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Caution over coronavirus still warranted in investment grade corporates

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      By Vishal Khanduja, CFADirector of Investment Grade Fixed-Income Portfolio Management and Trading, Calvert Research and Management and Brian S. Ellis, CFACalvert Fixed Income Portfolio Manager

      Boston - Following the Federal Reserve's surprise interest rate cut on Tuesday, we believe caution is still justified in the investment grade bond market until investors can gain more clarity over the global economic impact of the coronavirus.

      To us, the Fed's move on Tuesday was a surprise, in terms of both timing and magnitude. Before the announcement, the Treasury market was pricing in four 25-basis-point rate cuts by the end of 2020; few were expecting an inter-meeting cut of 50 basis points. For some perspective, the last time the US central bank made an emergency cut of this size was during the financial crisis in late 2008. Such a dramatic, preemptive move by the Fed — only two weeks ahead of its next planned meeting — appears to us to be purely for risk mitigation purposes. Frankly, we think policymakers seem to be as panicked as the public.

      The surprise cut followed the G7's coordinated statement, which did not offer concrete steps but did show that global policymakers were closely watching the risks to growth caused by the coronavirus outbreak. While the ultimate impact of the coronavirus is unclear for now, what we do think is certain is that the efficacy of central banks is increasingly coming into question, particularly given the volatility in equity markets immediately following the Fed's announcement.

      As we noted in our market outlook for 2020, we believe volatility will be higher, mainly because of the fading effects of monetary policy. Financial markets appear to us to be waking up to the notion that fiscal stimulus is what may be needed to sustain growth. At this point, given the liquidity injected over the prior decade, how economically stimulative can this latest round be? We think the answer is "not very." We believe it is critical now to hear what the global fiscal stimulus response will be.

      So should fixed income investors also begin to panic? Entering 2020, we expected US fixed income returns to be lower than they were in 2019. Long-term credit spreads were near their tightest levels of the current economic cycle, which meant that investors had to be willing to accept lower potential returns. As volatility began to pick up last month due to fears over the impact of the coronavirus, credit spreads did not gap wider even as equities began to price in more downside. Instead, the investment grade corporate bond market was still experiencing inflows. For most investors, it made sense to remain closer to investment grade benchmarks given tight spreads and limited opportunities in other sectors which had more potential downside risk. We have started to see an unwind as volatility has increased. The good news is that fixed income markets have been orderly thus far. There has not been a liquidity-led disruption that one would expect to accompany a surprise 50 basis point rate cut from the Fed.

      However, we still do not believe credit spreads are pricing in a recession scenario. For that reason, we remain cautious in the investment grade corporate space, and we have been specific about where we are adding risk. There are areas of the market where we expect to see true fundamental issues stemming from the coronavirus to impact bonds. We do think the US consumer remains strong. For example, housing-related areas of the market may receive a boost because of the Fed's rate cut. In addition, much easier US monetary policy should bode well for emerging market corporate bonds.

      Bottom line: The Fed has surprised a market that is struggling for more clarity on the containment of the coronavirus. What is clear is that there is a growing acknowledgement that the personal and economic impact of the coronavirus may be significant and that it will be important to hear how governments will also tackle the issue through potential fiscal stimulus. As fixed income investors, we are taking this as an opportunity to look closely at opportunities in which we have high conviction as we also wait for more clarity.