COVID-19 almost broke the bond market. Then the Fed stepped in.
The Fed’s decisive action has likely averted a worst-case scenario, and it has critical implications for investors.
- Wider credit spreads, surging demand for liquidity and a sudden stop to global economic activity created a toxic mix
- The Federal Reserve (Fed) stepped in with aggressive, unprecedented policy responses to help normalize spreads and get credit flowing to the real economy; these actions should create a powerful tailwind for corporate and municipal debt markets
- There will still be disruption as corporate, municipal and household balance sheets adjust to the shocks, but the Fed’s actions helped avert a worst-case outcome
- We believe investors can follow the Fed’s lead and begin purchasing municipal, investment grade—and even select high yield—securities to potentially earn handsome returns
The COVID-19 shock has wreaked havoc on the stock market, but it almost broke the bond market—and that is a much more serious issue for the economy. When the bond market is broken, it’s like the economy can’t breathe. It took decisive action from the Fed to help resuscitate the bond market. While it is still recovering, making final pronouncements premature, it seems the Fed’s actions helped avert a worst-case scenario for the economy.
Credit is oxygen for the economy
Let’s try to ignore the COVID-19 crisis for a moment and focus on credit. Credit is oxygen for the economy. Economic growth is only feasible if the cost of credit is below expected returns. Interest rates—the cost of credit—are ultimately determined by the market. The Fed, however, exercises a fairly strong degree of influence.
For borrowers that aren’t the government, interest rates are set according to how risky a credit the borrower is. Normally, municipalities and established corporations can borrow at rates only slightly higher than the U.S. government’s.1 Mortgage rates are a bit higher than that, and rates on the riskiest loans (to new or challenged businesses, for consumer credit cards, etc.) are higher still.
What caused the relationship between credit spreads to break down?
In the simplest sense, the shock from COVID-19 has caused the natural relationship between credit spreads to break down for three primary reasons:
- Cash flow is at risk. A side effect of the main COVID-19 containment strategy—bringing to a sudden stop vast portions of the global economy—is constrained cash flow. When borrowers’ (for example, airlines’) cash flows are disrupted, lenders get nervous, and credit spreads rise to reflect the reduced creditworthiness of the borrowers.
- Investors have scrambled for cash. Investors who had used leverage (invested with borrowed money) to build up large positions suddenly faced margin calls (they needed to put up cash to cover potential losses). To raise cash, they sold what they could—typically, the most secure and liquid assets, like Treasury and municipal bonds, and short- term instruments (money market funds). This selling pressure led, in turn, to even lower asset prices and higher yields.
- Liquidity has been in high demand. This surge in demand for cash (or liquidity) itself caused interest rates to rise. Rates are just the price for liquidity, and greater demand leads to higher prices.
Simply, both sides of the supply and demand equation, working in tandem, caused interest rates to spike.
In response, the Fed almost immediately cut the fed funds rate to zero—but in this case, the market did not cooperate with the Fed. Rates on the shortest-term commercial paper have not declined as we would have expected in response to Fed rate cuts. Furthermore, mortgage rates are well above where they normally are, and corporations are not getting the borrowing costs they need to issue new debt and roll over existing debt when it matures.
Mortgages most expensive relative to Treasuries since since the Global Financial Crisis
Source: Bloomberg, Bankrate.com. March 27, 2020. Note: We compare 30-year mortgages to 10-year Treasuries to adjust for duration.
The line chart shows the 30-year mortgage rate with the 10-year Treasury rate subtracted from 2005 through 2020. It shows that the current levels are equal to those during the Global Financial Crisis.
New Fed programs rein in credit spreads so they won’t constrict growth
The Fed recognized the turmoil in bond markets and implemented a set of targeted credit programs (more on these below). They are designed to provide either excess supply of liquidity or demand for debt, in both cases to bring credit spreads back to levels that won’t constrict economic growth. Overall, the support the Fed has given borrowers is providing a backstop that, for bondholders and lenders, increases confidence in issuers’ creditworthiness.
To calm short-term debt markets, the Fed relaunched several facilities it used during the Global Financial Crisis—and made some enhancements to them. The Commercial Paper Funding Facility (CPFF) purchases short-term debt directly from corporate, financial and municipal issuers. The Money Market Mutual Fund Lending Facility (MMLF) lends money to banks, under the condition that the proceeds are used to purchase assets from money market funds (including repurchase agreements and commercial paper). These new programs are in addition to the many traditional mechanisms the Fed uses to increase the supply of liquidity: repurchase operations, the Primary Dealer Credit Facility, lowering the discount window rate and reducing banks’ reserve requirements.
Fed actions, familiar and new, should give corporate debt markets a powerful tailwind
To influence interest rates at longer maturities, the Fed has restarted quantitative easing (QE), under which it will use newly created reserves to purchase Treasury and agency mortgage-backed securities (MBS). QE adds a robust source of demand for longer-term Treasury bonds (which pushes their rates down) and agency MBS—which should put downward pressure on mortgage rates.
The Fed has also created two new facilities that will directly impact the corporate bond market. The Primary Market Corporate Credit Funding Facility (PMCCF) will lend money directly to investment grade companies. The Secondary Market Corporate Credit Funding Facility (SMCCF) will purchase investment grade debt and investment grade debt ETFs at market rates. Both these programs are unprecedented actions from the Fed, and should create a powerful tailwind for corporate debt markets. Indeed, inflows into corporate bond funds have surged already, and both investment grade and high yield spreads have shown signs of stabilization.
Investment grade and high yield spreads showing signs of stabilization
Source: J.P. Morgan, Bloomberg. March 27, 2020.
The line chart shows the JULIS Index spread and JPDFHY Index from February 1, 2020, through March 27, 2020. It indicates that both investment grade and high yield spreads have started to decrease from their peaks around March 21, 2020, indicating a sign of stabilization.
Fed actions for Main Street: Helpful and aggressive
To support Main Street, the Fed has reinstituted the Term Asset Lending Facility, which lends banks money to purchase high-quality, consumer asset-backed securities. These securities are composed of bundles of auto loans, credit card loans, student loans, etc. By incentivizing demand, this program should help keep consumer-facing borrowing costs down.
Finally, part of Congress’s Coronavirus Aid, Relief and Economic Security (CARES) Act was an injection of around $425 billion into Treasury’s Emergency Stabilization Fund, which the Fed can lever up 10 times to provide up to $4.25 trillion in loans to small and medium-sized businesses across the country. Details are still scarce, but our early sense is that these loans will not only help small and medium-sized businesses get through the COVID-19 shock, it is also possible that some of the loans will be extended to businesses that issue high yield debt to markets.
The Fed is doing all it can to support the economy
The alphabet soup can be overwhelming, and it will take time for all of these facilities to at full capacity. But remember: All the Fed is trying to do is normalize credit spreads so that borrowing costs fall. The combination of wider credit spreads and the sudden stop in economic activity mandated to halt the spread of COVID-19 threatened to create a toxic mix for markets and the real economy. That is why the Fed stepped in. There will still be disruption as corporate, municipal and household balance sheets adjust to the shock, but the Fed’s actions helped avert a worst-case outcome.
For investors, the implications seem clear. The Fed is providing an implicit backstop for a wide array of borrowers, and has become a massive source of demand for dislocated securities. We believe investors likewise can—if it is appropriate for their goals and risk tolerances—begin to purchase these same municipal, investment grade, and even select high yield, securities to potentially earn handsome returns.