Why JPMorgan's Aronov was planning for a credit bust

Now a 21-year veteran of financial markets, Aronov leads market strategy for the $16 billion absolute return fixed-income platform at J.P. Morgan Asset Management in New York. Fascinated by the mathematical bounds of bond markets, she says fixed-income investors need to learn the value of cash in this latest crisis. She spoke to Bloomberg Markets about the opportunities and hazards she sees ahead.

Q: In the eye of the credit market storm, what do we know?

A: There's a fair amount of complacency around the breadth and the depth of the impact that an extended economic shutdown will have on businesses, particularly in the lower-rated part of high yield. These are smaller businesses likely to have the most difficult time. We can't really manage something that we can't yet measure. That's the big difference between 2008 and today. We've never been in a situation like this, where the economy is effectively shut down.

In terms of the pandemic, we are still in the very early stages of the escalation phase. As testing ramps up and the number of cases continues to explode, and unfortunately we see more fatalities from the disease, it's hard to imagine that there will be anything constructive priced into the market.

Q: You were already very worried at the start of this year, when most others weren't. Why?

A: The lower yields went, the more bullish the consensus sounded. That's really kind of astounding given that in Europe, if you're buying a negative-yielding bond, you're locking in a loss. We were bearish because everything was priced for perfection. The moment anything less than perfection materializes, you have very violent price discovery.

Q: What were the biggest signs of excess?

A: We were absolutely looking at a bubble in sovereign bonds. Not in emerging markets, though there were definitely pockets there. Central banks are not omnipotent. There's a limit to how much people will believe in their ability to deliver returns. In Europe savings rates were on the rise, telling you that people were really concerned about their financial future. That telegraphs probably a reduced amount of belief in what the ECB [European Central Bank] can do. The spreads looked like 2007; the euphoria felt like 2007. When I went to Europe-the land of negative rates-and I sat with investors there, and they told me they need 5%, and I thought about how much risk they have to take to get to that-I got palpitations! This is how things go wrong: There's no appreciation for the underlying risks of what you're buying. You're just following the herd.

Look at junk bonds that were trading with negative yields in Europe, Swiss bonds trading at $150 above par, the 1,000-year junk bond in Europe at sub-2% yields. The writing was on the wall.

We saw the return of enhanced cash. It was all the rage. There were a lot of these short-term portfolios out there that were being marketed as cash alternatives, but when you looked under the hood, there were things like collateralized loan obligations. That's something we saw a lot of in 2007, when there were all these enhanced cash strategies that eventually did very poorly.

Q: Was there more leverage coming into this crisis?

A: What 2008 exposed was that you had plain-vanilla core bond portfolios that were all of a sudden falling 10% to 20%, and in one case 80%, because these investors were taking on an increasingly large amount of risk to maximize that yield. To generate 7% or 10% of return, you just need to take a lot more risk. And [before this recent crisis] you were starting to see a lot more leverage in portfolios as a result. Leverage is what inevitably gets investors into trouble. We were in that part of the cycle where leverage was very popular.

Q: What's your view of negative-yielding debt?

A: These are fixed-loss investments unless you can sell them to a central bank or another greater-fool buyer. It's a price-only game. Fixed income is a mathematically bound asset class, and that's a dangerous place to be.

Q: How are you positioned as of March 23?

A: Nearly half of our portfolio is completely liquid. How do we rate the value of the liquidity in the market right now? We would rate it as a seven, not yet a 10. Ten signifies "let's start deploying liquidity." Ideally, you want to start getting involved when sentiment is at its worst, when sentiment has priced in the absolute worst-case scenario.

Q: Will Federal Reserve purchases of corporate debt provide support?

A: It probably helps at least symbolically and psychologically. I do not believe that it will actually prevent the cascade of downgrades we're going to see in the triple-B part of that market. We do have the experience of the ECB in Europe, which has been doing that for years, and it's created a somewhat zombified corporate landscape. But it hasn't prevented them from going through the same spread dislocation that we're going through here.

Markets will go back to reckoning with how fundamentals are impacted by everything that's going on. A lot of these companies in the lower part of investment-grade and below just won't be able to survive.

Q: When would you buy back into credit?

A: There will be incredible opportunities as a result of this. If we can pick up our eyes and look out over the horizon of just over the next few months, the opportunity on the back of this will be phenomenal, and high yield especially generates great returns for those who judiciously put capital to work during times like this.

The credit market hasn't yet gone far enough to price in the types of defaults that we will likely see on the back of this. The cascade of downgrades we're going to see will be pretty dramatic, and considering that triple-Bs are $2 trillion-plus at this point, even 20% of downgrades is a lot of debt falling into the high-yield market. There's more pain to be had. We're getting close to that 1,200 [basis points high-yield spread] frontier where it will start to get interesting-we'll potentially get involved in something. We have to see significant discounts in areas like closed-end funds. That's another sign of capitulation, when you start to see discounts that are 10% or 15%, and we're just not there yet either.

Q: What's your outlook for defaults?

A: We haven't seen the kind of defaults on the scale that we're going to see. I'm not saying we need to wait for them to peak, because by the time they peak, spreads will be probably halfway in already. But you do need to start to see those defaults start to come in regularly.

Before the Fed and central banks began essentially supporting markets, the average default in high yield used to be 6%. Prior to 2008, if you had a high-yield manager who was operating at half that rate, that was a pretty good track record. Now [that] we've been at 1% to 2% for a number of years, that's going to go up. Eventually, we could get to 10% [default rate]. That's not unreasonable at all.

Q: What flaws has this crisis exposed?

A: Every fixed-income portfolio out there is run with the same mantra of being fully invested across the cycle because the idea is to maximize yield. That's how the fixed-income industry has always evolved. We're in a different paradigm now, where maximization of yield means you are essentially subjecting yourself to these types of periods of no liquidity, where the yield is simply not enough, because it's so skinny, and you're left with having to sell something when you're hit with redemptions, or sell something to buy something when you see opportunities-and that's the problem.

Liquidity has shifted to the buy side, and the buy side has not retooled to really recognize that. It's really hard to tell an investor you're going to keep up to 50% in cash because you think there will be better buying opportunities. That's why every income strategy out there is getting hit with outflows.

Q: What are the long-term lessons we can learn?

A: There is a point in time when things get rich, and that point in time is fairly easily identifiable in fixed income. There's that natural mathematical bound, and the closer you get to it, you know you're in a very richly valued and a highly correlated market.

When you reach for yield, you're making your portfolio vulnerable to shock. If it comes, you have no cushion to protect you. When things get highly rich and highly correlated, it's always the same story. The tougher part of this picture is that you don't have the interest rate bailing you out anymore.

Q: What does it mean for credit investing more broadly?

A: The fixed-income industry will absolutely have some very tough questions to answer, especially when you think about where has all the money gone in recent years. It has gone to strategies that have been entirely interest-rate-driven. More recently it's gone to strategies in that ultra-short space. The ultra-short space has been canceled, because short rates are at zero effectively.

[The industry is] going to muddle through here somehow, and then we're going to get back to the point where perhaps yields are higher and the whole merry-go-round begins again. It would be nice that they retooled and actually invested based on value, as opposed to a market risk-driven benchmark, particularly the passive part of the fixed-income market. I never really understood why you would want to just let a passive index drag you through the market cycle, which is clearly headed for zero rates.

Q: What needs to change?

A: We have to stop answering the question of what are the best opportunities in fixed income from a long-only standpoint. We have to also try to answer it by broadening our view across not just traditional but also alternative instruments. Investors and portfolio managers get into trouble the same way every time, which is reaching for yield and overlevering-they need to rethink portfolio construction. Cash is a fixed-income asset class, and sometimes that is where you need to be in order to preserve capital and have an optionality hedge. That option is really valuable during periods like this.

We have to, as an industry, really embrace that and improve outcomes. As a fixed-income manager, your No. 1 job is capital preservation. There are periods when you have to be brave enough to be in cash-and we are in a period like that right now.