Liquidity and debt – who’s buying?

The COVID-19 global market rout has generated levels of market volatility not seen since the 2008 Global Financial Crisis. Central bankers have responded to the shock to growth by following essentially the same playbook: cutting interest rates to zero as rapidly as possible, followed up with quantitative easing and other programs to support financial markets.

Policy Makers are adding liquidity and buying debt again

Locally the Reserve Bank of Australia (RBA) has announced a variety of measures since late March to ease financial conditions and provide more liquidity to the economy. Firstly, the cash rate was cut to a new record low of 0.25%. QE was introduced for the first time; the RBA yield curve control program targets a 3-year bond rate at around 25 basis points, but it will buy whatever it needs to in order to encourage the market to get close to that rate. The RBA also setup a currency swap line with the US Fed, providing US dollar liquidity to market participants in Australia. Furthermore, the RBA introduced a Term Funding Facility for the banking system under which authorised deposit-taking institutions can get funding from the RBA for three years at a rate of 0.25%.

Fixed Income Markets froze up around the world

We saw liquidity conditions alter across the spectrum from Government bonds to corporate credit. Investors were looking to sell any assets to raise cash and the bid/offer spread in even the most liquid US Treasury market widened 2-3bp, more than 20 times the regular spread. The spread widening was more pronounced in other parts of the market with a drying up in secondary market trading and volume. AAA rated investment grade spreads doubled in both the US and Europe.

Although the Australian credit market being mostly investment grade is of a higher credit quality than the US, it was also severely affected and experienced considerable strain as investors rushed to sell bonds into a market where there was hardly any liquidity with materially increased spreads.

As a result of the financial markets being under significant stress trading costs significantly increased and Russell Investments along with many other market participants changed the buy and sell spreads on several funds to more accurately reflect the actual cost of transacting.

We are pleased that Russell Investments Select Corporate Bond ETF (RCB) performed as expected during this period fully replicating the index return of 1.30% over the 3 months to end of May.

Primary issuance returned to the market in May with strong support from both local and offshore investors and we have also seen spreads tighten in the secondary market. We subsequently reduced our spreads and have seen renewed flows into our ETF’s.

Invesment Grade Corporate Bond OptionAdjusted Spread

Russell Corporate Bond Index Change

At Russell Investments we consistently review and seek to incrementally improve our products as such after analysis of the index methodology of our Corporate Bond ETF, we have updated this to provide for a rule with the aim of limiting turnover in the index by restricting replacement of bonds from the same issuer. Effective from 01 June 2020, if a bond remains eligible for the index, it cannot be replaced by a bond from the same issuer for a period of 2 years from when the original bond entered the index. Subsequent to this amendment, we saw no change of membership in the constituents of the index at the June quarterly reconstitution.