- Both credit and equity markets have improved substantially since the dark days of late March, thanks largely to Federal Reserve support.
- Although the Fed proposed an array of lending facilities to buoy financial markets, the turnaround in credit markets has been accomplished without the Fed buying a single corporate bond.
- Despite the narrowing of spreads and greatly improved market conditions, risks remain and credit investors should continue to be diligent.
This month’s main article, Words Speak Louder Than Actions, discusses how Fed announcements have provided market stability.
Words Speak Louder than Actions
Eric Souza, Senior Portfolio Manager
As we mentioned in our April Market Insights, while the economy screeched to a halt earlier this spring, the Federal Reserve sprang into action and launched an array of emergency facilities with a specific focus on stabilizing credit markets. Since then, we have seen significant improvement in liquidity and spread tightening, not only in the credit markets but also in asset-backed and mortgage-backed securities. Equity markets also have enjoyed a 30 percent rebound from their March 23 lows, and somehow the tech-heavy Nasdaq has moved into positive territory for the year.
The amazing part of this turnaround is that it has been accomplished without the Fed buying a single corporate bond. Just the announcements alone have been enough to provide market stability and spur a risk-on rally.
Looking at four of the Bloomberg Barclays corporate credit indexes since spreads widened to their greatest levels in late March, it’s clear that the tightening within the investment grade indexes has been focused on the front end. It just so happens that this area experienced the greatest dislocation and illiquidity in March, and it was also the focus of the emergency lending facilities launched (announced) by the Fed. The short-term index has rallied more than 380 basis points (bps) from the widest levels that peaked at +465 bps.
Bloomberg Barclays US Corporate Credit Indices
|Source: Bloomberg as of 5/27/2020.|
Breaking down the short-term index by credit quality, the lower-rated (riskier) classes widened the most, with BBB spreads widening from +94 to +639 bps, though they have since narrowed significantly to +149 bps. Still, these spreads appear to offer attractive yields, relative to comparable Treasury maturities and government money market fund yields.
The Fed’s actions not only helped narrow spreads, but also fueled a record amount of new corporate bond issuance since its intervention. In March, there was $259 billion in new investment grade supply, and April was no slouch either with $285 billion of new issuance, including a record $117 billion priced in one week alone. The trend has continued through the first four weeks of May with more than $200 billion of new investment grade corporate debt coming to market. New supply reached $1 trillion in May, which is the fastest pace in history. In general, deals have been met with solid demand, and pricing has been tighter than anticipated. Even companies that have been significantly affected by COVID-19 have been able to issue corporate bonds and have enjoyed robust demand. For example, Boeing issued this year’s largest corporate bond offering, pricing $25 billion in bonds and receiving more than $70 billion in orders.
On May 12, the Fed embarked on a new era by officially launching the Secondary Market Corporate Credit Facility (SMCCF) to purchase eligible exchange-traded funds (ETFs) and corporate bonds. Within the first six days of the program launch, the facility purchased $1.8 billion of securities. Next on tap is the launch of the Primary Market Corporate Credit Facility (PMCCF), which will purchase bonds when they are initially issued in the primary market. However, it’s important to point out that while the introduction of these programs has been vital, the level of actual support by the Fed so far has been minimal and could end up being less than initially expected.
Helping with all this supply is a healthy amount of demand. Investment grade and high yield funds have seen record amounts of inflows since the pandemic. During the last week of May, there were over $17 billion of inflows into investment grade corporate bond mutual funds and ETFs which was the largest weekly inflow on record and over $40 billion of inflows over the previous four weeks.
Looking ahead, these unconventional Fed facilities, along with the other monetary and fiscal policy responses, clearly have improved the credit markets. However, we are not completely out of the woods and remain cautious in our outlook. In addition to monitoring and analyzing incoming economic data, our focus will be on COVID-19 case growth after cities and states reopen, the employment landscape, consumer spending and the overall economic rebound. If the reopening is a success (i.e., no spike in cases and Americans begin re-entering the labor force), we should continue to see an improvement in product spread. Although the road is uncertain, our highly selective approved issuer list should be well positioned for this current environment.
Jose Sevilla, Senior Portfolio Manager
The stock market may have bounced, but the economic data shows no sign of rebound just yet. Although data is a lagging indicator, the pandemic-driven economic disruption shows no sign of abating. Consumer spending has been badly damaged by the lockdowns, illustrated by a 16.4 percent month-over-month drop in retail sales. It’s no surprise that travel and leisure, hotels, restaurants, and theaters have been some of the worst-performing sectors. There was no silver lining in business investment either, which was anemic, thanks to a combination of weakening profits, continued uncertainty in the medium-term outlook, and plenty of spare capacity. Given this backdrop, it’s no surprise that the second print of first-quarter GDP, contracted by -5.0 percent reflecting the COVID-19–related shutdowns, has affected consumption.
The employment picture is equally grim as weekly unemployment claims continue to mount. On the one hand, weekly jobless claims have been trending downward each week since late March (see Figure 4) as some states are gradually reopening. On the other hand, continuing claims, often considered a better measure of unemployment, have been trending higher since the peak of the crisis in late March, hitting a post-COVID high of 24.9 million in early May.
The April jobs report confirmed the gravity of the situation as the unemployment rate tripled to 14.7 percent, equating to 20.5 million job losses, wiping out a decade’s worth of job growth. This was the highest unemployment rate since the Great Depression. The labor-force participation rate fell to 60.2 percent from 62.7 percent, the lowest rate since 1973. Average hourly earnings rose 4.7 percent in April and 7.9 percent year-over-year, which was more than twice March’s wage growth. However, this was skewed by the disproportionate loss of low-paying workers rather than an actual bump in employee paychecks.
The April Federal Open Market Committee (FOMC) minutes highlighted the ongoing risks to the economy and markets, and the Federal Reserve is evidently concerned that economic conditions may get worse before they improve. The main takeaway from the minutes was confirmation that the Fed will utilize its “balance sheet further to reinforce the Committee’s forward guidance regarding interest rates.” The Fed may consider yield curve controls and enforce specific yield targets similar to what the Bank of Japan had implemented. In an interview with 60 Minutes, Fed Chair Jerome Powell re-emphasized “the Fed’s commitment to using its full range of tools to support the economy, including keeping rates near zero for as long as necessary and continuing lending programs that have already pumped more than $3 trillion into the US economy.”
Reinforcing its commitment, the Fed left the fed funds rate unchanged at the June FOMC meeting as the Committee will keep rates low until they are confident that the economy has weathered economic effects from the pandemic and is on track to achieve maximum employment. Powell reiterated “we’re not even thinking about, thinking about raising rates.” So, while the financial markets have rallied and are embracing the Fed’s actions, the Main Street economy has not enjoyed a similar bounce to date.
Fiona Nguyen, Senior Credit Risk & Research Officer
If investors need a testament to the efficacy of monetary intervention, they should look no further than the state of the investment grade credit market today. This market segment has recouped nearly all its losses since the lows in March, thanks largely to a zero interest rate policy and the Federal Reserve’s intervention, including purchases bond exchange-traded funds (ETFs) and announcement of additional facility to buy individual corporate bonds, which is currently not being utilized. And while much of the real economy remains largely in lockdown and many sectors are still crippled by dwindling revenues, this massive policy response has kept liquidity flowing and provided an artificial safety net for markets to stay afloat.
Taking advantage of a favorable borrowing environment, many highly rated companies have come to the market for additional liquidity. This is partially to repay the temporary revolving credit lines that they tapped during the earlier phase of heightened volatility and also to fill up their war chests in anticipation of a prolonged lockdown. But has this current debt issuing spree gone too far?
According to Bloomberg, through the end of May corporate bond issuance from investment grade companies topped a whopping $1.1 trillion, or more than 90 percent of the volume issued in all of 2019 (see Figure 5). Roughly 31 percent of the issuance is debt raised by the financial sector, while consumer discretionary, energy and industrials account for another 30 percent. Many companies, such as Pfizer and Toyota, even managed to pay lower yields compared to their past borrowings. The surge in corporate issuance also coincides with a reported slowdown in revolving credit demand at large banks, as companies term out deals in the capital markets to pay back previous drawdowns.
Although this recovery in the credit markets looks encouraging, we need to be reminded that it is largely a function of external macro intervention and demand driven by investors seeking returns. All this borrowing will eventually need to be repaid, as companies cannot afford to roll over their debts in perpetuity without having strong underlying fundamentals.
As the economy slowly starts to reopen, businesses will need to generate cash flow organically to pay back the debts and sustain real economic recovery. For us as credit investors, being credit defensive means focusing on companies with the financial wherewithal to outlive the crisis through their operational flexibility, franchise strength and established, organic cash flow or capital stability. Even now with the Fed’s support, the importance of fundamentals should not be overlooked when it comes to security selection.
Jason Graveley, Senior Manager, Fixed Income Trading
As we all grow more comfortable with this strange new normal, the narrative of the COVID-19 pandemic is shifting to one of vaccine development and states reopening. Still, investors are left to dissect the true economic toll of the virus and to understand the path forward. There has been no shortage of headlines showcasing the magnitude of the economic stress, from record unemployment and new jobless claims to corporate bankruptcies. The next question on investors’ minds now centers around the trajectory, timeline and staying power of any recovery. Certainly, the equity markets are now suggesting good news, as the rebound has been almost as abrupt as the sell-off. After the S&P 500 Index plunged more than 30 percent in March, it has largely recovered in May. The Nasdaq composite has even turned positive for the year. This sharp rebound has been fueled by one thing: investor optimism.
This same optimism also has led to a sharp reversal in credit spreads. Investors were quick to return to the market once the Federal Reserve signaled its support and trading stabilized. Investors have been deploying large amounts of cash that built up during the heightened volatility. The front end has outperformed, with spreads recovering nearly 80 percent from their recent widest levels. And although the recovery has been broad, sector outperformance has been noted, as retailers like Walmart have seen a surge in demand, while cash-rich companies like Apple have become safe havens. Still, the supply and demand dynamic, which has always been tenuous in corporate bonds, remains difficult in the secondary space. Even with record new issuance on the back of a lower interest rate environment (a 90 percent increase year-over-year in new investment grade issuance), investors are wary to sell, as replacement options are minimal and all-in yields grind lower.
These market shifts have only reinforced our investment philosophy. Our focus on issuer selectivity has left client portfolios with strong, underlying credit fundamentals. Our select corporate investments are well positioned to weather the current volatility, and we expect them to continue to perform in the face of any additional headwinds. We have also enhanced diversification with AAA-rated credit card asset-backed securities, which we sought out for their strong loss protection and historical performance. And we continue to believe that Treasuries and AAA-rated money market funds add valuable elements of liquidity. Given the recent inflows into government and Treasury money market funds (more than $1 trillion, year-to-date) capital preservation and liquidity remain the two highest priorities for investors — just in case their recent optimism is unfounded.
|Treasury Rates:||Total Returns:|
|3-Month||0.13%||ML 3-Month Treasury||0.00%|
|6-Month||0.15%||ML 6-Month Treasury||-0.01%|
|1-Year||0.16%||ML 12-Month Treasury||-0.02%|
Source: Bloomberg, Silicon Valley Bank as of 5/29/20
SVB Asset Management's monthly Market Insights covers current topics on portfolio management, credit considerations and market events that influence corporate investment strategy.
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