Vaccines the next regime change for markets

Yet as a result of record public funding and support for COVID-19 vaccine research, Fauci has embraced a more optimistic assessment. Following the release this week of the results of the first human trial of Moderna’s vaccine, which triggered the desired immune response in all 45 people tested, Fauci declared that the US was on track to develop a vaccine before the end of the year. "I feel good about the projected timetable," Fauci said.

Crucially, Moderna has already started mass commercial production of its vaccine at three different plants across the US in anticipation of regulatory approval, and expects to be able to produce 500 million to one billion doses each year.

In total there are already 23 different COVID-19 vaccines in human trials globally, with six in, or about to start, final phase three trials, including programs in the US, China, Brazil and Russia.

There are nonetheless outstanding questions in relation to the efficacy of vaccines. We still don’t know how long the neutralising antibodies induced by them last for. It is entirely possible we will need to have regular updates, perhaps once a year. We also don’t know what proportion of patients the vaccine will actually protect. Dr Fauci says he would settle for a 70 to 75 per cent effectiveness rate.

The key for markets is that a vaccine will allow investors to finally see the light at the end of the tunnel. It will portend the world returning to some semblance of normality and almost certainly trigger another leg to the current risk rally.

In my own portfolios, I have been taking profits on the circa $1 billion of purchases we made in late February and March. In particular, I have net sold $937 million since the end of March, which almost exactly offsets our net investments in the months prior. We have, however, been more active than these numbers imply, buying and selling almost $9.2 billion of bonds since the start of 2020 with zero issues with liquidity.

The problems with liquidity in the corporate bond market in 2020 that folks have complained about have been limited to highly pro-cyclical assets that were always going to perform poorly in a recession like the current one. These include bonds issued by commercial property trusts, residential developers, retailers, airlines, and non-bank lenders that offer finance to riskier borrowers that cannot get approved via a normal bank.

Lots of investors loaded up on these credits in recent years to get access to the extra yield they pay. We avoided them because it was obvious that in any downturn liquidity for these superficially well-rated securities would disappear. In this sense, the diversification that a large portfolio of corporate bonds provided was a mirage: often investors were just loading up on correlated default and liquidity risks.

One asset we did pick-up last week was NAB’s new unlisted, or over-the-counter, hybrid, which paid a credit spread of 4 per cent above the quarterly bank bill swap rate (or a total running yield of about 4.1 per cent). That represented a chunky 0.50 per cent premium over the spread available on identical major bank hybrids on the ASX.

This investment-grade (or BBB- rated) hybrid was a landmark of sorts as the first OTC hybrid deal from a major bank in over a decade that was distributed widely via multiple brokers and banks. And it has since performed well with its spread compressing to about 3.88 per cent above bank bills, furnishing capital gains of about 50 basis points in its first week.

The most interesting development has, however, been the subsequent trading activity. With five different market-makers providing secondary liquidity, we have seen daily turnover in this single OTC hybrid that has been about 50 per cent of the entire ASX hybrid market.

While the ASX hybrid market will always have a role to play, banks are likely to shift at least some of their capital raising activities to the more sophisticated OTC domain. This is not negative for ASX hybrid holders because it presages a future scarcity premium for those who are limited to the listed market.