Assessing liquidity and finding opportunity in fixed income

The last few weeks have provided a test for fixed income markets, from liquidity challenges in key areas to extreme price movements across a range of assets. Rick Rieder, BlackRock’s CIO of Global Fixed Income, offers insights on how markets are functioning, what effect the U.S. Federal Reserve is having, and where he sees opportunity amid market dislocation.

How would you rate the response of the Fed to the turmoil in fixed income markets?

RR: Since this crisis started to affect markets, the Fed has shown that it is very sensitive to market dislocations, and that it is willing to do whatever it takes to make sure that the dislocations do not persist, or at the very least, that they are minimized. The Fed is really focused on making sure that transmission mechanisms remain smooth and efficient and on trying to restore effective functioning in the markets.                                            

It has committed to unlimited quantitative easing (QE) and recently announced that it intends to buy US$75 billion a day in the Treasury market, and that it will also buy a wide range of assets including corporates, commercial mortgages (CMBS), and bond ETFs. To put that figure in perspective, during the financial crisis, the Fed was buying US$75-85 billion in assets a month. The amount of liquidity the Fed is putting into the market currently is extraordinary.  So, I’d say the overall response has been tremendously constructive.

Has liquidity improved since the Fed acted?

RR: It depends on which sector of the market. The repo markets were one of the first places to come under severe stress and, not coincidentally, one of the first markets that the Fed stepped into. Funding markets have now largely returned to normalcy, and that’s hugely important to the overall functioning of the system.

The other part of the market that is hugely important, and that wasn’t functioning properly, is the Treasury market. But now that the Fed has become a large-scale buyer,  liquidity has meaningfully improved. It may not be all the way back to pre-crisis levels, but it is significantly better. Until the Fed helped to restore some order here, it was very difficult to price other fixed income assets accurately, because they take their cue from the level of Treasury prices. And because the Fed has been actively buying off-the-run securities, that’s allowed those securities to come off of dealers' balance sheets, which enables the dealers to provide more liquidity to the market.

The agency mortgage market, like the Treasury market, is seeing much better liquidity as the Fed has become a large buyer of mortgages. As you move further out the risk spectrum, things are also improving, albeit more slowly. Liquidity in investment grade credit is getting somewhat better, especially in the front end of the curve. In securitized markets, we believe there is still some liquidation that’s taking place, but the market appears to be stabilizing from some unusually weak levels.

Is there anything else that the Fed can do, or have they spent all their bullets?

RR: I think the Fed has unlimited bullets, particularly with inflation running as low as it is, and I expect that it will continue to do whatever it takes to ensure that markets function smoothly. 

We've already seen the Fed step in and do things that it hadn’t in the past, like buying corporate bonds and ETFs and launching lending programs to directly support small and medium enterprises, states and municipalities. So, to think that there is nothing more it can do would be mistaken.

How are all of these developments affecting your portfolio positioning?

In the U.S., I think you want to follow the Fed. So that means investing in Treasuries as a core part of the portfolio today, with more exposure out the yield curve than earlier in the year due to carry and hedging-potential longer on the curve.  While mortgages were very attractive and will be well-supported by the Fed, their valuations have richened considerably. 

Credit looks reasonable again, for the first time in a long-time.  We would continue to follow the Fed towards the investment-grade market with some higher-quality high yield. Also, the securitized market, particularly high-quality asset-backed securities and commercial mortgage paper, looks reasonable to us today, with some tactical exposure to high-quality CLOs.

Over in Europe, the European Central Bank has had its own “whatever-it-takes” moment. It is buying close to 130 billion euros a month in fixed income and is looking to monetize any fiscal needs going forward. We think this will go a long way to helping Italy, in particular, and that we’ll see spreads between Italy and Germany continue to compress.

Finally, I’d add that this is still a time to run a high level of cash in portfolios, both to mitigate the downside and to take advantage of evolving opportunities.