Insights
Recent Fed Actions: Implications for the High Yield Market
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Market Pulse
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April 20, 2020
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April 20, 2020
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Recent Fed Actions: Implications for the High Yield Market
Recent Fed Actions: Implications for the High Yield Market |
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Fed Actions:
The Fed announced on April 9 that they will expand their corporate bond buying program to include some fallen angels and High Yield Exchange Traded Funds (ETFs) via the Secondary Market Corporate Credit Facility. Eligible ETFs and fallen angels include:
Eligible High Yield ETFs
- ETFs “whose primary investment objective is exposure to U.S. high-yield (HY) corporate bonds.”
- Fed purchase capped at 20% of any ETF
- Street estimates equate this to a maximum of $7.7B of HY ETF purchases, which is less than 1% of the U.S. HY market. That being said, the ETF bid will greatly impact daily flows and market tone.
- Street estimates equate this to a maximum of $7.7B of HY ETF purchases, which is less than 1% of the U.S. HY market. That being said, the ETF bid will greatly impact daily flows and market tone.
Eligible Fallen Angels
- The issuer was rated at least BBB-/Baa3 as of March 22, 2020.
- The issuer is a business that was created or organized in the United States, with significant operations in and a majority of its employees based in the United States.
- The issuer is not an insured depository institution or depository institution holding company, as such terms are defined in the Dodd-Frank Act.
- The issuer has not received any support pursuant to the CARES Act.
- Fed purchase capped at 10% of any eligible issuers maximum bonds outstanding.
Implications for Overall High Yield and Middle Market
This announcement sent HY ETFs soaring, with the largest high yield ETF gaining over 6% in one single day. The Bloomberg Barclays U.S. Corporate Index also tightened aggressively on this news, closing the week 157bps tighter at 785bps and the market saw the largest high yield bond fund inflow ever of $10.5bn. The Fed’s involvement in high yield is unprecedented, so we have no prior history to look back upon as a guide. We do believe that while the Fed’s actions will immediately and most directly benefit the specific instruments they are buying (eligible fallen angels and ETFs), broadly speaking their actions should support the high yield market as a whole. However it will take time for these policies to ultimately impact all corners of the high yield market.
Given our portfolios focus predominately on middle market high yield credits, we expect to experience some near term pain. Historically, middle market tends to outperform on the downside, as managers usually sell the largest, most liquid cap structures and ETF names first to meet redemptions in periods of rapid spread widening. The middle market then tends to lag on the upside because the same large, liquid cap structures rally the quickest as investors tend to buy these names back first. Now for the first time in history, one of these investors is the Fed. Given this, we expect the performance lag this time around to be particularly exaggerated.
We have selectively been adding larger capital structures that may benefit from the Fed bid, through the secondary and primary markets when possible. Conversely, we have been using recent strength to sell credits we believe to be challenged in this environment and most at risk of a near-term default. ETFs trade to track an index with no regard for fundamentals, so to the extent we can sell into that indiscriminate buying to help limit our default experience, we will. This technical is overwhelming the fundamentals right now, but we believe fundamentals win out in the longer term.
The speed at which some bond prices are recovering is as remarkable as the speed at which they sold off in March. Already since the Fed announcement on April 9, many of these ETF names have rallied to levels that we believe are fully priced and in some cases even overpriced at the moment. Investors are now looking further into the HY universe to find value, and we are starting to see middle market names recover and move upward. We would note that the market is still clearly separated into winners and losers based on segments most impacted by coronavirus shutdowns and segments least impacted by coronavirus shutdowns, which transcends large cap vs middle market, and we expect this dispersion to persist for some time.
RISK CONSIDERATIONS
There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in this portfolio. Please be aware that this portfolio may be subject to certain additional risks. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. High yield securities (“junk bonds”) are lower rated securities that may have a higher degree of credit and liquidity risk. Public bank loans are subject to liquidity risk and the credit risks of lower rated securities. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks. Distressed and defaulted securities are speculative and involve substantial risks in addition to the risks of investing in junk bonds. The Portfolio will generally not receive interest payments on the distressed securities and the principal may also be at risk. These securities may present a substantial risk of default or may be in default at the time of investment, requiring the portfolio to incur additional costs. Preferred securities are subject to interest rate risk and generally decreases in value if interest rates rise and increase in value if interest rates fall. Mezzanine investments are subordinated debt securities, thus they carry the risk that the issuer will not be able to meet its obligations and they may lose value. Foreign securities are subject to currency, political, economic and market risks. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed countries. In general, equity securities' values also fluctuate in response to activities specific to a company. Illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk).