Of Pandemics & Panics

Fears and realities of the covid-19 pandemic led to another rough week for equities. Many major equity indices are now down 30-40% from just a month ago and causing widespread investor panic. Our experience is that declines of this speed and magnitude can tempt even the most disciplined investors to change course.


Before assessing where markets are and how to respond, it is worth noting some of my beliefs about equities:

  • Equities are a long-term investment. Historically, equities have outperformed fixed-income and cash by a wide margin, but they come with quite a bit more volatility and sometimes underperform other asset classes. I often say that volatility is the price of admission for those higher expected returns and discourage making any equity allocations with capital that is needed within five years.
  • Equity exposure should be diversified, so that no single stock or industry can permanent damage a portfolio. There are often one or two industries that get decimate in bear markets (tech and telecom in 2000, financials and real estate in 2008, and now energy and airlines).
  • Asset allocation is important. Even though many equity indices are down 30-40% from just a month ago, fixed-income and alternative investments provide ballast to help portfolios make it through difficult times.
  • It is nearly impossible to consistently guess when the market will go up and when it will go down (especially after expenses and taxes). Study after study indicates that committing to a strategy produces better results than rotating strategies or attempting to time the market. Many investors often counsel that the best strategy is the one that you can stick with and that “time in the market” is more important than “timing the market.”
  • Volatility produces opportunities for tactical moves such as tax-loss harvesting and rebalancing, among other things.

Although simple, concepts like diversification, asset allocation, and committing to a single strategy have stood the test of time and many bear markets. At a minimum, they prevent catastrophic losses.

Bear Markets

Of course all of the above sounds nice, but it can be difficult to remain disciplined during uncertain times. Every bear market is unique in some way and the covid-19 pandemic is no different. We have never lived through a pandemic, but we have lived and invested through several bear markets. 

  • Investing after a 30-40% decline in prices has generally been a good time to invest (or stay invested). Sometimes prices continue to slide lower, but they are often higher just 6-12 months later. Unfortunately, nobody knows if this will be a 30%, 40%, or 50% decline and it is always hard to imagine the market going up during times of panic.
  • As we have seen, bear markets produce extreme volatility and missing a single 10% “up” day can really impair longer-term returns. It is often a white-knuckled ride, but I do not advise waiting until it appears safe to invest.
  • The market will turn before the data or narrative changes. I often say that prices drives narratives. When equities hit bottom and a new bull market is born, many will not believe the first leg up and we are likely to hear things like, “its a short covering rally” (which it probably will be, to start), “this is a dead cat bounce, the other shoe is about to drop,” or some conspiracy theory about Fed and/or Treasury manipulation.
  • It is generally not a good time to sell when investors are panicked and selling indiscriminately. These things can push market prices lower, but the panic often subsides and cooler heads prevail.

The COVID-19 Pandemic and Market Panic

In these situations, I find it useful to invert the question of whether to sell equities. It can be helpful to ask, “If I had a lump sum of cash, should I be buying equities?” If the answer is yes, then the answer to “Should I sell?” is no. I’ll be the first admit that no one knows where the bottom is. It could be tomorrow, it could be in a week or month or even a year or more. Nobody knows how much of the health and economic situation is already accounted for in equity prices, nor does anyone know what fiscal policy is forthcoming. Nonetheless, I do not think it is a bad idea to begin investing after a 30-40% decline (unless you might need the capital within the next five years) and many of the other market indicators that I follow affirm this belief.

This pandemic is unprecedented and will likely produce the worst economic numbers that we have ever seen. However, I believe that the duration of the economic decline is more important than the depth. We can review the various projections, worrying indicators, and hopeful indicators, but the reality is that nobody knows what will happen. There are some horrific scenarios that I can imagine, as well as some best case ones, although reality will likely land somewhere in the middle. I’m convinced that the health situation will get worse before it gets better and the outlook appears dire, but pandemics do not last forever nor do panics.

Challenges & Opportunities in Fixed-Income

The wild oscillations in the equity markets have made the headlines recently, but I believe all eyes will soon be on fixed-income markets. As I wrote earlier this week, the Treasury and Agency MBS (mortgage backed securities) markets that underlie much of the financial system were experiencing unprecedented illiquidity. The Federal Reserve has announced a series of programs to mitigate the liquidity issues, although it appears that they may have to increase the size of their purchases at this point.

As you can imagine, if the most liquid assets on the planet are having liquidity issues, then it is even worse in the credit (non-government bond) markets. Indeed, we are witnessing unprecedented illiquidity in credit too. As volatility increases and liquidity declines, it is very difficult to value bonds. Much of the market is frozen, except for forced transactions such as liquidations and distressed sellers. Being forced to sell into an illiquid market with no bids is not something anyone wants to do, but some investors are forced to do it. Imagine a mutual fund or ETF receiving investor redemptions; those funds HAVE to sell. Or a hedge fund that has borrowed to buy more assets than it started with; if the value of those assets start falling, then the lender will liquidate the fund’s positions for them. These are some simple examples, but there are much more complex examples that have imploded in this and past cycles.

How is this impacting fixed-income funds? Fixed-income fund “net asset values” (NAV) are typically derived using the “bid” (the price that someone is willing to buy a bond for, rather than the “ask” or what some is willing to sell for). So, what happens when a market is frozen and there are no bids? What happens when nobody wants to buy and everyone knows that there are forced sellers and bids are lowered to fire sale prices? This is what is happening right now. NAVs are all over the place within the fund universe. Within the ETF universe, we are seeing many ETFs trade at deep discounts to NAV which indicates that investors do not trust the ETF’s reported NAV.

Regarding investment vehicles and fund selection, this environment highlights a few key points:

  1. As I often counsel, avoid fixed-income index funds and fixed-income ETFs. They do not possess all of the tax benefits often associated with equity index funds and equity ETFs, yet they carry additional risks. We will not dive into the mechanics here, but they are well documented for those who want to do some online research.
  2. If invested in an open-end fund (such as a mutual fund or ETF), evaluate the fund’s investor base. Is it retail investors or institutional investors? Does the number of shares outstanding appear stable over time or does it have large moves up and down? Investors should look for a committed investor base that will not flee when prices are falling.

What facts do we know today?

  • Liquidity has evaporated. Even government-backed securities like MBS are having issues.
  • Many funds are having difficulty pricing their portfolios.
  • There are forced sellers driving values down.

Much of the selling is warranted, but some of it is not. I believe the key to long-term outperformance to lose less on the downside and really capitalize on the upside.

Although the relative safety of Treasuries and Agency MBS (mortgage backed securities) is being called into question during this latest bout of volatility, the US federal government is the only entity that can create US dollars to pay its debt. Although the prices may move differently than expected, I view these as having zero credit risk and believe some of these assets are being mispriced.

Many “investment-grade” assets have sold off just as sharply as lower-quality assets in the past few days. Our view is that a lot of the assets that people thought were investment grade are actually below investment grade, including A LOT of “investment grade” corporate credit. However, there are some quality credit assets that are being punished harshly, such as agency CMBS (backed by the government) and other AAA-rated assets (rather than single A or BBB, which are also considered investment grade). Although it is painful to see high-quality assets decline in value (for investors who own them), it is also a great time to buy these assets as I believe that they are selling at deep discounts. This is where investment vehicle selection, investor base, and portfolio management matter, as investors need to be able able to capitalize on these market dislocations. The past two weeks have been a bumpy ride for fixed-income investors and I expect the volatility to continue, but I believe this environment is one of the best opportunities that well-prepared investors will ever see.

Monetary Policy Response to COVID-19: Necessary & Insufficient

Trading in government securities (such as US Treasury bonds and Agency Mortgage-Backed Securities) has become much more illiquid in the past several weeks. The reason this matters is that much of our financial world relies on these assets and markets, from our banking system to insurance companies, pensions, mortgages,¬† money market funds, and so on. These markets are an important part of the “plumbing” of the US and global economy.

To address liquidity issues, the Federal Reserve announced last week that it would dramatically expand repurchases (repos), which allow financial institutions to borrow dollars if they post government securities as collateral. It is essentially swapping one government security (such a Treasury bond) for another (US dollars). The best analogy I have heard is that repos are like the change machines at an arcade; it does not matter how many $20 bills you have if the machines only accept quarters. Similarly, it doesn’t matter how good a balance sheet is if some of the assets are not dollars. Expanding repos is the Fed’s attempt to provide cash to financial institutions that own (less liquid than cash) government-backed bonds.¬†Understanding the size of the program is best illustrated by a quote we read last week: “The Fed just brought an aircraft carrier to a knife fight.”

The Fed was scheduled to meet (on Tuesday and Wednesday of) this week, but held the meeting (secretly via teleconference) on Sunday and concluded with a surprise announcement and press conference. The major announcements were:

  • A 100 basis point (1%) cut to the target federal funds rate
  • A new round of Quantitative Easing (QE 4), of up to $500B in Treasury bonds and $200B of Agency MBS
  • Swap lines to ensure US dollars would be available to major trading partners
  • Elimination of reserve requirements for banks and an encouragement that the banks use the discount window

While the rate cut marginally decreases borrowing costs for businesses and consumers, the other announcements are likely much more consequential. While it remains to be seen if liquidity in Treasury trading improves, the QE announcement immediately bolstered MBS prices (and brought their concerning spreads down). Additionally, the swap lines and and banking news were meant to bolster the banking system and signal that although we may have health and economic problems, we will not have banking problems to worry about too.

These monetary policy actions are necessary, but not sufficient. The Fed saw some anomalies in the economy’s plumbing system and decided to act. If your house is on fire, a functioning plumbing system will not save your house. However, a dysfunctional plumbing system or fire hydrant could doom it.

The health and economic challenges that we face can only be solved with fiscal policy. As spending grinds to halt, businesses will find it difficult (or impossible) to pay their employees, vendors, rents, and then those businesses will not be able to pay their people and expenses, and so on. It does not matter if rates are higher or lower because nobody will be borrowing in the first place. The Fed has done what it can, but the economy really needs the federal government to step in and spend whatever is needed to get us through this health crisis. Hopefully, the fiscal authorities (The White House and Congress) can pass something soon.

A Wild Week For Fixed-Income

As the financial markets react to the covid-19 crisis, many investors are focused on the wild price action in equity markets. However, much more interesting and consequential things are happening in fixed-income markets. We saw crazy price action in Treasuries, MBS, and fixed-income ETFs, which I’ve outlined below.


This past Monday, Treasuries opened at levels never seen before. Below is a YTD chart of the 10-year Treasury yield, which touched .33% on Monday morning before rebounding the rest of the week. Moves of this magnitude are unprecedented and highlight a few issues:

  • There was a massive flight to safety. The steep drop in rates may have been reinforced by convexity hedging (as mortgage holders may have been forced to buy more Treasuries as prices rose, thereby driving rates down even more).
  • There were many reports this week about Treasuries being as illiquid as they’ve ever been. This likely exacerbated price volatility.
  • Even if yields are expected to fall to (or below) 0%, I personally do not see a lot reasons for individual investors to own medium- or long-term Treasuries at these levels. The yields are unattractive and the interest rate risk is high (even if the probability of a sharp rise in yields may be low). Why not just hold cash?

Mortgage-Backed Securities

Agency mortgage-backed securities (MBS) are generally viewed as safe assets due to their government guarantee. However, the aforementioned illiquidity hit MBS a lot harder than Treasuries. The top panel of the below chart shows that MBS yields often trade at a premium to Treasury yields, but that spread blew out to crisis levels this past week (see the bottom panel). To my knowledge, there is still no question about the credit quality of Agency MBS, so the spike in spreads is a liquidity issue rather than a credit issue (and which many expect that the Federal Reserve will resolve).

Fixed-Income ETFs

Fixed-income ETFs had a very weird week as well, as many fixed-income ETFs traded well below their Net Asset Values (NAV). While this happens from time to time in less liquid sectors (such as high yield), we saw this phenomenon for the first time in many investment grade funds. The $50B Vanguard Total Bond Market ETF traded at a deep discount to its NAV on Thursday. Interestingly, since Vanguards ETFs are simply a share class of their existing mutual funds, an investor could have redeemed their mutual fund investment at NAV and bought the same portfolio back (through the ETF) at a 6%+ discount! If you do not understand fixed-income fund NAVs or ETF redemption mechanics, Dave Nadig wrote a good explainer on it or check out Rick Ferri’s analogy.

Although unprecedented, it is quite conceivable how a discount could appear for a fund holding at least some credit. However, we saw similar action in ETFs that only hold Treasuries. Even the $20B iShares 20+ Year Treasury Bond ETF traded at a ~5% discount to the underlying value of its holdings. Treasuries are the most liquid asset in the world, so it is indicative of just how much volatility and illiquidity exists in the Treasury market.

Looking Ahead

The above examples indicate an extreme level of illiquidity in the financial markets. We are witnessing things that we have not seen since 2008 or ever before. Who knew that Treasuries could swing so wildly? Who thought that Agency MBS would trade so wide of Treasuries? And who could imagine a Treasury ETF trading at a deep discount to its NAV. NAVs are certainly moving around more than usual (and probably more than expected for most), but this illiquidity also brings unprecedented opportunity as some safe* assets are clearly mispriced.

*Safe meaning backed by the US federal government. There is a lot of credit (non-government) fixed-income trading at very distressed levels right now, but the above post is not focused on credit assets.

Why Aren’t Mortgage Rates Lower?

Even though mortgage rates are near all-time lows, many are looking at the benchmark 10-year Treasury yield and asking why mortgage rates are not even lower. Even though the 10 year Treasury yield (dark blue line) has fallen off a cliff, the average 30 year mortgage rate (light blue line) has remained stubbornly high. The difference between the two rates can be visualized in the lower panel. What gives?

Source: Bloomberg, 3.6.2020

There are several reasons for the difference in rates, which are illustrated in the chart below:

  1. Mortgage-backed securities (MBS) are not Treasury bonds. Yes, many MBS are backed by the federal government or by federally-backed Government-Sponsored Enterprises (GSEs, like Fannie Mae and Freddie Mac), but MBS are structured differently. One important distinction is that MBS can be “called” by the borrower and repaid early at par, which is typically done by refinancing the existing mortgage with a new mortgage at a lower rate. Thus, MBS yields (green line) are typically higher than Treasury yields (pink line) and they have not kept pace with the decline in Treasury yields in 2020 (MBS yields down about 1% YTD vs a roughly 1.5% decline in the 10 year Treasury yield YTD).
  2. The GSEs charge fees for securitizing and providing a federal backstop to MBS investors (these costs are why the white line is at a premium to the green line).
  3. Lenders need to generate a profit, so they add a spread on top of the rate that they commit to the GSEs. As of March 2020, lenders are reportedly at capacity for new loans, so there is no incentive for lenders to lower the rates offered to borrowers (even if the wholesale rates have declined). The red line represents the average 30-year mortgage rate.
Source: Bloomberg, 3.9.2020

The above only applies to government- and GSE-backed loans, known as “conforming” or “agency” mortgages. Non-agency mortgage rates are driven much more by investor risk appetite than the above factors.

S&P 500 vs Russell 1000

When comparing the S&P 500 and the Russell 1000, I found a story of two distinct eras. From 1994 until today, the returns are practically identical with only a .01% annualized difference!

Source: Bloomberg

However, the S&P 500 beat the Russell 1000 by a wide margin from the common datas’ inception of 1978 to 1994.

Source: Bloomberg

Selecting a benchmark includes many factors, but I found the above interesting.