Macaskill on markets: Central bank and chill?


Jon Macaskill
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Central bank corporate credit support is helping to cut debt costs for borrowers such as Netflix. A government put option won’t cure all the problems looming in the credit markets, however.


The European Central Bank moved towards joining the Federal Reserve as a buyer of last resort for high-yield debt on Wednesday April 22, with a relaxation of the quality of collateral it will accept for loans.

This gave another push to a recovery in credit spreads over government benchmarks from the highs seen in March, which has helped to keep the market for new issuance of corporate bonds open for borrowers of different types.

Netflix, the online screening firm that has seen demand for its output soar during the coronavirus lockdown, was one beneficiary of the move by central banks to support credit markets.

Netflix issued €470 million of five-year debt with a 3% coupon that marked its lowest cost to date for a bond issue on the day after the ECB’s collateral move, alongside a $500 million note with the same maturity and a 3.625% coupon.

Analysts are divided on whether or not the ECB will eventually add outright purchases of high-yield bonds to its existing buying of investment grade paper.

The universe of European high-yield bonds is limited, with bank issuance and non-eurozone paper accounting for over a third of a market of about €340 billion. That could present some technical limitations to purchases if the ECB wanted to avoid becoming too dominant a buyer of debt; and there would be a deep reluctance to eventually own defaulted high-yield corporate bonds among central bankers from countries such as Germany and the Netherlands.

Government backstop

But the trend towards additional support for corporate debt issuance by both the Federal Reserve and the ECB is clear.


Christine Lagarde,

This perception of a new government backstop – a ‘Powell put option’ named after the Federal Reserve chairman for US credit issuance or a ‘Lagarde guarantee’ by his ECB counterpart for European corporate borrowers – has contributed to relatively smooth conditions for new debt sales, despite the enormous looming impact on fundamental creditworthiness from the coronavirus crisis.

The market for investment grade debt issuance is booming across the world, the US high-yield sector is seeing brisk issuance from borrowers such as The Gap and MGM, and now European high-yield bond demand is reawakening after two months of dormancy.

The perceived central bank backstop is also boosting investment funds designed to take advantage of dislocation in the corporate debt markets. The marketing of these funds has been helped by reports of a few spectacular trading scores in the period when the markets were at their most troubled by growing awareness of the coronavirus crisis.

The most dramatic dealing coup was the well-timed purchase of default swap index protection by Bill Ackman, the founder of hedge fund group Pershing Square.

He bought default swaps in late February on the two main investment grade credit derivatives indices – the CDX in the US and iTraxx for Europe – along with some protection on the high-yield variant of the CDX.

All three indices were trading at spreads that were close to their historical lows (around 50 basis points for the US investment grade benchmark) and Ackman was subsequently able to close the positions for a net gain of $2.6 billion when markets were stressed in the middle of March.

Jay-Powell-R 160x186

Jerome Powell,
Federal Reserve

This trade was so perfectly timed that scepticism would have been in order if its details had emerged by the common hedge fund tactic of selective leaks to media outlets.

Ackman confirmed key trade dates and returns in a public statement, however, and no evidence to counter his claims has emerged from any of the dealing counterparties to what was roughly $70 billion of trading in standard five-year index default swap contracts.

Ackman’s big credit short proceeds were used to fund his continuing exposure to equities and roughly matched mark-to-market losses on his core portfolio, leaving Pershing Square flat for the year when he made his public statement.

A fund that specializes in credit investing – Boaz Weinstein’s Saba Capital – made a bigger percentage net gain in trading as the coronavirus crisis developed.

Weinstein’s main gambit was a move to short high-yield exposure while going long investment grade credit, resulting in gains that were variously reported as more than 100% at certain points in March and around 80% by the end of the first quarter.

If that bet is still open (Saba Capital declined to comment), then some unrealized gains may have been reduced by the effect of central bank steps to back the credit markets.

At one point in March the high-yield US CDX index was down by over 20% in terms of total returns in the year to date, while the main investment grade index was down by only 4% during the worst of the Covid-related panic.

By late April, both markets had seen their spreads fall substantially and the gap between investment grade and high-yield returns had narrowed.

Downgrades and defaults

But neither current spreads over government bonds nor recent returns from credit derivatives trading necessarily reflect how the coronavirus crisis will play out in terms of future default rates for corporations – or recovery amounts for creditors.

And there are relatively arcane areas of the credit markets that are facing strain ahead of the impact on actual defaults from an unprecedented shock to real economic performance around the world.

Rating agency Moody’s has placed almost 1,000 tranches of collateralized loan obligations (CLOs) under review for potential downgrades, and competitors S&P and Fitch have followed suit, although at a slightly slower pace.

Any dislocations in the structured credit markets will create opportunities for investors with enough cash to take on new commitments, but they could cause some problems for the banks that arrange deals 

The effect of selling related to downgrades – and then the impact of actual defaults – will test the hypothesis that the CLO sector is fundamentally safer than the mortgage-backed structured finance vehicles that failed so spectacularly in the 2008 financial crisis.

Any dislocations in the structured credit markets will create opportunities for investors with enough cash to take on new commitments, but they could cause some problems for the banks that arrange deals, even if exposure is not comparable to the mortgage-backed collateralized debt obligations that had been warehoused by banks in 2008.

Exceptionally strong trading performance due to high client volumes and wider bid/offer spreads cushioned recent first-quarter results for all the big US banks, but there was some differentiation in performance within credit.

Goldman Sachs cited strong credit derivatives index performance on the back of client flows, for example, while other banks framed growth in overall fixed income revenues as a function of rates and FX activity outweighing weakness in credit.

Central banks are playing a vital role in ensuring that markets for corporate debt issuance remain open, but they cannot solve all the coming problems in credit.