At the end of last week we saw yet another significant intervention by the US Federal Reserve in the financial markets, to the tune of $2.3 trillion in loans to support the economy through the COVID-19 crisis.
When the Fed announced last month that it would be buying investment grade corporate bonds as part of its stimulus package – a measure it didn’t even deem necessary in the darkest days of the global financial crisis), the central bank was said to have thrown the kitchen sink at the problem. After this latest move, there are holes where the kitchen cabinets used to be.
In addition to a ‘Municipal Liquidity Facility’ that will offer up to $500 billion in lending to states and municipalities and a ‘Main Street Lending Program’ that will purchase of up to $600 billion in loans to small and mid-sized businesses, the Fed on Thursday said it would be expanding the size and scope of the credit market support unveiled on March 23.
Non-financial corporates rated investment grade on March 22, 2020 will now be included in the Primary and Secondary Market Corporate Credit Facilities (PMCCF and SMCCF), as long as their ratings from at least two agencies remain BB- or higher. Exchange-traded fund (ETF) purchases have also been expanded to include US high yield corporate funds. The SMCCF will be funded with $25 billion of equity capital from the Treasury (previously $10 billion) and the leverage used on the equity will be 10x for IG bonds and 7x for non-IG. Meanwhile, the AAA tranches of both outstanding CMBS and newly issued CLOs are now eligible for the Term ABS Securities Loan Facility (TALF).
Between them, these three programs will now support up to $850 billion in credit, backed by $85 billion in protection provided by the Treasury, lending ever more credence to the old adage “don’t fight the Fed”.
While support for SMEs, states and municipalities had been widely anticipated, the move to support high yield debt came as a surprise to some market participants. However, we should remember the Fed is facing a potentially unprecedented downturn in economic activity, massive negative GDP revisions, record unemployment, and a fast approaching earnings season that is sure to be horrific. All these factors point to a deep recession and expectations for higher default rates. In our view, the Fed is simply getting ahead of the curve by looking to add support for lower rated debt, and perhaps also charting a course for other central banks to follow. We would also note that this new measure is still relatively specific in scope, and we wouldn’t be surprised to see broader HY initiatives going forward.
The US credit markets signaled their approval of the Fed’s actions virtually across the board last week. Ford Motor Company could arguably be one of the biggest beneficiaries, having been downgraded to high yield and ‘fallen angel’ status on March 25 (and now eligible); the carmaker’s benchmark 7.45% July 2031 bonds rallied by around 17 points on Thursday. One actively traded high yield bond issuer, Kraft Heinz Co (downgraded to HY in February), saw its 3.75% April 2030s rise by around five points on the day. The two largest high yield ETFs, HYG and JNK, also enjoyed meaningful market moves, rallying approximately five and six points, respectively. T-Mobile’s IG rated secured 3.875% April 2030 bonds rallied 45bp, or around 4.5 points, showing the rally was not confined to the high yield space. The BAML IG index rallied by 22bp to a spread of 261bp (still 160bp off its YTD lows) and the BAML HY index rallied 85bp to a spread of 796bp (436bp off its YTD lows).
In recent weeks investors have had precious little time to get used to a ‘first’ from the Fed before another has come along, but this reach into high yield could be a game-changer for fixed income markets, especially if other central banks follow suit. We think the move largely came as a surprise to investors, and as such it again shows the Fed is willing to lead the way and act decisively to tackle disruption to the markets. The European Central Bank, Bank of England and Bank of Japan of course all have their own corporate bond purchasing programs, but the Fed has raised the bar again, reiterating its commitment to utilize all its tools (and invent new ones) in order to support not only Wall Street, but Main Street and the global economy too.
The follow through is now important. We do not have the exact timeline as to how, when and by how much the Fed’s balance sheet is set to increase, but it is on course to potentially surpass $6 trillion. IG new issuance in the US has reached record levels on a daily, weekly and quarterly basis, with new issues coming at attractive levels for investors, which in our view demonstrates the urgent need for liquidity and why Fed support at this stage could be critical. We would not be surprised to see other global central banks to follow the Fed down the credit curve.