Credit investors will begin to discriminate
In its updated term sheet for its corporate bonds facilities, the US Federal Reserve (Fed) has emphasized its role as lender of last resort and announced that these facilities will be launched in early May.
Some of the main points the Fed outlined are as follows: Recent rising stars are excluded from the facilities; companies will need to opt in by certifying both their eligibility and their inability to find adequate funding elsewhere; exchange-traded funds (ETFs) trading above a defined premium are excluded. These clarifications reinforce our prior assessment that the Fed will not strive to become an active player in the US corporate bond market. Instead, its aim is to guarantee adequate funding needs for solvent companies and ensure the smooth functioning of capital markets.
The stigma associated with applying for these facilities, the certification companies have to provide showing they cannot find other sources of funding, and the surge in bond issuance are all factors that lead us to expect the take-up for the Primary Market Corporate Credit Facility (PMCCF), the Secondary Market Corporate Credit Facility (SMCCF) to be relatively small. Put another way, we expect the Fed to play a less significant role on the US investment-grade (IG) corporate bond market than what many market participants seem to be pricing. But at some stage, the latter are likely to refocus again on companies’ fundamentals more than broad market technicals.
The wave of fallen angels in the US and euro credit markets keeps growing, reaching an all-time high of USD219 bn in the US on a 12-month trailing basis. While such waves are common in times of economic stress, in 2020 it could be particularly large. While fallen angels already represent 16% of the US and euro HY universes, this figure is likely to increase to 20% by the end of 2021.
On average, these fallen angels will likely end up improving the overall quality of HY indices. However, some hard-hit companies could still end up defaulting or requesting government help, probably at the expense of shareholders. This means differentiating debt issues according to individual company fundamentals will be crucial. We expect default rates to continue rising, from 5.1% in April to 15% by year’s end in US HY, and from 2.4% to 8% in euro HY.
Despite the expected wave of defaults, US and euro HY spreads have tightened significantly from their March highs. However, HY spreads on companies rated CCC and lower have started to pick up again, diverging from the rest of the pack. Although we expect indirect support to some US HY bonds through the Fed’s Main Street Lending Program, investors will likely differentiate HY companies further, making selection primordial.