By Robin Marshall, Director, Fixed Income Research
The coronavirus shock, and enforced shutdowns, come after a period of high corporate debt issuance, in response to very low interest rates. Credit quality has fallen in recent years, judged by the share of BBB-rated bonds currently making up over 40% of the FTSE USBIG Index, and the share of AA and AAA-rated bonds being near 25-year lows (see chart below).
Deep economic contractions look a perfect storm for “fallen angels” (bonds downgraded from investment-grade to sub-investment grade, or high yield by the credit-rating agencies).
Share of AAA, AA, A and BBB issues in FTSE USBIG Index
Source: FTSE Russell. Data as of April 13, 2020. Past performance is no guarantee to future results. Please see the end for important disclosures.
However, this is a unique end to a credit cycle, because it is largely driven by government-imposed shutdowns, so inferences drawn from previous cycles may be misplaced.
A different end to the cycle…
The current crisis is a public health emergency and allowing a deep recession to become entrenched would risk a permanent loss of economic capacity and employment. As a result, an enormous public policy response, including broader QE programs, and fiscal support for wage bills and tax holidays, has materialized and may be supplemented by helicopter money.
…as the Fed broadens QE
Central banks have relaxed credit criteria for sovereign and corporate bond purchases, and the US Fed has broadened its QE asset purchases, with a corporate credit facility of up to $750bn (April 9). This includes purchases of high yield ETFs and corporate bonds that have become fallen angels since March 22, 2020. The Fed’s purchases will leverage the $75bn equity committed by the US Treasury by up to 10:1.
And central banks emerge as (substantial) buyers of last resort in corporate bonds
This means the Fed has become a buyer of last resort in corporate bonds, for the first time. If the Fed only bought high-yield issues in the secondary market, it could purchase up to $175bn, a meaningful market share when the US high-yield and investment-grade markets are about $914bn and $7.6trn* in size, respectively. Credit spreads have already fallen sharply, as the chart below shows.
US and Eurozone credit spreads, investment grade and high yield
Source: FTSE Russell. Data as of April 13, 2020. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
Similarly, the ECB announced a pandemic emergency purchase program of an extra €750bn on March 26 and relaxed its sovereign credit rating criteria and 33% country limit, while both central banks have plenty of balance sheet room to expand corporate bond purchases.
ECB public sector and corporate bond holdings
Source: ECB. Data as of March, 2020. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
These purchases raise the issue of moral hazard
Extending the Fed’s QE asset purchases to high-yield bond ETFs raises a moral hazard, if debt issuers believe the Fed will always purchase these bonds. The purchases carry greater risks to central bank balance sheets, given lower credit quality. But given the scale of the economic shock, the Fed appears prepared to accept these risks as the cost of preventing permanent damage to the economy.
Expanded QE corporate purchases create quandary for rating agencies
Expanded QE programs, and loan support from central banks for corporates, create a quandary for credit-rating agencies, in rating companies on fundamentals alone, particularly as there is no precedent for a credit cycle to end as suddenly, but with central bank support for credit spreads. This makes the process of assessing the correct credit rating more complex, given the unique macro-economic backdrop. One of the lessons of the global financial crisis was the increased tiering of financial sector bonds, as banks were obliged to issue different bonds to cope with the crisis. Similarly, the Fed’s credit facility would allow purchase of Covid-19 corporate bond issues.
Lowering the height of the cliff-edge?
These factors combined suggest the implications for credit spreads from the economic contractions underway, are more difficult to forecast than the severity of the contractions would suggest.
*Market value of FTSE US high yield market index % FTSE US Broad Investment Grade Credit index.
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