has won for top credit hedge fund for the last 5 years at the Canadian Hedge Fund Awards.

So, all this means that Sandy really knows his stuff, and I’m happy to have him here today so that, you know, I can ask him some questions about what he learned from past financial crises and how that’s informed how he’s dealing with this one.

Sandy, thanks for joining me today.

Thanks for having me Som.

So, we probably don’t have to talk about what has occurred in the corporate credit world because it has been somewhat similar to equities. Equities have had the quickest bear market on record while corporate debt, though not quite as painful as equities, has traded lower on both investment grade, which is the sort of the higher-quality side, and, of course, the non-investment side which is generally considered high yield.

Let’s talk about the last credit crisis in ‘08 and how you navigated that as a portfolio manager. How is what’s happening now similar to 2008 and how is it different?

I’d be glad to comment on that. As you know, I was at Bear Stearns in New York in 2008 and had a front row seat for the last credit crisis. Later on, after Lehman Bros. went bankrupt, I was on the buy side running money. So, from everything I saw then, compared to this recent crisis, I think there are a couple of important differences.

The first is that, in 2008, there was much more forced selling and that was the result of decades of leverage building up in the investment world and clients getting forced margin calls that were triggered by the Lehman bankruptcy, ultimately. So, in 2008 it was much more common for clients, and I saw this when I was at Bear Stearns, to have 4:1 or 5:1 leverage, or borrowed money, against a portfolio of bonds.

So, when Lehman went bankrupt it forced a lot of selling and everyone had to sell at the same time because their credit lines got pulled. So, as a general statement, in 2020, I think the world is a little bit different because the investment world has come into the crisis with higher cash balances. In our two main credit funds for example we don’t use leverage at all and came in with 20% and 40% cash, respectively. So, as a general statement the investment world today is better equipped at handling this downturn. And there’s actually evidence of that fact, for example, last week, and it feels like we’re still in the crisis, but last week the high yield bond market actually saw its greatest weekly inflow ever, or new money invested from the sidelines.

And in the investment grade market, which is the higher quality bond market, in the month of March, even through the crisis companies are continuing to borrow money in the corporate bond markets, and in the U.S. the investment grade new issuance was three times the normal average for that month. So, companies are successfully accessing the corporate debt market and there’s definitely dry powder out there.

The second reason why 2020 is very different than 2008 is that we see governments and central banks react very, very quickly to this crisis to support individuals and businesses affected. The reason the reaction function has been much quicker is, number one, central banks and governments are much more coordinated in terms of getting together and discussing what’s needed for the financial markets.

The reaction function this time has been really, it’s more like the reaction to a natural disaster than a financial crisis, because in this one, in 2020, there aren’t really bad guys in this crisis which is different than in 2008 where Wall Street greed was the bad guy. The Fed didn’t really want to set an example by rescuing companies that were going bankrupt. But in 2020 there aren’t really bad guys.

So, the U.S. government was quick to approve a $2.2 trillion rescue program and spending on corporations, small businesses, individuals. They’re mailing a $1200 cheque to every adult in the country, and so, for example, the U.S. budget deficit prior to the spending program was a trillion dollars and they basically tripled it, just like that, because it is an election year in the U.S. and the last thing the incumbent president wants to see is a lot of widespread bankruptcy.

But, aside from the government, essential banks are also doing their part. They have dropped short term interest rates to zero and they’re printing unlimited money to buy bonds in order to buy liquidity capital markets and, as I mentioned before, it’s working because in the month of March there was more issuance than normal.

So, the markets continue to function, so that’s really different than in 2008, whereas in 2020 governments and central banks are throwing a lot of money at the problem and capital markets are open for business. So, it really is open-ended and if it doesn’t work, if the economy does poorly coming out of this then they’ll continue to throw trillions of free money at the problem.

So, you know it’s interesting, because when we talk about ’08 and the leverage in the system of course was a massive challenge and we talk going into this crisis that we’re in right now that leveraged corporate debts, balance sheets, all of these things, leveraged finance, these are all at their peaks, or we’ve seen for some time because of the low interest rate environment.

One of the other things that I’m concerned about or I know that we’re getting a lot of noise out there maybe, and I’d love to get your perspective on, is that when we think about this challenge, it’s much more of a micro-challenge. The last one was, you had to put solvency and support into the big institutions, the banks and others, the insurers and major asset players. In this, it’s about small businesses, it’s the heart of the economy, it’s people and jobs. We’ve seen the big spike in unemployment.

What are the implications of this? I know people are talking about how does this impact real estate? Who’s holding the bag on mortgages on real estate? Or the assets on real estate? Or how does this impact businesses that are declined meaningful and more leveraged finance? I know we hear the words “collateralized loan obligations” and the size of the impacts of these assets.

What’s your take on this, we can call it the “floor,” that could fall out from these, and is there a floor that ultimately is there?

You know what, Som, I think it’s pretty clear to all of us, because let’s face it we’re all at home this week, everyone’s Visa bill is going to be a lot lower than it has, and the economy, and really the global economy, has tanked. Second quarter GDP is the U.S., I mean it could be down 50%, it’s going to be a very big number. On the other hand, I think that the thing to appreciate when you’re investing is that the market is always looking forward. So, yes, we are in a recession, the recession has occurred quickly and as a result the securities prices have traded down, but what you have to look at is what’s been discounted in the market already.

For example, one of the hardest hit sectors, that you mentioned, is the real estate sector and it used to be, prior to this crisis, which “prior to this crisis” was actually only about a month ago, prior to this crisis the global REIT collectively normally traded around its net asset value, which meant that if you went into the stock market to buy a real estate company you’d be creating the underlying real estate and roughly the market value. There wasn’t much difference, and as of today, the average real estate company is trading at 50% of its net asset value, so, what the marketing has discounted is that real estate value today is 50% less than it was a month ago.

It probably seems like that does seem excessive, just because some rent cheques are going to be late or not paid for a few months, it’s not clear to me why, in a zero interest rate environment, real estate should be worth 50% less. I think it’s important to note that if you wait for things to get better then the market horse will have left the barn already, because the markets are a very good discounting mechanism. It has been very quick to discount the recession that’s here today, but what’s important is that the market, in the coming weeks, months, quarters, is going to look ahead to what a normal state is going to be down the road past this recession.

Interesting, so you’re thinking that a lot of this, call it, noise and challenges have been priced in the market already. It reminds me of a great comment that Howard Marks always says that it’s not just buying great companies at value prices, it’s about buying good assets or relatively good assets at great prices and that how you be a great investor.

Given all this, what’s your view of how investors and advisors should be approaching everything right now?

Well, the thing about investing is that it’s not about having certainty, it’s about investing when the odds are in your favour. It’s number one have a long-term view and a long-term view would be looking towards when things are normal, and the gap from here to there in terms of what happens between the recession today and a normalized state.

So, having a long-term view, number one, and number two, investing when the odds are in your favour. I’ll address the odds in your favour comment: In the corporate debt world, when you look at valuation, we look at something called the credit spread. Everyone knows that, when it comes to stocks, you’re looking at a P/E ratio, that the most quoted valuation metric for stock that’s priced over earnings. In corporate debt, we look at the credit spread which is how much incremental yield or interest are you getting above government bonds.

As of the last week or so, the credit spread in the high-yield bond market is roughly 1000 over treasuries, so what that means is that U.S. treasuries are under 1% and you’re getting 10 times that in the high-yield market.

What does that mean historically? If you invested every time that the credit spread was 1000 basis points over governments, the odds are very much in your favour. We did our own study where we looked at the past three recessions, and when bonds were a thousand over you actually made over 30%, and in two of the occasions over 20%. That’s total return in one year, on the third occasion. So that’s the signal we’re getting today from the bond market.

JP Morgan did a similar study, their benchmark wasn’t 1000 over, it was 900 over, they found that on 25 occasions historically, where spreads were 900 over treasury, 900 basis points so that’s 9%, they found that in those 25 occasions you never lost money over one year in the high-yield bond market.

The key is to think about having the odds in your favour and it’s pretty clear that, yes, we’re in a recession today but when you think about the odds and when you think as a long-term investor towards when things are normal, the odds are in your favour today  when you look towards normalized worlds and the risk/reward is in the investor’s favour.

Does that mean that in your opinion that today’s the day when everyone should start to pile into the markets and be fully invested? What are your thoughts about the people who are being cautious at this stage? How would you play getting into the markets or repositioning in the markets today?

Fully invested, not necessarily. I think what it means is that we’re more comfortable making new investments today, and Som, you know our process, we’re a research-driven credit shop and so we generally get to know the companies, the industries, the environment, and we try to get to the finish line in terms of having a thesis that has been well-researched.

What it means is we’re more comfortable making new investments and we have been putting our cash to work slowly as we’ve entered this recession. We also know we can’t bank on the ability to call the bottom the day it happens and that markets continue to be volatile, so a decent cash balance is a margin of safety when it comes to navigating through volatility. As a team what we’re doing is slowly deploying our cash in our best investment ideas through this downturn and that when the world returns to normal those investments and portfolios will reap the rewards.

And you see the same on the equities side as you do on the credit side right now?

I believe there’s an opportunity on the equities side longer-term, but what I will say is that when yield spreads widen out to 1000 over the high-yield bond market has actually out-performed the equity market in the following 12-month period. And anyone who’s been in this business in the last cycle knows that high-yield bonds actually crushed the S&P 500 in 2009 and 2010, which was an early cycle investing environment and that’s the kind of environment that we’re in right now.

Great. This has been excellent Sandy, thank you for taking a couple minutes. I will say to everyone that’s listening, this is a heightened moment and I know we pay a lot of attention to what’s happening to the equity markets. We listen to the news, we’re paying a lot of attention to the economic concerns and the fallout of this, and the social challenges that we have here.

The bond market oftentimes gives us a lot of great information and paying attention to that will help you navigate the difficult moment we’re in and start to signal you when it will be a good time to start to be more aggressive, when to be more conservative, and how to balance those two in a more measured way.

Sandy, thanks for that and we’ll get you back for more insights as time goes on and I think this has been really helpful for everybody so thank you for your time today.

Thanks, Som, appreciate it.