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Key themes in credit markets

  • Financial Analyst
  • Blog post submitted on 23rd June 2020

Central banks are the modern day knights in shining armour, spear heading the charge in market momentum. Following the reporting of the Federal Reserve minutes last week, the direction which Fed chair Powell intends to footslog has become even clearer to markets.

The main takeaway from the Fed last week was hidden at the end of the published Q&A on the corporate bond purchases, being that the Fed will buy corporate bonds until it sees “sustained improvement in market functioning, to levels at or near those prevailing prior to the COVID-19 dislocation”.

In practice this means that the Fed will be exercising a level of control over the spread-curve, increasing the purchases of bonds should spreads widen. This reaction gives confidence to credit markets, and signifies that any dips will be shallow and the overall direction should be tighter.

Across the pond, the ECB is traversing a similar path, albeit more aggressively and thus having a greater impact on credit. The ECB purchased circa $9.5 billion dollars’ worth of corporate bonds, compared to the Fed’s $5.2 billion. This equates to 43.9 percent of net supply compared to 24.5 percent for the Fed, and 9.6 percent of the overall market size compared to the Fed’s 1.5 percent.

All of this has been in the backdrop of larger than usual amount of supply emanating from Primary markets in the past few weeks, which is expected to taper. Last week was the busiest week ever for high yield issuance on the back of strong Fed support to the corporate market, contributing to what is already the second busiest month in history. As companies reach their required financing requirements, even in virus-hit sectors such as consumers and energy, supply should start to ease.

The Fed published a list of metrics for which it would deem the market to be operating at a sufficient level. Assessing these metrics implies that there is further room for US investment grade spreads to tighten in order to reach the Fed’s goal. This implies that the Fed is likely to continue to purchase corporate bonds at least at the same pace as now.

The encouraging Fed actions provide a good opportunity for issuers to step into the primary market and hoard enough cash to reach comfortable liquidity levels. Such accommodative decisions, which initially were announced by the Fed in early April were imperative in re-instating confidence within the primary market following a deadlock in the month of March. This has encourage typically more risk averse investors to go to lower ratings names, especially given the lower general yields.

In the UK, the Bank of England (BoE) increased its asset purchase facility by £100bn, specifying that the additional quantitative easing will be spent on UK government bonds. The original (at least) £10bn target for corporate bonds remains unchanged. At this point a significant increase in corporate QE has become more unlikely, unless the economic recovery disappoints. This is despite the fact that, at the current pace, the £10bn mark will be met in August. Even in this scenario, the market impact is likely to be limited, given the small weight of the BoE corporate buying programme. The BoE holds £15bn corporate bonds, which represents 10 percent of its £148bn eligible list, compared to 16 percent for the ECB.

The technicals for credit are therefore pointing in the right direction, however caution should remain at the individual company level, as the corporate default rate has been creeping upwards, despite the sustained efforts from stakeholders to support corporate liquidity. Identifying an underlying sustainable long term business model remains key, especially in high yield credit names.

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