The last two months have been a difficult period for everyone around the globe due to the economic lockdown imposed to fight COVID-19. Millions of US workers have found themselves furloughed or laid-off from their jobs and some lack the savings to manage through a multi-week or multi-month period of being unemployed. For these individuals it is important to have access to a source of income, whether assistance from the government or access to credit from banks in the form of home equity lines or credit cards, to manage through the period of uncertainty.
Corporations are in a similar position as individuals. Revenue has dried up but payroll, rent, interest payments, and other fixed expenses still need to be paid. With the liquidity issues of the Great Financial Crisis on their minds, the Federal Reserve (Fed) has stepped in to fill the void for corporations much like the government did for small businesses with the Paycheck Protection Program. Over the last two months, the Fed has introduced several credit facilities to help corporations gain access to capital. Two such facilities were the Primary Market Corporate Credit Facility (PMCCF) and the Secondary Market Corporate Credit Facility (SMCFF).
Investment Grade Corporates:
The Fed created the $500 billion PMCCF and the $250 billion SMCCF to unclog the fixed income capital market pipes. The announcement of the two programs has helped the new issue market to re-open for investment grade corporations as well as facilitating transactions in the secondary market. These actions have lowered the credit risk premium that investors require to buy corporate bonds by approximately 167 basis points since March 23rd (as of April 29). Although neither program has been officially launched, the mere announcement seems to have thawed a corporate bond market that was beginning to freeze-up and allowed $409 billion of new corporate debt to be issued over the last month. This compares to just $202 billion between February 3rd and March 22nd according to Bloomberg.
Prior to the crisis, investment grade corporates had been our preferred asset class within the fixed income arena. Our confidence in the asset class has grown with the Fed’s latest commitment to keep capital flowing to US corporations. In addition to policy support from the Fed, we like investment grade corporate bonds for the following reasons:
- Investment grade companies are less levered in general and are expected to maintain access to credit through banks and capital markets.
- Yields relative to Treasuries are elevated and offer an opportunity for price appreciation as the credit risk premium declines to more normal levels.
Hence, in the RiverFront Moderate Growth and Income Portfolios we currently hold approximately 21% in short to intermediate corporate bond exposure and are overweight versus the benchmark.
High Yield Bonds:
The high yield credit risk premium has also come down since the Fed announced that the SMCCF could purchase high yield ETFs and individual bonds of ‘fallen angel’ companies. ‘Fallen angel’ bonds are those issued by former investment grade-rated companies that have been downgraded to double-B (the highest rated category in high yield). However, the SMCCF’s provision only covers a small subset of the high yield universe and is more implicit than the explicit backstop provided for investment grade corporates. Currently, high yield credit risk premiums are hovering near recessionary levels and we believe that if there is not a facility put in place specifically for high yield bonds rated below double-B there is a chance that default rates will rise.
Historically, high yield default rates have averaged around 4% since 1981 and have spiked to around 10% during recessions. As of May 1, 2020, the high yield index, as measured by ICE BofA, is yielding 8.04% while investment grade corporates, as measured by ICE BofA are yielding 2.78%. At first glance, investors might prefer high yield over investment grade corporates and not consider the differences between the two vehicles in order to get this additional yield pick-up. However, we believe investors must consider default and recovery rates when comparing the two asset classes rather than focusing on yield alone.
Eventually, we believe that the current high yield market dynamics could offer an appropriate risk/ reward to investors if there is further economic clarity surrounding the pandemic. Since it is anyone’s guess where default rates will end up for 2020, we continue to prefer investment grade corporates over high yield in the short-term but will look for opportunities to add additional yield in the portfolios when we believe the economic and viral outlook is more certain.