Not a game changer, but it helps
The extended version of the already announced corporate bond buying facilities by the US Federal Reserve (US Fed) now includes high yield bonds. While this will only partly help, and will likely not prevent volatility and stress in the high yield bond market, we believe that high yield bonds overall offer value.
On 9 April the Fed provided further details on its corporate bond buying facilities, known as the Primary Market Corporate Credit Facility (PMCCF) and the Secondary Market Corporate Credit Facility (SMCCF), as part of the comprehensive monetary and liquidity package in response to the COVID-19 crisis.
How will the Fed’s two corporate bond buying facilities work?
The PMCCF allows the US central bank to subscribe for corporate bonds directly in the new bond issue market. Effectively, issuers can borrow directly from the central bank as liquidity provider. Meanwhile, the Fed will buy bonds in the secondary market via the SMCCF. The focus of the SMCCF is pricing as it aims to contain spread widening against treasuries and so prevent issuers from having to borrow at excessive spreads.
A substantial amount available, but mostly reserved for investment grade bonds
The PMCCF and SMCCF have conditions attached and a defined maximum amount which can be bought overall and per issuer. The primary and secondary facilities have been equipped with $50bn (primary) and $25bn (secondary) and can be scaled up to a maximum of 10 times (depending on the securities bought and the facility) through secured loans from the Fed. This theoretically provides up to $750bn of purchasing power for corporate debt.
While both facilities were limited to investment grade bonds originally, the Fed has extended the rating criteria recently. Now, the facilities include “issuers that were rated at least BBB-/Baa3 as of March 22, 2020, but are subsequently downgraded” however they “must be rated at least BB-/Ba3 at the time the facility makes a purchase”. This implies that the Fed is not buying high yield bonds as such, but is only focusing on bonds of BB-rated “fallen angel” issuers (those downgraded from investment grade to high yield status) within the high yield segment
While the SMCCF also allows purchases in high yield exchange traded funds (ETF), we believe that this has more a signalling effect given the limitations. Even if the Fed bought within the mandate 20% of HY ETFs this would only translate into less than 1% of the high yield market.
Which bond market sectors might benefit most?
Given the programme excludes bond with maturity over four (PMCCF) and five (SMCCF) years and is not reserved for bonds issued by banks, shorter dated non-financial corporate bonds should be mostly supported by the facility. When setting up the facility the Fed presumably had the higher leveraged BBB sector in mind, as AA or A-rated companies are likely less exposed by the current crisis.
While the risk of downgrades to high yield status has not necessarily diminished, the facility tackles another well-known risk: excessive price risk. Within the investment grade market, BBB-rated issuers have increased leverage substantially over the last decade and therefore they are very exposed to fallen angel risk in the current challenging environment. Investors with a strict investment grade mandate would become forced sellers, pushing down prices. Meanwhile, there would likely be insufficient demand among high yield investors to carry the weight of the increased potential downgrades given the large size of the BBB bond market.
BBB and some BB-rated bonds to outperform?
With the extended mandate, the Fed should now step in and buy fallen angel debt (usually issued by large, well-known, companies) which is set to result in relative outperformance for BB and BBB-rated bonds versus AA or A-rated bonds. The primary US dollar investment grade market issued approximately $1.2tn last year. $500bn seems substantial in this context.
The secondary market purchases of the Fed would roughly translate into 20% of the respective market. From a technical point of view this should provide ample support for the BBB and part of the BB segment which trades at historically wide spreads after March’s sell off.
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