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After the most volatile week on Wall Street since the 2008 financial crisis as the coronavirus epidemic began to shut down swaths of the U.S. economy, the health of the U.S. stock and bond markets may now depend on how corporate debt fares in the coming months.
The S&P 500 SPX, +9.29% index and the Dow Jones Industrial Average DJIA, +9.36% this week suffered the worst week since the 2008 financial crisis and both benchmarks fell into a bear market, declining more than 20% from record highs.
Market pundits now suggest whole industries like airlines and energy could go underwater without support from the federal government after President Trump restricted travel from Europe to the U.S. this week and cities and states shut down sporting, cultural and entertainment events. The oil price war started by Saudi Arabia and Russia will not help the energy sector either.
As a result investors are now eyeing the potential for a crunch in the market for corporate debt and even potential bankruptcies after the rapid credit growth since the 2008 financial crisis as businesses took advantage of low interest rates to leverage up and boost their profits.
Investors and financial regulators have already raised concerns in recent months that funds handling corporate bonds, leveraged loans and other fixed-income securities are particularly vulnerable to a liquidity freeze-up when faced with outflows.
Some investors are starting to contemplate the worst-case scenario whereby corporate bond fund managers struggling to deal with outflows will have to engage in forced selling and a lack of liquidity in an already hard-to-trade $9 trillion market.
“The concern is you might get flashbacks to 2008,” said Kevin Giddis, chief fixed-income strategist at Raymond James, in an interview, referring to when Wall Street saw a run on money-market funds and highly leveraged hedge funds.
Analysts say if bond fund managers attempt to sell corporate debt holdings in order to raise cash and deal with redemption requests, the worry is that other investors will also try to get ahead of this selling. This sparks a dash to the exit door that, in turn, exacerbates the lack of liquidity and could mean investors will have to sell their debt securities at beaten-down prices, accelerating their losses.
“The global credit cycle looks increasingly likely to end and defaults set to rise,” wrote Gaurav Saroliya, director of macro strategy at Oxford Economics, in a Thursday note.
The pressure in corporate debt markets has pushed down their prices, raising the yield premium investors demand to own high-yield bonds over U.S. Treasurys, or the credit spread.
This spread for sub-investment grade bonds, or “junk”, blew up to 7.42 percentage points on Thursday, the highest level since December 2015, according to data tracked by ICE Data Services. A wider spread can indicate when investors are less willing to buy corporate debt.
“You’re starting to see spreads blow out at a faster rate than 2008,” Clifton Hill, global macro portfolio manager at Acadian Asset Management, told MarketWatch.
“We are starting to see real problems in liquidity even in the high-grade corporate space,” said Giddis. Investment-grade corporate bonds, or high-grade debt, tend to trade more smoothly and at a lower transaction cost than junk bonds.
For so-called open-ended funds that promise clients the ability to pull their money out of the fund on a daily basis, they will have to off-load whatever securities that can be sold swiftly to free up cash in order to meet a redemption request. Sometimes this can be U.S. Treasurys or liquid credit derivative products that track the performance of broader corporate bond markets.
“In a crisis situation, there is no liquidity. You sell what you can sell, not what you want to sell,”said Patrick Leary, chief market strategist at Incapital, an underwriter of corporate bonds, in an interview.
But the worry is that once investors empty their funds of the most liquid assets, they’ll be forced to sell their most illiquid debt to raise cash.
Given the difficulty of selling corporate debt securities swiftly, mutual funds dealing with redemptions may thus try to sell their holdings before others have the chance to dump their own bonds. But if investors rush for the door at the same time, trading in corporate credit could freeze and force investors to sell at fire-sale prices.
It’s unclear how much of this is already taking place. Many fund managers say there has been little sign of forced selling, but others like Ed Al-Hussainy said redemptions were picking up speed this week.
“We’re there. That was all of this week,” said the senior global rates and currencies analyst for Columbia Threadneedle, in an interview.
Investment-grade bond funds across the globe shed $15.9 billion of cash, their largest week of outflows on record, according to EPFR Data. Investors also pulled $11.2 billion from high-yield bond funds, the second-highest ever on record.
See: Oil market crash exposes liquidity drought in corporate debt trading
Compounding the market concerns, some say the Federal Reserve’s bond purchases in the Treasurys market and the frequent repo injections have not arrested the volatility in corporate credit. Despite expectations for the Fed to cut its benchmark interest rate all the way to zero by the end of this week’s meeting on Wednesday, pressure has not relented on corporate bonds.
Some analysts have suggested the Fed should request Congress to change the law to allow the U.S. central bank to include corporate bonds in any future iterations of its asset purchases program, akin to how the European Central Bank has bought corporate debt after the eurozone debt crisis.
“The market is so used to the central banks coming out above and beyond what they could expect,” said Hill.
But the Acadian strategist says more and more investors are beginning to grapple with the big question of “what is the playbook if central bank intervention does not help? I don’t think many have an answer to that question, and that’s where the risk lies,” he said.
Read: Why corporate credit is in the spotlight as governments weigh economic stimulus
Check Out: Cracks are forming in corporate bonds as coronavirus slams Wall Street
