As is typical, the month of May is shaping up to be a test for markets. The good news is that there seems to be progress being made on COVID-19 treatments and vaccines. Confidence among medical experts and pharmaceutical companies appears to be growing that a vaccine can be developed, with optimistic forecasts suggesting doses could be ready by the end of the year. Meanwhile, a robust trial of Gilead’s Remdesivir seems to have returned positive results earlier this week. The findings suggest that if administered soon after symptoms emerge, the drug can help patients recover and reduce the length of their hospital stays. That’s an encouraging development and should make reopening the economy a bit easier. Yet for markets like investment grade credit, there are other hurdles beyond the virus that must be overcome in May.
One obvious challenge for credit markets is the breakneck pace of supply. As companies exit earnings blackout periods, issuance tends to increase to make May one of the busier months of the year. But supply is already running at 188% of 2019’s pace ($746 billion YTD in 2020 vs $397 billion over the same period in 2019), so there is some concern that another month of heavy supply could overwhelm demand. Dealer forecasts for May seem to be in the $200-250 billion range, which is 50-100% above a typical May. Indeed, there is a good chance that by mid-year, there will have been as much issued in the first six months of 2020 as in all of 2019.
For the investment grade credit markets, the surge in issuance over the past 6-8 weeks has proved relatively easy to digest because it came at significantly wider spreads and with generous concessions. Whether the next few months of supply prove to be a different story is the question. In recent days, deals have been pricing with less than 10 basis points of concession and performing in-line with the market on the break. The one notable exception is Boeing, which required a healthy 50 basis point discount to existing bonds to get done given the nature of the credit story, the size of the deal ($25 billion) and the specific industry.
A second concern for credit is what sort of follow through can be expected from the Fed after their March 22 announcement introducing the primary and secondary market corporate credit facilities. As of May 1st, the PMCCF and SMCCF have yet to buy any bonds and there is some concern that they have been set up as lending facilities of last resort as opposed to the corporate bond buying programs of the ECB and BOE. In the case of the SMCCF for instance, there is a requirement that companies self-certify their eligibility to the Fed in order to have their bonds bought by the facility. As such, a very plausible result is that few companies do this unless absolutely required to by market circumstances or policymaker coercion. The risk then is that investors that have made large purchases expecting to sell them on to the Fed are unable to do so and the market finds itself increasingly oversupplied.
The idea that the PMCCF and SMCCF could go largely unused is not a foregone conclusion. The Fed has proven to be extremely flexible and proactive regarding its various crisis programs and willing to make tweaks where needed, as demonstrated by the changes they made to the municipal and main street lending facilities in the past week. If they perceive there to be a stigma associate with their programs, it is possible the Fed modifies the eligibility criteria or pivots to doing more corporate bond ETF purchases instead. In any case, investors should have a better sense of the Fed’s intentions by the end of May with the programs widely expected to go live in the next few weeks.
Finally, credit markets will continue to be confronted with economic data that can only be described as terrible and yet still capable of surprising to the downside. Indeed, Citi’s economic surprise index for the U.S. is at the lowest levels since its construction in 2003. Moreover, as bad as the recent data has been, it’s largely irrelevant as it covers the first quarter of the year and only 2-3 weeks of shutdown. By comparison, the second quarter will be much worse as the higher-frequency data will demonstrate throughout the coming month. For the moment, markets have done well to not focus on the depth of the contraction, but the real test for investors is still yet to come in that regard. To the extent that U.S.-China trade relations become a causality of the virus blame game or European sovereign risk reappears, markets may lose faith in the recovery.
There’s a reason the phrase “sell in May and go away” has stood the test of time. Yet investing rules are rarely that straightforward. Spreads have come down a lot since the middle of March and the “obvious” cheapness of A-rated credit has disappeared. At roughly 200 basis points, the U.S. Credit Index is compensating investors at the low-end of what is typical during a recession (Long Credit is at 240 basis points) and the spread ratio of BBB-to-A-rated credit is nearly back to pre-March levels, highlighting that high-quality credit has been outperforming. But while there are catalysts that could drive spreads wider in the near term, credit markets are simultaneously becoming more idiosyncratic as winners and losers start to emerge. This dynamic should favor active managers that can identify which companies are positioned to weather the COVID-19 crisis. Even if the market as whole continues to move sideways over the next month, the environment remains rich with opportunity.
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