An experiment in credit market sponsorship by the US central bank began on May 12 with its first corporate bond exchange-traded fund purchases.
The new world of government support began not with a bang but with a whimper.
Although the Federal Reserve bought $1.8 billion in its first weekly round of support, the effect on markets was muted, as it had already initiated a powerful global rally in credit spreads and spurred record debt issuance with the announcement in March that it would buy corporate bonds in both the primary and secondary markets.
Matt King, Citi
Veteran observers warn that provision of credit liquidity by central banks may simply delay elevated default rates and obscure market pricing signals.
“It has already had a hugely distorting effect on credit spreads,” says Matt King, global head of credit products strategy at Citi. “Investment grade spreads are hundreds of basis points tight and high-yield spreads around 1,000 basis points tight to where you would put them on fundamentals.”
The rally has been a strange one, with some participants feeling that they cannot avoid buying, especially traditional asset managers with renewed inflows to their funds.
“Many investors are almost prisoners of the price action,” says King.
Hedge fund managers, by contrast, can make their own decisions on whether central banks will be able to cure all that ails the credit markets.
“What they were trying to do is restore calm, but lots of companies are defaulting and becoming more stressed,” says Boaz Weinstein, founder of Saba Capital.
In my 22 years in the credit markets, until six months ago I had never before seen an opportunity to short so many single-B and double-B rated companies at the same spread as l could go long investment-grade companies- Boaz Weinstein, Saba Capital
Weinstein’s $2.7 billion fund was one of the best performing asset managers during the worst of the coronavirus-related market panic, with Saba’s flagship fund up by 77.2% in the year to the end of April, according to figures compiled by HSBC.
Much of this outperformance stemmed from relative value trades in late 2019 and early 2020 designed to take advantage of credit spreads that made virtually no distinction between investment grade and high-yield borrowers.
“In my 22 years in the credit markets, until six months ago I had never before seen an opportunity to short so many single-B and double-B rated companies at the same spread as l could go long companies like AT&T, Disney and IBM,” says Weinstein.
A restoration of credit spread differentials during the worst of the market downturn of mid-March was partly reversed by central bank moves to support corporate debt markets. This gave borrowers an opportunity to issue new bonds to bolster their operations and reduce reliance on short-term debt while the Covid-19 economic downturn unfolds.
US corporate bond issuance of around $250 billion in March marked a monthly record and more than half of this total came after the Federal Reserve made its credit market support announcement on March 23.
The European bond market is smaller, with greater reliance on loans by corporate borrowers than in the US, but a similar wave of debt issuance was seen from late March onwards and a record annual issuance total in excess of €400 billion now seems likely.
With new debt issuance markets functioning smoothly, investors can now return to the question of whether credit spreads accurately reflect the likely increase in defaults due to the impact of the Covid-19 crisis.
There will be second and third order effects on corporate performance from the impact of changes in consumer solvency and spending patterns; and investors also have to consider the tactical impact of central bank intervention and hedging needs by other market participants.
The tactics of intervention should be more closely examined by credit investors, according to Citi’s King. “They should focus in much greater detail on what is bought and what is not bought by central banks,” he says.
He also cautions against the assumption that central bank liquidity provision will ensure a repeat of the market recovery after the global financial crisis of 2008, when riskier asset classes rallied in turn.
“If the fundamental solvency problems are as huge as we think they will be, then it is likely that the liquidity will not trickle through,” says King.
That argues for credit spread differentials to be significantly wider, whether that is between rating categories, such as investment grade and high yield, between economic sectors or by different types of debt structure.
Investors looking to profit from renewed credit dispersion don’t just have to respect the old trading adage that you should not fight the Fed – in this case by taking care to avoid selling bonds or taking out credit default swap protection on names that might see buying by the New York Federal Reserve via its trading agent BlackRock.
They also have to gauge the likelihood that some corporations will be judged more deserving of state support than others, with less likelihood of default.
Companies that are big employers are obvious candidates for help, especially in Europe. Renault is in ‘fallen angel’ status after losing investment grade ratings for its €17 billion of bonds, but it is unlikely that France will allow a full default and significant job losses among its roughly 120,000 employees, for example.
In the US, Ford is another fallen angel that lost its investment grade rating this year but is widely viewed as a good corporate citizen, as well as a major employer.
However, there is less goodwill towards corporations that are owned by private equity firms that have loaded their balance sheets with debt. When J Crew joined other US retailers in filing for bankruptcy in early May, sympathy was in especially short supply. J Crew had become a poster child for abuse of the mechanics of loan market structuring and there are plenty of similar companies with leveraged finance exposure engineered by their private equity owners that are likely to fail.
There are many intangibles to consider for investors who are tempted to fight the Fed – or at least to engage in the credit market equivalent of guerrilla warfare.
Suspicion about BlackRock’s access to information has been rife since the world’s biggest asset manager was awarded the year’s most controversial mandate, in the form of its contract to support credit markets as a fiduciary to the Federal Reserve.
The details of primary debt market support in the US are not yet clear and initial secondary market sponsorship was confined to central bank buying of corporate bond exchange-traded funds.
In Europe there is uncertainty about whether the European Central Bank will move towards greater direct support of the local high-yield debt market and whether a move towards mutual issuance of debt across governments will develop momentum.
And above all, the shape of an eventual economic recovery from the impact of Covid-19 remains unknown. Credit investors and risk managers will have to hope that the liquidity respite supplied by central banks has at least bought enough time for thorough evaluation of opportunities and pitfalls.