On 9 April 2020, the Fed announced an aggressive expansion of its stimulus program which will boost the scope and size of its various lending and asset purchase schemes by up to $2.3 trillion.
As widely expected, the Fed introduced a Main Street Lending Program to provide credit to small and mid-sized businesses, which will comprise 4-year loans to companies with up to 10,000 workers or less than $2.5b in revenues. Principal and interest payments will be deferred for one year. Banks originating loans under the program would sell 95% to the Fed’s Main Street Facility which will purchase up to $600b of loans.
The Fed also went beyond market expectations by announcing that it will provide support to previously orphaned asset classes - such as high-yield bonds, non-agency commercial mortgage-backed securities and leveraged loans – which were not covered under its asset purchase programs before.
Under its Secondary Market Corporate Credit Facility (SMCCF), the Fed will now purchase US HY corporate bonds ETFs. Also, AAA-rated CMBS and collateralized loan obligations are now eligible for non-recourse financing under the Term Asset-Backed Securities Loan Facility.
In addition, the Fed increased its investment grade corporate credit program to $750b, and also addressed the “fallen angels” problem for BBB-minus rated companies by allowing them to continue accessing the credit program even if they were subsequently downgraded.
In the direct aftermath of the Fed’s aggressive moves, equities and credit rallied. Gold also appreciated, likely due to the view that the Fed’s moves would increase the risk of inflation over the long term, which was in line with upward moves in 5-year and 10-year inflation break-evens seen over the trading session. The US 10-year Treasury yield treaded water between 0.7% - 0.8%.
Not surprisingly, US HY bonds ETFs also rallied after the announcement. We expect the risk-on response to follow through to the tightening of US high-yield spreads ahead.
An analysis of market data over the year to date shows that the asset classes where the Fed was intervening in – i.e., US Treasuries, US investment grade bonds, municipals, agency MBS and CMBS – have performed the most strongly. As the Fed expands its purchase program into US high-yield bonds ETFs, we see this phenomenon extending to US high-yield bonds over the near term.
Over the medium to long term, however, we are cautious of negative countervailing forces coming into play as US high-yield default rates are expected to increase. This would trigger valuation headwinds and adverse market reactions, although the severity would depend on the length of the recession, the amount of stimulus buffer to come from policymakers, and how much negativity is already priced into heightened spreads.
Another development relevant to the US high-yield bonds asset class is the recent announcement from OPEC+ yesterday that it will reduce crude oil output by 9.7 million barrels per day in May and June, 8 million barrels per day from July to the end of the year, followed by 6 million barrels per day until April 2022. In an otherwise challenging environment for crude oil prices characterized by over-supply and falling demand during a global recession, these output cuts are - at the margin - a positive factor for the US shale oil sector, to which the US high-yield bond asset class has significant exposure.
As we had highlighted earlier, one of the three signposts we will be watching for in April as we navigate markets is the announcement of additional stimulus buffers from policy makers, which would have powerful effects in driving asset prices and in counteracting the economic and financial shocks from the Covid-19 crisis.
During the initial stages of the global Covid-19 crisis in early March, we had downgraded our view in Developed Markets high-yield bonds to underweight, which has been the right call as the ICE BofAML Developed Markets High Yield Index fell as much as 21% over the period to date and remains 11% lower at the time of writing.
Following these latest developments, we are upgrading our view DM HY bonds from underweight to neutral. This reflects our view balanced between the three factors which are: 1) positive forces from Fed intervention; 2) weakening fundamentals as economic pressures weigh on bond issuers; and 3) less demanding pricing after a significant correction over the year to date.
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Version: March 2020