By Robin Marshall, director, Global Markets Research Fixed Income
Following the extreme stress in March, corporate credit markets rode a resurgence in risk appetite in April amid unprecedented central-bank support – in particular Fed and European Central bank plans to extend QE programs to lower-grade debt – and the start of a gradual easing of lockdowns in many countries.
As part of its $2.3-trillion rescue package, the Fed announced on April 9 that it would expand an existing facility to include purchases of ‘fallen angels’, or issuers recently downgraded to high-yield status from triple B minus ratings or above on March 22. Later in April, the ECB relaxed collateral rules for refinancing ‘fallen angel’ bonds through September 21, while also signaling willingness to add purchases of this riskier debt as part of its €2.8 trillion pandemic rescue program launched in late March.
As the chart below shows, US and Eurozone corporate bond returns rose 3.5-6% for the month, though high-yield returns for the year to date remain down by 10-12%. Inflation-linked bonds also rebounded strongly, as inflation expectations stabilized and real yields fell in response to central- bank asset-buying announcements and the deeply uncertain growth outlook.
Global bond markets total returns – April 2020 (USD & local currency, %)
Source: FTSE Russell. Data as of April 30, 2020. Past performance is no guarantee to future results. Please see the end for important disclosures.
Given previous concerns about moral hazard, the Fed and ECB’s willingness to take more corporate term risk onto their balance sheets is a radical development in QE programs, and far more substantial than the short-term liquidity support offered during the 2008 financial crisis. This may explain the mood shift in credit markets, and the power of the April 9 ‘announcement effect’, though the programs didn’t start until early May. Aggregate credit spreads fell sharply for the month, particularly in the US, and despite increased supply of corporate debt.
US and Eurozone corporate bond spreads (basis points)
Source: FTSE Russell. April 30, 2020. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
But COVID credit challenges remain
While recent QE announcements helped restore stability, central banks will continue to face structural challenges at the end of this credit cycle if they hope to return spreads to pre-COVID-19 shock levels and prevent a wave of credit defaults.
Debt service costs today are lower than in 2008-2009, when the last credit cycle ended in the GFC, while the proliferation of covenant-lite corporate bonds reduces default risks. However, the impact of measures to contain the pandemic on demand has been greater than during the GFC, as have the uncertainties about future consumer and business spending. Low oil prices have already unmasked the fragility of the energy sector, and the relatively high proportion of energy issues in the US high-yield sector is another factor (15% of the FTSE US high-yield index). As the chart below illustrates, energy spreads remain near 2016 highs, despite the April rally.
Source: FTSE Russell. April 30, 2020. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
Benchmarking default rates against those of the GFC, US high-yield spreads of around 750 basis points, as shown above, imply a default rate of about 12.5%, assuming a debt recovery rate of 40%. That compares with a peak of 13.2% during the GFC. However, defaults were heavily concentrated in the financial sector then, and central-banks asset purchases did not include high yield. These factors suggest that central bank success in restoring stability in April is the first battle in a lengthy war on credit spreads.
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