U.S. Fixed Income

Corporate credit spreads widened aggressively in March 2020

Credit markets have seen extreme repricing over the past month as a result of the market stress caused by coronavirus and its impact to the economy.
April 2020

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Credit markets have seen extreme repricing over the past month as a result of the market stress caused by coronavirus and its impact to the economy. The period through March 26 saw some of the most aggressive corporate spread widening in history, with the worst days experiencing almost twice as much widening as any day in 2008. Global investment grade corporate credit spreads reached 340 basis points after having started the year at 102, and we saw global high yield spreads widen past 1,000 basis points as an index, which is generally the level considered the threshold for individual bonds to be considered part of distressed indices.

Global Investment Grade Credit Spreads

Global Investment Grade Credit Spreads

Source: ICE Bank of America Global Corporate Index, Bloomberg. 30 March 2020.

Emerging from this, we have seen a number of themes dominate the market. Namely:

  • Liquidity
  • Downgrade and default risk
  • Market opportunities: US versus EU relative value and short end credit spreads

 

Liquidity in credit had been challenged throughout March as we saw the market become inundated with sellers and a resultant imbalance in supply and demand develop. This has hit cash markets, which have underperformed derivatives particularly hard, evidencing that it pays to be a provider of liquidity in stressed markets. Quite often investors will hold shorter dated credit (5-year maturity and under) as part of their liquid asset reserves and they tap into this when they need to raise cash. We saw this happen on an unprecedented scale in early March as markets tumbled on Coronavirus fears and, coupled with investors looking to mitigate risk in their portfolios or unwind index hedges, this all but took liquidity completely out of the market and led to the observed blow out in credit spreads above as investors struggled to find bids and clearing prices on corporate paper.

This situation only reversed after the Federal Reserve Bank (Fed), Bank of England (BoE) and the European Central Bank (ECB) all announced monetary policy measures to shore up markets, while at the same time governments in the US, the UK and in the European Union introduced fiscal measures to protect their respective economies. The Fed’s announcement carried the most weight; a massive expansion of policy notably expanding quantitative easing from $700 billion (announced only a week earlier) to “the amount needed”, introducing two facilities to purchase corporate bonds, and initiating facilities to support asset backed securities, commercial paper and money markets.

These announcements and measures have helped to bring some stability and positive sentiment back into the credit markets. Liquidity however remains thin within secondary markets, as investors look to hold onto names seen to be of good quality and nobody looking to buy names perceived to be of weaker credit quality. Companies have been quick to catch onto this and as a result we have seen record-breaking levels of new debt being issued across the US and Europe as the primary market has become the main source of liquidity for buyers. There is very high demand from investors for bonds issued by high quality names, especially as deals are being priced at spreads not seen since the financial crisis and at attractive new issue premiums. These terms have led to deals being heavily oversubscribed and strong secondary market performance.

Adding fuel to the fire, we have also seen a spike in the number of credit downgrades from rating agencies as they begin to price in the impact of Covid-19 on industries and businesses. The main story here is around fallen angels (bonds that have been downgraded from investment grade to high yield), with analysts estimating a 10% increase in the high yield universe, if not more, as a result of the current crisis. Three of the top 5 issuers in the high yield universe are now fallen angels, namely Kraft Heinz, Ford and Occidental. As of March 26, fallen angels total $120bn in the US and €30bn in Europe. These numbers are still low compared to historic averages however, as the full economic impact of the virus continues to feed through, we would expect these numbers to rise in the near term. This creates a lot of change within investment grade and high yield indices as investors become forced sellers and/or buyers, and it can present opportunities for those investors who are not constrained by an index-based benchmark. To help manage some of this change, index providers including ICE and Bank of America have suspended their index rebalancing events for March, instead pushing these out to April 2020. Default rates on the other hand remain low, although we would expect these to increase as the effect of the virus pandemic on businesses unwinds, as demonstrated in the chart below.

Trailing 12-month speculative-grade default rate forecasts under three scenarios

Trailing 12-month speculative-grade default rate forecasts under three scenarios

Source: Moody’s Investors Service and Moody’s Analytics.

Market turmoil and dislocations do present opportunities to investors who can take advantage of them. Two areas that we have noted are the relative value in spreads between US and EU names, and the outright level of credit spreads, predominantly in shorter duration tenors.

The BoE and the ECB were the first of the central banks to announce monetary easing measures and they were followed several days later by the Fed which contributed to US spreads widening further in the US than in UK and Europe before the market found support. Consequently, and as can be seen in the chart that follows, the dollar market now looks more attractive on an outright basis than the sterling or euro credit markets. This may present opportunities to switch between the same or equivalent euro and dollar issues, albeit that any decision to switch should be made net of the cost of currency hedging. Through the beginning and middle of March we saw a dash for dollar cash causing 3-month EUR-USD cross currency spreads (EONIA vs Fed Funds) to widen significantly to -150 basis points, meaning an investor would need to pay EONIA -150 basis points to hedge dollar currency exposures. We have since seen the spread normalise to approximately -75 basis points, which is still stretched compared to pre-COVID levels (approximately -20), and it is improving as Fed action makes it cheaper for banks to access US dollars. We are consequently seeing opportunities to switch to be on a name by name basis rather than across the broader market.

Change in credit spreads over 3 months by maturity

Change in credit spreads over 3 months by maturity

Source: ICE Bank of America indices, Bloomberg. Change spread to government between 30 December 2019 and 30 March 2020.

The chart above also highlights the degree to which credit spread curves have flattened, meaning that investors are not being fully compensated for buying longer dated credit. A large part of this is down to spread widening at shorter maturities for the reasons outlined above. Where investors hold short dated credit for liquidity purposes, they tend to be price takers which causes spreads to widen further than would otherwise be the case. We would expect this to be a temporary dislocation and the curve to return to being upward sloping in time which, together with the overall outright level of spreads, does provide a good buying market for investors looking to allocate capital into credit.

As with all markets, things can change very quickly and in fact investment grade spreads have already tightened by approximately 50 basis points since their peak on the 23rd March. This buying opportunity is unlikely to persist for long, although the economic impact of Covid-19 looks formidable and the crisis is far from over so there is a risk that credit spreads could move wider still should liquidity deteriorate further.  As mentioned above, while liquidity in the secondary market is currently generally thin, there are good pockets of liquidity on a name-by-name basis which is dependent on bank axes. We believe the best approach to take advantage of this at the moment is to work an order book of names with a bank, picking and choosing within the book where liquidity allows. We expect to see some cyclical volatility as the speed of the economic decline may cause some investors to sell credit along with their equities and as equity income investors realize that dividends will be slashed, as we’ve seen in the banking sector, investment grade corporate bonds (backstopped by the Fed and the ECB) may well be the new income opportunity. This makes the current opportunity within credit even more compelling, and the investors best placed to take advantage of it are those who have cash to allocate to credit and are able to tolerate some mark-to-market volatility as the crisis plays out.

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Disclosures

Views and opinions have been arrived at by BMO Global Asset Management. The information, estimates or forecasts provided were obtained from sources reasonably deemed to be reliable but are subject to change at any time. This publication is prepared for general information only; it should not be construed as investment advice or relied upon in making an investment decision. All investments involve risk, including the loss of principal. Past performance is not a guarantee of future results.

The mention of specific securities is not a recommendation or solicitation for any person to buy, sell or hold any particular security. A credit spread is the difference in yield between two bonds of similar maturity but different credit quality. Basis
points (bps) represent 1/100th of a percent (for example: 50 bps equals 0.50%).

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