June 1, 2020
By Matt Kelley
Portfolio Strategy Manager, ESL Federal Credit Union
While the stock market has stolen most of the headlines during this pandemic, the bond market has been equally interesting. Similar to the stock market, investors have seen turmoil for both investment and speculative grade bonds in the market. The investment grade bond market, in this case represented by the iShares Investment Grade Corporate Bond ETF (LQD), fell almost 22% from its high on March 6, to the market lows of March 23. A wild ride for investors that hoped investment grade bonds would serve as the conservative allocations in their portfolios. LQD has since recouped almost all of those losses, and is up 2.85% year-to-date as of this writing. Much of that rebound has to do with the Federal Reserve’s action during the crisis, namely the Primary Market Corporate Credit Facility (PMCCF) and Secondary Market Corporate Credit Facility (SMCCF).
An Explainer on Corporate Bonds
Corporate bonds often have a higher yield than other fixed income securities, like treasuries and agency-backed bonds. This extra yield offsets assumed risk for investors against the company’s inability to repay the bond at maturity. Credit agencies (ex. Moody’s, S&P, Fitch) often step in to opine on the credit default risk of a company, issuing a credit rating. Investment grade bond ratings range from AAA (highest quality) to BBB- (lowest quality). Speculative grade (high yield) bond ratings range from BB+ to CC.
The drop in corporate bond prices in March reflected the increased risk of corporate defaults due to the coronavirus pandemic. A drop in consumer demand from social distancing and/or government-mandated shutdowns triggered a drop in company revenue and the ability to make interest payments and repay debt. What exacerbates this problem is companies who had planned to issue debt (i.e. to fund operations, pay off/restructure existing debt, merge with/acquire a company) would now have to do so at higher interest rates. Higher default risk, means higher corporate interest rates, leading to higher coupon payments and lower earnings.
Bond Issuance Surges in 2020
We have seen record bond issuance so far in 2020, with MarketWatch recently citing more than $807 billion in the start of the year. While one might assume much of the issuance increase occurred in the beginning of the year, before the economic crisis, data shows issuance has increased significantly in the midst of the pandemic. Debt issuance in 2020 was on pace with each of the prior three years, until it pulled away in April and May.
A primary factor in issuance being where it is today is because of the Federal Reserve’s actions to support the U.S. economy. On March 23, the Fed announced extensive measures to assist, including the PMCCF and SMCCF.
The PMCCF provides credit directly to investment grade companies so they can maintain business operations during the economic crisis related to the pandemic. The SMCCF purchases outstanding corporate bonds issued by investment grade companies and exchange-traded funds whose investment objective is to provide broad exposure to investment grade corporate bonds. LQD falls in this latter category.
On April 9, the Fed expanded the SMCCF to include “fallen angels,” bonds that had been downgraded from investment grade to speculate grade (also called high yield or junk bonds). The fed picking up downgraded bonds is important because when a company loses its investment grade rating, there will be forced selling from institutions and investment funds that are not allowed to hold speculative grade debt.
Addressing The Fed’s Impact
The Fed announced that it would begin buying corporate debt ETFs on May 12. While the Fed has not announced specifically what ETFs will be purchased, we do know that they appointed Blackrock to run the bond purchasing facility. LQD is the largest corporate bond ETF, with $48 billion in assets, and iShares is owned by Blackrock. Whether or not it is a direct beneficiary of Fed purchasing, LQD had record fund flows in March and April, totaling more than $10 billion, as investors rushed to get ahead of anticipated Fed purchasing. Since the May 12 announcement, the Fed has purchased $1.8 billion in corporate bond ETFs via the credit facility.
The March 23 lows reflected credit spreads not seen since the global financial crisis of 2008. It is unlikely we would have seen issuance where it is today had spreads stayed at that level. Without these facilities, any debt issuance would have most likely been at painful interest rates. According to S&P Global, almost $2 trillion in US corporate debt is scheduled to mature in 2020 and 2021. Most of this will have to be rolled into new debt with maturities further in the future. With the Fed as a buyer, companies can likely continue issuance at a lower rate, to ensure support the U.S. economy.
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Matt Kelley is a Portfolio Strategy Manager with ESL Federal Credit Union. In his role, Matt oversees the portfolio strategy team at ESL and is responsible for the investment philosophy, approach, and overall performance of internal and external investment portfolios for ESL.
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