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A Credit Market Update: Is the Smoke Clearing?

Bill Zox, CFA, and John McClain, CFA
April 15, 2020

What a difference a few weeks make. Since our last blog post, High Yield Update: Pricing for Recession?, unprecedented actions taken by the Fed, the Treasury and Congress have injected some welcome confidence back into credit markets. Here, we answer questions credit market participants may have.

After this credit market rally, is it too late to invest in high yield and investment grade corporate bond strategies?

We believe the asset class remains attractive over the long-term. What’s more, it is difficult if not impossible to time a market bottom—and fortunately, you don’t have to time the bottom to generate attractive long-term returns.

The option-adjusted spread of the ICE BofA US High Yield Index at last week’s close (April 9) was 796 basis points. This compares to the 23-year average of 555 basis points and median of 483 basis points. It is still important to avoid defaults, but we are confident spreads will return to below-average and below-median levels and believe long-term returns will be attractive from here.

Will “fallen angels” overwhelm the high yield market?

There has been much concern about the impact of a flood of fallen angels (bonds that have been downgraded from investment grade to high yield), but we believe they present an attractive risk/return profile.

There have already been over $100 billion of fallen angels year-to-date, and there could be hundreds of billions of dollars more this year (on a $1.2 trillion high yield market). However, our view is, at the right price, hundreds of billions of dollars could come into the high yield market to absorb new entrants. Consider: The high yield market grew rapidly after the 2008-2009 financial crisis but is now smaller than it was five years ago. There seems plenty of room for capital to come back. Add to that the Fed April 9 announcement that its facilities to purchase existing and new issue investment grade corporate bonds were being extended to post-March 22 fallen angels. That should help mitigate a good deal of market fear.

As to the opportunity—because of corporate bond market segmentation into investment grade and high yield, capital and attention are often not focused on bonds that are in the process of crossing over from investment grade to high yield. Further, many of the fallen angels are long-maturity bonds that dedicated high yield managers avoid either by mandate or custom. Yet, before investment grade bonds migrate to the high yield market, they are often more-than-priced for the downgrade—all else equal, this over-reaction can make certain bonds attractively valued over the long term. We often look to get involved with potential fallen angels—those that may be getting unfairly punished based on the quality of their business models and balance sheets—before those bonds are reclassified as high yield.

Should we be surprised by how much support the government is providing to the credit markets, even extending it to some high yield issuers?

On September 20, 2008, the Saturday after Lehman Brothers filed bankruptcy, many financial sector bonds were priced for a high probability of default. The Wall Street Journal published “Government Bailouts: A U.S. Tradition Dating to Hamilton,” by Michael M. Phillips, containing one of the most valuable quotes we have ever read:

But a short walk through U.S. history demonstrates the point … “If you would like an empirical law of government behavior, it is that in a panic or threatened financial collapse, governments intervene—every government, every party, every country, every time.

The only questions are: (1) how much do asset prices have to fall before the government takes which steps, (2) where will the government draw the line as to who receives support and who does not, and (3) who will fail because they can’t survive long enough to see how (1) and (2) are resolved.

For the roughly one month to March 23, 2020, financial markets collapsed with rapid deleveraging and massive open-end fund redemptions. Investment grade corporate bond spreads (as measured by the ICE BofA US Corporate Index) widened from about 100 basis points to 400 basis points, and high yield spreads (as measured by the ICE BofA US High Yield Index) widened from about 360 basis points to close to 1,100 basis points. This answered the first question: The Fed, Treasury and Congress seemed ready to do more by March 23 than they were after 18 months during the 2008-2009 financial crisis. Investment grade corporate bonds would receive massive support. And on April 9, it became clear that certain parts of the high yield market—such as fallen angels of any size and smaller issuers (10,000 employees or less, or $2.5 billion in revenues or less) where $150 million of credit can move the needle—would receive support. Further, the Fed announced that it could buy high yield ETFs.

An open question remains how much of leveraged finance (high yield, leveraged loan and private credit) will receive government support. Leveraged finance represents about 30% of the $10 trillion of business debt, and a fair amount of small business and consumer credit flows through it, so we believe that a high proportion of leveraged finance will receive either direct or indirect government support. What’s more, in a clear sign of its intention to provide sufficient funding, Congress has already appropriated close to $500 billion for the first loss position which can then be leveraged 7-10 times. If that does prove insufficient, given recent actions, we anticipate Congress would appropriate more.

How have corporate bond ETFs held up over recent weeks?

The bond ETF market has also received promise of support—on March 23, the Fed announced that it could buy investment grade corporate bond ETFs. On April 9, the Fed announced that it could buy high yield bond ETFs.

At the close on March 20, iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD), iShares iBoxx High Yield Corporate Bond ETF (HYG) and SPDR Bloomberg Barclays High Yield Bond ETF (JNK) were all trading at discounts to net asset value: 2.8% for LQD, 1.3% for HYG and 1.6% for JNK. By the close on April 9, all three were trading at premiums to net asset value: 3.2% for LQD, 4.6% for HYG and 4.7% for JNK.

While all three ETFs offered liquidity during the extreme distress through March 20, that came at a steep cost in terms of poor performance of the underlying bonds and frequent discounts to net asset value. LQD was at a 5%-plus discount to net asset value twice before March 23. HYG and JNK were trading above and below net asset value, peaking at the March 20 discounts previously mentioned.

The Fed becoming a buyer of corporate bond ETFs has already provided a dual benefit to the ETFs: Bonds owned by the ETFs have done much better than the broader market, and the discounts have turned to premiums. This has led to dramatic ETF outperformance over the last three weeks, but we do not believe it will be sustained. In fact, the Fed term sheet says it will avoid purchasing ETFs at a material premium to net asset value, although material has not yet been defined. We expect non-ETF bonds and bonds that are smaller weights in the ETF to make up ground going forward.

Can companies raise capital in the corporate bond market?

It appears so. Investment grade corporate issuance was very light until March 17 and then exploded to nearly $260 billion, making March the largest issuance month ever. Investment grade issuers were far more concerned with access to capital than cost of capital, in many cases replacing uncertain short-term funding with longer maturity corporate bonds. Investment grade issuance has been at spreads that would have been attractive in the high yield market two months ago, and that has drawn capital from high yield and distressed managers. Some more stressed investment grade issuers have also raised equity-linked capital in conjunction with their corporate bond issuance.

High yield new issuance was effectively shut down from March 5 until March 30. But we are starting to see progress on high yield new issuance, and we believe the actions taken by the government on April 9 could lead to a similar deluge of issuance and access to equity-linked capital as in the investment grade market. However, weaker and smaller credits may still have trouble accessing the market.

This is a good demonstration of corporate bond market resilience. When credit becomes stressed, the new issue markets may shut down for some time—but as they reprice, capital is eventually attracted back. Access to capital, even at wide spreads, can help the secondary market as investors become more confident that existing bonds will be refinanced. And it might open other sources of capital, like equity or equity-linked capital. This is what we saw in the energy sector in 2016 which brought down and then quickly resurrected the rest of the high yield market as issuers started to access equity and equity-linked capital.

What can we learn from the European Central Bank (ECB) corporate bond purchase program that began in 2016?

On June 8, 2016, the ECB announced it would buy non-financial investment grade corporate bonds. While the ECB never purchased high yield bonds, one of its objectives was to narrow high yield spreads through the portfolio rebalancing channel. The idea was, as spreads narrowed in the bonds that the ECB was purchasing, investors would shift their investments to other bonds, thereby narrowing the spreads on those bonds as well.

For the first four months, the ECB program benefited investment grade non-financial corporate bonds the most, but by October 24, 2017, the option-adjusted spread of the ICE BofA Euro Non-Financial Index had narrowed 27 basis points from 115 to 88 while the option-adjusted spread of the ICE BofA Euro High Yield Index had narrowed 212 basis points from 445 to 233. So, the program ultimately helped the high yield market more than the non-financial investment grade market, even though the high yield market was never part of the program. In the U.S., substantial parts of the high yield market are explicitly part of the government programs, and we believe some of the remainder of the market should benefit from the portfolio rebalancing channel. Of course, the government programs may also be extended in the future to more parts of the high yield market.

This material is for informational purposes and is prepared by Diamond Hill Capital Management. The opinions expressed are as of the date of publication and are subject to change. These opinions are not intended to be a forecast of future events, the guarantee of future results or investment advice.

Reliance upon this information is in the sole discretion of the reader. Investing involves risk, including the possible loss of principal.

The option-adjusted spread is market-cap weighted difference between the index yield and the Treasury spot curve, adjusted for option payments.

Investment Grade is a Bond Quality Rating of AAA, AA, A or BBB.

The ICE BofA U.S. High Yield Index tracks the performance of the U.S. dollar denominated below investment grade corporate debt publicly issued in the U.S. domestic market. The index data referenced herein is the property of ICE Data Indices, LLC, its affiliates (“ICE Data”) and/or its third party suppliers and has been licensed for use by Diamond Hill Capital Management, Inc. ICE Data and its third party suppliers accept no liability in connection with its use. See diamond-hill.com/disclosures for a full copy of the disclaimer.

ICE BofA Euro Non-Financial Index tracks the performance of tracks the performance of non-financial EUR denominated investment grade corporate debt publicly issued in the euro domestic or eurobond markets.

ICE BofA Euro High Yield Index tracks the performance of Euro denominated below investment grade corporate debt publicly issued in the euro domestic or eurobond markets.

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