With Dislocations in the Markets in Q1 2020 Caused by a Global Pandemic– It Was a Good Time to Hold Assets Backed by the Fed

HANDLS Indexes co-founder Matthew Patterson speaks with Nasdaq’s Jill Malandrino, on #TradeTalks to discuss dislocations in the markets caused by a Global Pandemic, and the aggressive actions the Federal Reserve took to forestall a major dislocation in the securities market. In the following blog post we highlight some of the key points of the video. For the full interview click here: #TradeTalks.

The first quarter of 2020 illustrated how dangerous concentrated portfolios can be for income investors, particularly retirees dependent upon savings to fund their lifestyle needs. Late in February, as the economic consequences of the Covid crisis began to emerge, markets saw the sort of flight to quality that typically precedes recessions, with US Treasuries rallying and stocks selling off. By early March, a full-blown panic had taken root, with the credit markets broadly selling off, led first by high-yield bonds and followed by investment grade corporate bonds, municipal bonds and mortgage-backed securities (MBS).

Having learned from the Great Financial Crisis, the Federal Reserve took aggressive actions to forestall a major dislocation in the securities markets. On March 15^th, the Federal Reserve slashed its benchmark interest rate to zero and announced a $700 billion quantitative easing (QE) program to purchase Treasuries and mortgage-backed securities.

While the QE package provided support for Treasuries and MBS, the credit markets continued to sell off, culminating in a panic from March 18 through March 20^th that saw investors throwing away anything with credit risk as well as any mutual funds or CEFs with exposure to those asset classes.

The Federal Reserve responded with an announcement on March 20^th that it would begin supplying liquidity to the municipal bond market. It followed this up on March 23^rd with an expansion of its liquidity facilities to include investment grade corporate bonds and a bigger swath of MBSs. By April, for the first time in history, the Fed had added high-yield bonds to the assets it might purchase.

While the actions of the Federal Reserve prevented a major downturn in the securities markets, the effects varied depending on the asset class. Those assets with strong backing from the Federal Reserve, like Treasuries, MBS, municipal bonds and investment grade bonds, have largely recovered to pre-crisis levels. Those assets with tepid or no backing from the Fed experienced some recovery but remain below pre-crisis levels.

The table below provides return data for major income-oriented asset categories for the period from January 1, 2020 through April 15, 2020. Also included are returns for the Nasdaq 7HANDL Index, a multi-asset index of ETFs. The only categories with positive returns over the period were those with explicit backing from the Federal Reserve. The worst returns came in covered call strategies and REITS.

Over the long run, however, the story looks different. The table below provides return data for the same asset categories for the period from January 1, 2009 through April 15, 2020. The highest gross returns came from riskier asset categories, with core equity leading the pack. The highest risk-adjusted returns (annualized return divided by annualized standard deviation), however, were generated by the index of ETFs offering exposure to all the asset categories.

Some suggestions come to mind for investors as they plan for their financial futures. Most of the Bloomberg Barclays U.S. Aggregate Bond Index is now either guaranteed by the full faith and credit of the U.S. government or backstopped by the Federal Reserve. Investors need significant exposure to these assets because they provide stability and protect against major drawdowns. But investors also need exposure to riskier asset classes to maximize risk-adjusted returns.

The strength of the recent rally in broad equity indexes obscures large patches of weakness in the stock market. High-dividend equities have been one of the year’s biggest underperformers. Unlike tech stocks, which always seem to trade on hope and faith, dividend equities trade on yield in the minds of many investors. With many companies having cut or suspended their dividends, high-dividend equities may trade with more volatility until long-term impact of the crisis on payouts becomes clearer.

Similarly, structural changes in the economy may provide challenging for asset categories like REITS and MLP with exposure to sectors disproportionately impacted by the crisis. At the same time, they offer the potential to provide excess returns. Income investors need exposure to asset classes like this if they are to maximize risk-adjusted returns, but as with high-dividend equities, they should do so as part of a well-diversified portfolio.