Investment grade credit markets experienced extreme volatility in March as the double black swan events of the coronavirus pandemic and freefall in oil prices gave investors whiplash after a strong start to the year—which, while hard to remember at this point, given recent events—had been characterized by credit spreads at or near historic tight levels. Since then, the price moves have been dramatic, and in some cases historic, as fear gripped markets and liquidity took over as investors’ top concern. The previously tight spreads blew out to the widest levels seen since 2009. The U.S. Federal Reserve (Fed) cut interest rates by 150 basis points—bringing them near zero—and introduced a host of old and new programs, including QE4, in an attempt to ease market liquidity and keep credit flowing. Though still early, indications are good that the worst of the market illiquidity is behind us, at least for now.
IG Spreads Experience Extreme Widening in Midst of Volatility
SOURCE: Barings. As of March 31, 2020.
Liquidity and Fallen Angels
During the most stressed period of this crisis (mid-March) to date, the cascading liquidity effects were felt throughout investment grade markets—with Treasury rates sensing trouble first, followed in short order by commercial paper and corporates. As the volatility came to a head, liquidity-starved investors overwhelmingly sold what they could, primarily in the form of higher quality, shorter duration paper—resulting in wider spreads for the highest-rated paper. As such, we witnessed the rare phenomenon of an inverted corporate credit curve—typically a sign of distress for individual credits, but especially unusual on a market-wide basis, and another indication of just how uncommon conditions were in the market during this period of stress. On the positive side, even on the most challenged trading days of the period, volumes remained robust as markets functioned well, albeit at a high cost to sellers.
In addition to the technical, liquidity-driven pressure on markets, credit concerns also came back to the forefront as previous investor concerns over fallen angels, which had faded in recent months, resurfaced on the back of what now looks set to be a fairly severe economic slowdown. The downgrade of Ford was the most notable example over the period. While expected to some degree, the sheer size of the issue (~2.4% of the high yield index ) highlighted concerns about the potential impact of ratings downgrades on high yield markets, and on forced sellers in the investment grade space.
While we will undoubtedly see more downgrades materialize as the situation unfolds in the near-term, the ratings agencies have been more front-footed than was the case during the GFC, or even during the commodity crisis of 2015/2016, when markets were arguably less prepared to digest these technical moves. This time around, weaker BBBs have at least been telegraphed to a greater extent than in prior periods of volatility, which may result in a more orderly transition for names that fall from investment grade to high yield.
If there is a positive to emerge from this, from a longer-term perspective, it may well be the ‘spring cleaning’ effect that it should have on the investment grade index, ultimately resulting in a skew toward higher-rated issues and improved issuer metrics including debt-to-EBITDA, among others.
Forecasting the Future May be a Story of Twin Peaks
As we continue to gauge the length and depth of the crisis, we think there are two primary factors to consider—the peak policy response, which we believe may be occurring now, and the peak virus.
On the policy front, despite some political back-and-forth, the fact that Congress acted relatively quickly, to pass a $2 trillion stimulus package, should help corporate sentiment by injecting a much-needed fiscal boost to the real economy—the details of which are provided below:
- $454 billion—loans to businesses
- $349 billion—small business loans
- $32 billion—airline and cargo grants
- $301 billion—household payments
- $250 billion—unemployment insurance
- $221 billion—tax deferrals and extended deadlines
- $150 billion—aid to states
- $29 billion—airline and cargo carriers
- $198 billion—other
- $117 billion—hospitals and veterans’ care
- $25 billion—public transit
While there are question marks around the exact mechanisms of delivery and timing of this capital being injected into the economy, as well as the long-term implications for companies that accept this money, the package should help to put a floor under the most pessimistic economic scenarios and ease some credit concerns.
Additionally, when it comes to the capital markets themselves, the buy-back measures enacted by the Fed have eased conditions across Treasury, commercial paper, corporate and securitized markets. While the programs themselves are not all encompassing—for instance, the initial versions did not include Agency CMBS—markets have responded well and liquidity conditions have improved materially since the most-challenged conditions of mid-March.
On the virus front, markets tend to be forward-discounting mechanisms, meaning they need to see a potential for resolution of the COVID-19 pandemic in order to accurately set prices. As we gain more clarity through the trajectory in Italy and China—and have a reasonable estimate for when the virus may trend downward in most countries—we believe markets will start to settle. But it is still too early to draw any clear conclusions.
A Bias Toward Quality and Liquidity
‘Opportunity’ may feel like a strong word at this point. But we do see areas of potential value on the horizon. Given the recent price action, we don’t think investors need to take on a lot of unnecessary risk to earn potentially compelling returns in the months ahead. As such, we see opportunities to earn attractive yields even in the largest, most liquid corporate issuers. We also see value in shorter-duration corporate issues, which offer healthy yields and benefit from a near- to medium-term pull-to-par effect. Outside of traditional corporate bonds, we see long-term value opportunities in the higher part of the capital structure in securitized products like CLOs and ABS, which have been trading at more attractive levels than they have in years, and continue to benefit from strong structural protections. Importantly, we want to stress that we are not out of the woods yet—and even as parts of the market appear to improve, we remain vigilant and will evaluate the evolving situation on a daily basis in the weeks and months ahead.