Investment Grade Credit: Whatever It Takes
It’s clear that the U.S. Federal Reserve (Fed) means business, having implemented a number of programs—from purchasing fallen angels and shares in high yield ETFs to buying individual corporate bonds—to counter the sharp and sweeping effects of COVID-19 on markets. The downstream effects of these programs have been impressive. Investment grade (IG) corporate performance, for one, was up 8.98% for the quarter, and spreads have tightened significantly since March. New issuance has also surged, in some cases to record levels, as companies have capitalized on the window of opportunity to bolster their balance sheets. But building up war chests is not without risk, in this case from adding more debt at a time when much uncertainty remains around the economy and corporate earnings.
IG SPREADS EXPERIENCE A STRONG RECOVERY
Source: Barings. As of June 30, 2020.
Concerns that weighed on investors’ minds in the first quarter—like the potential for a mass wave of fallen angels and the high yield market’s ability to absorb the extra supply in an orderly fashion—have also largely subsided given the Fed’s wiliness to take action. In fact, the central bank even backdated its program to buy fallen angels to include large issuers, such as Ford, that at the time of the announcement had already been downgraded to high yield.
Away from traditional corporate issuers, the moves across the investment grade landscape were more varied. Collateralized loan obligations (CLOs), for instance, were somewhat slower to recover as they were not directly impacted by the Fed’s programs and also continued to face challenges of their own. The asset class has regained ground more recently, however, from broad-based buying and improving forecasts around defaults and downgrades, as well as potential cash flow diversions.
Across the securitized space, asset backed security (ABS) markets have come back the most. The outlook for ABS is more idiosyncratic, however, given the very large scope of the space. On the one hand, COVID-exposed industries like aviation and auto, particularly rental cars, are still looking very uncertain—Hertz’s recent bankruptcy filing underscores this. On the bright side, other segments of the market, such as high-rated FFELP student loans, should be less impacted going forward and appear to offer attractive relative value.
Commercial mortgage-based securities (CMBS) were slower to recover initially, although certain higher-rated parts of the market have begun to outperform more recently. While deals backed by COVID-impacted sectors—such as retail and travel & leisure—will likely face difficulties, other sectors like warehouses and data centers look better positioned to offer attractive value going forward.
The Fed’s stated goal is to enhance liquidity and ensure that crucial markets are operating efficiently. So far, its programs appear to be working, having opened up new issue markets and bolstered asset prices. Investors have seemingly been right—at least until now—not to “fight the Fed,” and there are no immediate signs that this mentality should change anytime soon. That said, it’s possible that markets have gotten ahead of themselves, although this is largely dependent on the extent of further COVID-19 outbreaks and the resulting economic impact. Not to mention, of course, that the liquidity being injected into the market is not free—in fact, what was once considered unconventional, or to some unthinkable (e.g. the Fed buying shares in high yield ETFs), is now business as usual—and at some point, the costs will need to be addressed. The full ramifications of this for capital markets are not yet clear, and may not begin to crystallize for years to come. For now, the music continues to play—although investors will need to be mindful of where they’re standing when it stops.
