Volatility in U.S. credit markets could spike if the Federal Reserve meets its long-term expectation to pull back on efforts to support the economy.
Borrowing costs are rising for U.S. companies that gorged on debt during the COVID-19 pandemic, yet support from the Fed's liquidity programs means that for now, credit rating upgrades are more likely than downgrades.
But strategists are concerned that when the Fed eventually does taper its asset purchases, the reduction in liquidity could spawn a volatile period for credit markets with borrowing costs spiking and companies finding it difficult to refinance debt. The Fed has stressed that it has no plans to taper its $120 billion monthly bond purchase program, but it intends to at some point, and companies will then discover how much investor demand for corporate bonds remains.
"There is the risk that we'll see choppy demand in the primary bond market when the Federal Reserve starts tapering, which will bring refinancing risk for weaker companies," said Althea Spinozzi, fixed income strategist at Saxo Bank.
The yield on 10-year Treasurys shot up to 1.74% as of March 19 from 0.93% on Jan. 1, as investors demand higher compensation to make up for the expected rise in inflation as the economy recovers. That increase is feeding into higher borrowing costs for companies.
Meanwhile, the yield on the S&P U.S. Investment Grade Corporate Bond BBB Index rose from 1.85% on Jan. 1 to 2.34% as of March 19. This means refinancing costs are rising for over $3 trillion of debt rated by S&P Global Ratings as only one notch above "junk" status.
But as a result of the Fed's liquidity injections through its quantitative easing program, the index of BBB bonds is yielding less than the AA index — the second-highest rating constituting some of the safest American companies including Apple Inc., Amazon.com Inc. and Berkshire Hathaway Inc. — did before the pandemic.
"I'm not worried about it at all and that's a reflection of where we are in the credit cycle," Viktor Hjort, global head of credit strategy at BNP Paribas, said of the $3 trillion of BBB-rated debt load. "My concern there is that credit spreads are actually quite tight, so when you also get a reversal in flows — which is inevitable — it could be volatile. That's not a story for now but it could be in the second half of the year."
The yield on the BBB index fell from a high of 4.9% in March 2020 to below the pre-pandemic level of the yield for the S&P AA corporate bond index of 2.38% on Jan. 1, 2020.
Improving earnings momentum, high cash levels and peaking leverage means the potential for a spate of fallen angels — companies downgraded from investment grade to high yield where liquidity is lower and refinancing costs are higher — is receding.
"More than triple-Bs being downgraded to BB, you're likely to see BBs upgraded to triple-B," Hjort said, noting BNP Paribas forecasts that so-called "rising stars" will total $85 billion in 2021.
The economic collapse in 2020 resulted in 24 fallen angels, the second-highest annual total after 2009 when 57 companies were downgraded because of the financial crisis. Oil & gas was the hardest hit sector in 2020, with four companies downgraded following the collapse in energy prices — including Continental Resources Inc., APA Corp. and Occidental Petroleum Corp. Delta Air Lines Inc. and department store chain Macy's Inc. were also among those affected.
Ratings lists a further 43 potential fallen angels with a combined $276.39 billion of debt, including aerospace manufacturer Boeing Co., energy group Energy Transfer LP and financials group Ally Financial Inc. But the flow of fallen angels dried up toward the end of 2020 and there have been none in 2021, even as COVID-19 continues to cause significant disruption. One reason for this is the vastly improved cash position of U.S. companies.
Companies were able to issue bonds at record levels in 2020, aided by the Fed pumping liquidity into the credit markets. U.S. investment-grade bond issuance totaled $1.687 trillion in 2020, up from $1.057 trillion in 2019, according to data from LCD, an offering of S&P Global Market Intelligence. BBB-rated debt accounted for $822.7 billion of the 2020 total with a monthly peak of $142 billion in April as companies made a dash for cash to cover shortfalls in revenue.
About three-quarters of the funds raised by investment-grade companies in 2020 through debt issuance has been kept on company balance sheets, according to estimates by Ratings. Ongoing issuance is a result of refinancing debt at lower borrowing costs rather than raising cash.
Companies are now better positioned to cover their debts than before the pandemic even as corporate debt levels in North America rose to 89% of GDP in 2020, up from 79% in 2019, according to Ratings. This figure is expected to drop back to 84% in 2021 as revenues recover and the economy grows.
Liquidity trumps borrowing costs as the key concern
Even if a company is downgraded, there is less of a price to be paid. The spread in yield between BBB-rated bonds and BB — the least risky portion of sub-investment grade rated debt — is 119 basis points, up from the recent low of 96 bps on Feb. 16, but far narrower than the pandemic peak of 384 bps in March 2020.
However, the opportunity for companies to continue tapping bond markets is dependent on continued liquidity, which is uncertain without the Fed acting as a backstop.
"Current market operations are functioning because the Federal Reserve is providing liquidity," Spinozzi said, noting that the prospect of removing this liquidity is "massively concerning."
Liquidity is typically much lower in the high-yield market than in the investment-grade segment. As a result, downgrades of companies with large debt profiles can have significant impacts.
In May 2005, both General Motors Co. and Ford Motor Co. were downgraded to BB from investment-grade ratings. The anticipation of two of the largest corporate borrowers in the world — with over $400 billion in combined debt at the time— swelling the speculative-grade debt market caused bond spreads to surge in the two months before the downgrade decisions, rising by about 200 bps to 450 bps before settling back to 300 bps as investors adjusted to the supply shock.
Ford was again downgraded from BBB to BB in March 2020, but the Fed's support for U.S. companies was extended to fallen angels, easing the pressure on credit markets.
This time the Fed is hoping that as it withdraws support, the economy will be well placed and markets will remain liquid.
"Perhaps at the June 2021 meeting, the [Federal Open Market Committee] will begin discussing the details for winding down the programs. Until then, we believe the FOMC wants to ensure monetary conditions remain accommodative so that the economy can make substantial progress," said Tiffany Wilding, U.S. economist at PIMCO, in a March 18 note.
But Spinozzi believes the Fed will struggle to exit the market. "I believe that the Fed is in QE for the long term and that eventually, it will need to step in even to slow down the current fast rise in yields because they will soon prove disruptive."