The Federal Reserve (Fed) made another step into the unknown last Thursday, with some new, extraordinary policy actions. We wanted to share our initial thoughts pertaining to what we know and what we’ll continue to monitor in this period of heightened volatility.
In our view, the Fed is committed to doing “whatever it takes” to #bridgethegap until the economy recovers from the COVID-19 crisis.
Complementing the March 23, 2020, announcement that the Fed would purchase investment-grade (IG) bonds and exchange-traded funds (ETFs), the April 9, 2020, announcement expanded those measures into parts of the high-yield (HY) market. As we stated at the time of the first announcement, the Fed’s initial actions were going to leave out the HY market, and those issuers would likely be at a severe liquidity disadvantage — did the Fed realize there was going to be a downgrade wave coming? The most recent actions by the Fed help the HY market, but only slightly in our view. That is because while the April 9, 2020 announcement adds HY ETFs to the Fed’s arsenal, it will only buy the underlying bonds of so-called “fallen angels,” or issuers that were downgraded to HY by a majority of the three nationally recognized statistical rating organizations (NRSROs) after March 22, 2020. Since that time, the three NRSROs have already issued a collective 31 downgrades, the likes of which include Ford Motor Company, Macy’s Inc., and some of the largest airlines.
While the headline actions themselves are extraordinary, the announcement continued with some additional steps into the unknown, adding leverage to the Fed’s bond purchases:
- 10 times (x) for IG bonds
- 7x for HY bonds (that is, corporates that were rated IG as of March 22, 2020); and
- 3-7x for “any other type of eligible asset,” which we interpret as IG and HY ETFs.
In essence, the Fed has transformed from “lender of last resort” to a commercial lender of sorts, with an unlimited balance sheet. While liquidity in the IG and HY markets has improved in the near term, the impact on corporate bond price discovery is still playing out. Drawing a proverbial line in the sand on March 22, 2020 for fallen angels is obviously going to improve the liquidity for a subset of issuers and not for most others. The addition of leverage to its arsenal is clearly something the Fed thinks we need, but if it doesn’t help the full HY market, then it’s not exactly what we want.
An additional facility was created to expand the Fed’s involvement in the municipal (muni) bond market, from just muni commercial paper (part of the original March 23, 2020, announcement) to actual muni bonds. However, this particular facility is limited to:
- US states and the District of Columbia;
- cities with a population greater than one million residents; and
- counties with a population greater than two million residents.
Despite the initial positive reaction to the announcement, remarkably just 10 cities and 15 counties qualify under these thresholds. We also found it interesting that given the challenging financial situation of some municipalities that do qualify (Illinois and Chicago, “I’m lookin’ at you!”), credit quality was not listed as a key consideration in the Fed’s muni facility parameters. Given the briefness of the Fed’s statement, it leaves us with more questions than answers. Thus, we wouldn’t be surprised to see the muni program expand at some point.
The addition of munis to its arsenal is clearly something the Fed thinks we need, but if it doesn’t help the full muni market (and small issuers under severe stress), then it’s not exactly what we want.
We’ve received a number of questions asking how the Fed can create these various facilities — isn’t it outside the Fed’s scope? As we saw in 2008, it is simply through the creation of special purpose vehicles (SPVs), funded by the Treasury via the Federal Reserve Act. Given many of the stimulus actions are taken from the 2008 “playbook,” the use of these SPVs is similar to what the Fed did with Bear Stearns and AIG. While there are so many facilities that have recently been created, the ones involving corporate and muni bonds are set to end on September 30, 2020, subject to review. For perspective, similar language was used when the first quantitative easing program began in 2008, with an initial end date of March 2010. However, it was reactivated that November and again in September 2012. Clearly this is a very different environment not ignited by a massive deleveraging wave, but rather an unprecedented global health crisis. The Fed is doing what it has to do per its mandates (maximum employment and stable prices) to help bridge the gap in the short run.
Oil Markets in Turmoil
To put it simply, the countervailing forces of the COVID-19 situation and OPEC+ production disagreements are leaving global oil markets in turmoil:
- The price of West Texas Intermediate (WTI) is hovering near 20-year lows (less than $22 per barrel as of this writing) compared to the breakeven price for North American shale production at roughly $45 per barrel.
- US energy demand has plummeted to the lowest level since 1990.
- India, which is the third largest oil-consuming economy, was set to end a three-week nationwide lockdown on April 15, but it has been extended into May, further impeding demand.
Even with headlines talking about the record production level cut, that is an absolute number. A 9.7 million barrels per day production cut doesn’t solve the supply/ demand imbalance. In fact, it doesn’t even get us back to levels prior to the OPEC+ price war started a month ago. According to data from Bloomberg L.P., it is estimated oil demand across the globe could fall by about 30 million barrels per day in the month of April. The agreed-upon production limits are only scheduled for two months before being reassessed. Furthermore, the agreement hinges on an oligopoly with evident self-interests and a poor track record of coordination.
It’s hard to say this effectively ends the OPEC+ price war, when WTI is nowhere near shale breakevens. At best, perhaps you could call this a stalemate, meaning this story isn’t over yet.
Issues in the oil market are a demand problem, which is unique to prior business cycles when most of the impact on oil pricing came from the supply side. If oil companies were just in a crisis over the March OPEC+ meeting, a near-term production agreement might actually have been salvageable. However, the COVID-19 situation is a much larger problem because of its extreme short-term impact on demand, not to mention whatever longer-term effect it brings about on changing consumption patterns, such as travel and so on.
As we’ve mentioned, while the Energy sector is less than 3% of the US stock market by market capitalization, it is more than 11% of the HY bond market. Therefore, it brings us back to the Fed’s actions to support fallen angels and HY ETFs, but not the wider scope of HY bonds. While one day does not make a trend, we found price movements on April 9 telling in that Energy exposure in HY ETFs outperformed the underlying bonds, +6.2% versus +5.5%, respectively.
Table 1: Energy Performance in Bonds versus ETFs versus Equities as of 4/9/20
|Index||4/9/20 Return||Year-to-Date Total Return|
|Bloomberg Barclays High Yield Index||+3.1%||-9.9%|
|Bloomberg Barclays High Yield Energy Index||+5.5%||-30.0%|
|SPDR Bloomberg Barclays High Yield Bond ETF — Energy Sector||+6.2%||-31.6%|
|Bloomberg Barclays High Yield Energy Index — Stock Returns (market cap-weighted)||+1.2%||-46.6%|
|Alerian Midstream Energy Index||+4.0%||-40.7%|
|S&P 500 Energy Sector||-1.1%||-42.4%|
Source: Bloomberg L.P.
We dug even deeper and looked at the equities of the HY issuers and found that while they did have a positive day overall (+1.2%), they materially lagged their fixed income counterparts because long-term growth prospects have not changed for the better, in our view.
The addition of HY ETFs to its arsenal is clearly something the Fed thinks we need, but if it is going to distort price discovery (and the Fed obviously doesn’t have any tools to help solve the OPEC+ price war either), then it’s not exactly what we want.
Bottom-line, recent Fed policies are unprecedented, but it’s not exactly what we wanted. While the near-term support for market liquidity is a welcome positive, additional fiscal support in the face of record-breaking unemployment claims is what we need. While there is much talk of a “Phase 4” fiscal stimulus package in the works, its urgency cannot be stressed enough, in our view.