Junk Bonds’ Guardian Angel Is Only So Benevolent

In case you were curious, the Fed’s decision to open its doors to fallen angels and include high yield credit ETFs in its secondary market corporate credit facility catalyzed the best one-day rally for high yield spreads in more than twenty years.

The ETFs themselves (using HYG and JNK as the poster children) each had their best sessions in a decade ahead of the long weekend, but the spread tightening (86bps in a single day, as illustrated in the top pane below) is a real eye-popper.

After officially venturing into distressed territory late last month, high yield spreads on average have come back in sharply, tightening inside 800bps (at the post-GFC wides, we were near 1,100).

It’s worth noting that just as the Fed’s initial announcement (late last month) that it would buy IG corporate debt quickly erased a worrisome discount to NAV in the popular investment grade credit ETF, the central bank’s foray into junk bonds prompted HYG to trade at a big premium to the value of the underlying.

The “value” of the liquidity wrapper is effectively enhanced by the Fed’s backstop. Never mind whether there’s a market for the actual bonds.

And yet, not everyone is a winner in this scenario. The message from Powell on Thursday was clear: Eventually, a “natural” turning of the cycle may indeed bring 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 an engineered shutdown of the economy to be the trigger event.

But just because the Fed wants to ameliorate what it clearly views as an unacceptable outcome based on an exogenous shock, doesn’t mean Powell is going to go dumpster diving in the riskiest credits.

Put simply: defaults, restructurings and other credit events are a foregone conclusion, so even with the Fed knee-deep in the market, CCCs aren’t likely to respond given the inhospitable environment and a lack of access to capital.

You’re reminded that even some investment grade issuers are being treated by the market as though they’re distressed – in some cases (e.g., Carnival) because they are.

It may well be that the prospective production cuts from OPEC+ will be a bigger boon to the riskiest credits than the Fed’s fallen angel plunge protection.

But, ultimately, the whole thing has a kind of fatalistic feel to it.