Are you concerned about “fallen angel” risk in the credit market?
Put differently, are you someone who’s spent the last month obsessing over the apparently imminent realization of the long-feared “BBB apocalypse”?
Well, don’t be – concerned, that is. Because the Fed will now buy high yield bonds.
The updated term sheet for the secondary market corporate credit facility released in conjunction with a raft of new measures and enhancements to existing facilities on Thursday morning, includes new guidance around recently-downgraded borrowers.
To qualify as an eligible issuer, the Fed now says the issuer must satisfy just the following conditions:
The issuer was rated at least BBB-/Baa3 as of March 22, 2020, by a major nationally recognized statistical rating organization (“NRSRO”). If rated by multiple major NRSROs, the issuer must be rated at least BBB-/Baa3 by two or more NRSROs as of March 22, 2020. a. An issuer that was rated at least BBB-/Baa3 as of March 22, 2020, but was subsequently downgraded, must be rated at least BB-/Ba3 as of the date on which the Facility makes a purchase. If rated by multiple major NRSROs, such an issuer must be rated at least BB-/Ba3 by two or more NRSROs at the time the Facility makes a purchase.
So, the Fed will buy BB bonds now. The message is clear: Eventually, a “natural” turning of the cycle may have brought about the massive wave of downgrades from the lowest IG bucket to junk that many market participants have spent the last several years warning about. But the Fed is not prepared to sit idly by and allow the coronavirus and engineered shutdown of the global economy to be the trigger event.
If you’re wondering whether the guidance now includes high yield ETFs as eligible for the for purchase, the answer is yes. But junk bond products won’t be the majority of the Fed’s ETF holdings. Here’s the Fed to explain:
The Facility also may purchase U.S.-listed ETFs whose investment objective is to provide broad exposure to the market for U.S. corporate bonds. The preponderance of ETF holdings will be of ETFs whose primary investment objective is exposure to U.S. investment-grade corporate bonds, and the remainder will be in ETFs whose primary investment objective is exposure to U.S. high-yield corporate bonds.
“This will alleviate concerns about borrowers falling out of the warmth and light of the Fed’s program into the outer dark of junk and seeing their yields spike”, Bloomberg’s Sebastian Boyd wrote.
The broad high yield ETFs – HYG and JNK – exploded higher on the news, rising nearly 8%.
As a reminder (and I doubt most readers need it), BBB had become the largest tranche in IG, accounting for around 40% of the entire investment grade universe.
Teetering precariously on the cusp of junk, the lowest tranche in IG also had a high sensitivity to oil prices. Obviously, downgrades in BBB would remove them from the IG universe, requiring IG funds to sell. As Deutsche Bank put it last month, “BBB (and indirectly, oil prices) are the biggest source of negative convexity in the present constellation of risks [and] the unprecedented widening of the IG sector [in March] was a function of these forces”.
Late last month, some suggested high yield offered the opportunity of a lifetime. “This is a once-in-a-decade opportunity” that will be “gone way before the fear subsides”, Invesco’s Scott Roberts told Bloomberg, in a series of e-mails from March 23 to March 30. “High yield has a history of bouncing back strongly from episodes of massive fear”.
High yield funds took in $7.09 billion in the week ended April 1, according to Lipper data (and we’ll get an updated figure soon). That was a new record.
The high yield index entered distressed territory for the first time since the GFC last month, as spreads topped 1,000bps.
But things have turned around since, and the Fed’s decision to step into the market will likely help ensure the recovery is sustainable, even as the fundamental backdrop remains exceptionally challenging.
A recent white paper by Fidelity said around $215 billion of US debt and €100 billion of European corporate bonds would likely be downgraded to junk in 2020.
Fidelity’s global head of research for fixed income Martin Dropkin said fallen angels could be a third shock to the high yield market, on top of the virus and the plunge in crude prices.
Fallen angels, Dropkin wrote, “tend to outperform when they move to high yield [but] there is reason to be cautious today, given the amount of bonds at risk of a downgrade”.
He also suggested BBB spreads were reflecting “some complacency”.
Well, now, fallen angels have a home. They are welcome (with some stipulations) at the Fed’s house, onto which Jerome Powell is furiously building new wings to accommodate the increasingly diverse population of “refugee” assets he’s inclined to shelter and feed.