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The Federal Reserve’s more than $2 trillion arsenal of funding to keep credit flowing during the coronavirus pandemic can’t fix everything.
The Fed doesn’t have a magic wand to stop COVID-19, nor the ability to make earnings appear on corporate balance sheets. Those realities, brought to the fore by a spike in coronavirus cases in several U.S. states this week and a grim U.S. economic outlook provided Wednesday by Fed Chairman Jerome Powell, hit markets Thursday like a ton of bricks.
“Wall Street had completely diverged from the economic reality on Main Street,” said Michael Terwilliger, a portfolio manager at Resource Credit Income Fund, which invests in distressed and alternative credit.
He pointed to “liquid markets that moved too fast, too quickly” on optimism about Fed backstops and the potential for states to contain COVID-19, while experimenting with ways to safely reopen for business, as reasons for the sharp pullback in markets Thursday.
“I’d be more concerned if the market wasn’t repricing,” he told MarketWatch. “That would mean the Fed has stomped out the market’s risk-response function.”
The blue-chip Dow Jones Industrial Average DJIA, -6.89% plunged more than 1,800 points, or 6.9%, in the worst day for major benchmarks since mid-March. Exchanged-traded funds that serve as a key source of liquidity for the more than $10 trillion corporate debt markets followed the stock-market’s relentless slide lower.
The high-yield, or “junk-bond” market’s biggest ETF, iShares iBoxx $ High Yield Corporate Bond ETF HYG, -2.56%, fell 2.6%, while the smaller SPDR Barclays High Yield Bond ETF JNK, -2.55% fell 2.5%, also their biggest daily percent drops since mid-March, according to FactSet data.
Even the high-grade market’s benchmark iShares iBoxx & Investment Grade Corporate Bond ETF LQD, -1.19% shed 1.6%.
“The move down today makes sense,” said Phil Toews of Toews Corporation, commenting on the spiralling equities market and the spillover into the U.S. corporate debt markets. “So long as earnings don’t justify the prices we are paying, markets will continue to fall.”
While the Fed’s unfurling of emergency backstops helped lift the high-yield market out of its mid-March morass, Towes pointed out that the central bank’s buying capacity through its corporate credit facilities actually remains limited in the high-yield bond sector.
“Yes, the Fed can buy high-yield ETFs,” he told MarketWatch, and “fallen angels,” or companies whose coveted investment-grade ratings have been cut to junk status, but only company debt that was downgraded after late March.
“It’s a situation where people are reading the headline,” Toews said, but not translating what that means for the larger $1.5 trillion U.S. high-yield bond market.
Coronavirus cases in the U.S. climbed past 2 million on Thursday, with California, Texas and Florida seeing an increasing rate of new infections just as states more broadly reopen for business and relax rules on public gatherings.
The Fed’s balance sheet has ballooned to more than $7 trillion in recent months, as it pulled more levers than ever before to shore up financial markets. Prior to Thursday, those efforts had been credited with helping lift U.S. stock benchmarks back to near all-time highs, from the crushing mid-March selloff. The Nasdaq Composite Index on Wednesday this week closed above a milestone 10,000 for the first time in history, a sign, for some, that the tech-heavy benchmark could enter a new bullish phase.
Corporate borrowing, a concern before the global pandemic, also hit a record $1 trillion for U.S. investment-grade companies in the year’s first five months, the fastest pace on record.
See: Highly rated U.S. companies are borrowing $1 trillion at a record clip
The rally in credit has helped U.S. businesses borrow cheaply to weather the uncertain quarters ahead for earnings.
Carl Pappo, chief investment officer of U.S. fixed income at Allianz Global Investors, pointed out that in the past month alone, investment-grade credit has rallied more than 50 basis points tighter in terms of spread and high-yield has compressed 175 basis points tighter, over that short period of time.
Tighter spreads, or the level of compensation investors get over a risk-free benchmark like U.S. Treasurys TMUBMUSD10Y, 0.673%, mean investors are getting paid less to take up bonds that comes with credit risk.
“The reality is that the market is likely tired from the rally and [it’s] not a bad time to take some profits,” Pappo said, in emailed comments.
But Lon Erickson, a portfolio manager at Thornburg Investment Management, thinks Thursday’s rout might mean investors need to rethink the path of the U.S. economy recovery from COVID-19.
“It appears that the markets really priced in a pretty solid ‘V’ shaped recovery, whether that’s stocks, investment-grade credit or high-yield,” he told MarketWatch.
It seems we have to reassess what the recovery might look like.
“As we, as human beings, see this unfold…we may be rethinking if we want to go out to a restaurant and have a meal, or get on a plane,” Erickson said. “And what does that mean for earnings and cash flows of the companies we own and follow.”
