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Investors breathed a sigh of relief this week as the Federal Reserve’s new emergency lending facilities announced on Monday put a floor under the corporate bond market after fund managers liquidated their least-impaired assets to raise cash and meet outflows.
But the Fed’s measures don’t extend help to those companies with credit ratings below investment-grade, leaving a $1 trillion market of highly leveraged issuers without aid. While bond issuance among highly rated companies is starting up again, investors say the debt market for sub-investment-grade issuers, or junk, remains frozen.
“There will be winners and losers in this whole thing,” said Patrick Leary, chief market strategist at Incapital, an underwriter of corporate bonds, told MarketWatch.
Backed by funds from the U.S. Treasury Department, the Fed set up two emergency credit facilities to give direct loans to issuers but also to buy bonds outright.
See: Here’s a breakdown of the Fed’s expanded rescue programs to keep credit flowing during the pandemic
Investors say the measures are already improving the mood of the market, with investment-grade companies like MasterCard MA, +9.97% , Deere DE, +6.79% and 3M MMM, +0.24% tapping debt markets this week.
The iShares iBoxx $ Investment Grade Corporate Bond exchange-traded fund LQD, +4.69% is up 13.8% this week, paring its year-to-date losses to 5.2%. However, its equivalent counterpart for junk bonds, the iShares iBoxx $ High Yield Corporate Bond ETF, HYG, +3.92% is down 20% year-to-date.
The yield for a basket of sub-investment-grade bonds shot up to more than 11.29% at the start of the week, hitting levels last seen in mid-2009.
Read: Pick a winner? Wall Street is already screening which corporate bonds may benefit from Fed purchases
Some argue it doesn’t make sense for the U.S. central bank to extend aid to junk-rated companies which saddled their balance sheets with debt and were therefore less likely to survive an ordinary recession. Providing relief to such issuers could encourage companies to leverage up in the knowledge that the Fed would have their backs, said John Sheehan, a portfolio manager at Osterweis Capital Management.
But the worry is that if investment-grade issuers eligible to receive funds from the Fed’s credit facilities when they were first announced may no longer stand to benefit after their ratings are cut to junk during the expected economic slowdown.
“They’ve created a bit of a cliff,” said Tony Rodriguez, head of fixed-income strategy at Nuveen, in an interview.
And investors are grappling with a wave of ratings downgrades due to the COVID-19 pandemic as corporate earnings and balance sheets are hit by the sudden decline in demand, with U.S. consumers staying home and curtailing spending.
Credit ratings agencies have recently pushed the likes of Occidental Petroleum OXY, +14.18% , Ford Motor Co. F, +15.56% and Delta Air Lines Inc. DAL, +20.68% into sub-investment-grade, or junk. Both Ford and Delta still remain investment-grade as at least two ratings agencies are needed to downgrade the company to junk.
Investors are still unsure whether the Fed will seek to grandfather in investment-grade issuers that had fallen to junk during the existence of the central bank’s lending facilities.
But it’s unlikely the central bank will look to open up its emergency credit programs to sub-investment grade companies as long as Fed officials feel broader markets in corporate credit and equities are insulated from the turmoil in the much smaller junk bond market, or the high yield debt market.
“The Fed would have to think the dislocations in high yield are transmitting into broader dislocations in markets,” said Rodriguez.
The Fed’s targeting of the investment-grade bonds may also help it avoid the issue of taking on excessive credit risk — the potential exposure to a company not paying its obligations.
“The Fed’s doing it this way because there’s a remote chance of them losing money,” said Brian Kennedy, portfolio manager at Loomis Sayles, in an interview.
In history, examples of investment-grade companies rated at the lowest rung — BBB — defaulting straightaway were nonexistent, he said.
The Fed’s measures won’t completely leave the junk bond market in the lurch, however.
If the central bank’s efforts to backstop the investment-grade corporate bond market restores normal trading, their intervention could also have a waterfall effect of benefiting lower-rated bonds. Once investment-grade corporate debt rallied sufficiently, investors may poke around corners of the high-yield bond market in search of better value.
“The Fed is trying to improve the weather in the marketplace, they’re not trying to bail out every security and issuer. If investment-grade improves, high-yield will start to follow,” said Leary.
