The behavior of markets over the past few weeks suggests that most of the “easy” money opportunities are gone. In this case, “easy” is something on a euphemism for trading opportunities that arose from a deterioration in liquidity and funding conditions. In retrospect, these problems proved “easy” for the central banks to fix with the tools at their disposal, especially as they were able to follow the road-map of the 2008/2009 crisis. Yet in recent days both credit and equity markets have lost some momentum, and that likely reflects the fact that monetary policy can only take markets so far. What’s needed next is progress on the virus front.
To their credit, the Fed hasn’t been standing still as their programs work through the financial system. A week ago, they sharply increased the capital devoted to their corporate bond purchase programs and expanded the eligibility to include recent fallen angels to high yield, and more controversially, high yield ETFs. Those latest moves helped the high yield market to rally almost 150 basis points from the day before the announcement.
Nevertheless, away from those asset classes that were added most recently to the Fed’s programs such as high yield, AAA CLOs, and AAA CMBS, other markets have been showing signs of wanting to take a breather.
Investment-grade credit is a good example of how investors are stopping to reassess. The Bloomberg Barclays Investment Grade Credit index entered the year at a spread of 90 basis points, hit a peak of 341 in the middle of March, and is now at 203 after managing to spend only one day this week below the 200-threshold. Obviously, there should be nothing special about 200 basis points from an economic or mathematical point of view, yet it is difficult to deny that psychology doesn’t sometimes play a role. In this case, the 200bp-threshold has been an unusually reliable indicator of when real credit risk questions are being asked by investors. Over the last twenty years, the investment-grade credit markets have only traded wide to 200 basis points on a few occasions: each of the last two recessions and the sovereign crisis of 2011/12. Meanwhile, during the commodities collapsed of 2015/16, the investment-grade market peaked at exactly 200 basis point.
Rightly or wrongly, 200 basis points seems to be a sort of line in the sand from a historical point of view. Said simply, it is likely that investors need to believe the current situation is less worse than past recessions for spreads to continue to rally. If investment grade credit does rally further in advance of an anticipated epidemiological-all clear being sounded, it would be tantamount to saying the Fed has transformed the COVID-19 crisis into more of a garden-variety risk off event. But for now, it’s easy to see why investors might begin to balk at investment grade credit spreads in the 100s.
Beyond psychological considerations, many of the largest dislocations that were present in the investment-grade market 2-3 weeks ago have since been resolved with the help of the Fed. For instance, the U.S. market no longer looks cheap to the Euro and Sterling markets as it did in mid-March. Likewise, the front-end of investment-grade has continued to normalize and is no longer inverted to intermediate tenor bonds. And finally, the truly spectacular concessions seen last month in the primary market are gone. Unfortunately, the 50 to 100 basis point concessions have been replaced with concessions of 5-15; some issuers are even able to print with zero discount to secondaries depending on the day.
While too soon to conclude that life is back to normal in the investment grade markets, it does feel that spreads are entering a more stable period where the next move tighter will be predicated on virus news and evidence of underlying economic recovery. That is a good transition to be making right now even if it means the “easy” trades are fading and the gains from here might be slower to accrue. For much of the tourist capital that was attracted into investment-grade from the distressed and high-yield markets, the transition to this next phase likely means a return to home and hopefully greener pastures.
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