On April 9, the U.S. Federal Reserve followed up on its March 23 statement with a series of unprecedented measures to support market liquidity. The two announcements have brought U.S. capital markets back from the brink through a series of increasingly bold and unprecedented steps.
The measures extend to multiple asset classes, many previously outside the scope of Fed liquidity support. Here we address questions about the new Primary Market Corporate Credit Facility (PMCCF) and the Secondary Market Corporate Credit Facility (SMCCF), which are targeted at supporting larger corporate borrowers, and about the impact of the Fed's announcements on corporate funding markets.
Frequently Asked Questions
How would you describe corporate funding conditions prior to the Fed's initial announcement on March 23?
We see corporate funding conditions prior to March 23 in two distinct phases: prior to Feb. 20, and the period from Feb. 20 to March 24. The year began with market sentiment riding high after the U.S. and China agreed in December on the "Phase 1" trade deal. At that time, COVID-19 was still unnamed and believed to be contained in China. As the coronavirus spread beyond mainland China, markets started to react with negative swings in equities and the occasional widening of spreads. However, these reactions were both mild and temporary.
By Feb. 20, it became clear that the U.S. was not insulated from the spread of the virus. Primary markets for speculative-grade debt came to a near complete halt, while secondary spreads widened past 500 basis points (bps) in the first days of March, after starting the year at 400 bps. From there, markets deteriorated quickly, with further widening of spreads and investment-grade issuance starting to freeze up (see chart 1).
Investor flows, which had been characterized by steady inflows of new money into investment-grade corporate mutual funds and exchange-traded funds (ETFs) earlier in the year, quickly reversed. Net outflows from investment-grade corporate bond mutual funds totaled $44 billion, and net outflows from speculative-grade funds totaled $17.2 billion over the four weeks ended March 18, leading up to the Fed's initial announcement. Confronted with sudden, sharp redemption demands, market liquidity all but evaporated, and many funds were forced to sell safe-haven assets, such as government bonds to meet redemptions, in turn extending the market dislocation further into Treasury markets.
What impact did the Fed's initial announcement have on corporate funding markets?
Prior to March 23, the Fed had intervened by lowering interest rates twice, which markets had a tepid, or even negative, response to. This all changed on March 23, when the Fed directly entered credit markets via its new liquidity facilities, including--for the first time in the post-financial crisis period--introducing purchases of investment-grade corporate bonds through a special purpose vehicle.
Market reaction was swift and immediate. Since the Fed's initial announcement, investment-grade bond issuance in the primary market has reached new highs. March issuance hit $249 billion, far eclipsing the prior record of $175 billion from May 2017, while between March 23 and March 31, $150 billion came to market, making it the third-largest monthly investment-grade total ever (see chart 2).
However, the issuance surge cannot be completely attributable to the Fed (the duration of many new issues would not meet Fed eligibility criteria). Some of the surge is the result of large, well-established firms taking advantage of better funding conditions brought about by the Fed's announcement to tap capital markets to secure funds ahead of the subsequent economic fallout.
While speculative-grade issuance was effectively shut down in March, speculative-grade spreads followed the tightening trajectory of investment grade, which helped to facilitate the reopening of the speculative-grade bond market (see chart 3).
In April, some primary market activity has resumed for speculative-grade bonds, with more than $20 billion in new issuance (through April 21). However, the bulk of these deals are rated in the 'BB' category, most are secured-debt offerings, and more than one-third comes from a single issuer. Ford Motor Co. returned to the primary markets after its recent fall to speculative grade with $8 billion in new issuance, though it did so at coupons 2%-3% higher than what was observed in the secondary market.
Why did investment-grade markets reopen while speculative-grade markets initially remained largely closed?
Several factors were at play initially. First, the initial Fed facilities offered little direct help to weaker borrowers. The primary and secondary market facilities were targeted at investment-grade borrowers, and it was not clear from the March 23 announcement whether fallen angels would be included. The initial announcement indicated an upcoming "Main Street" facility, which would offer support for smaller and medium-size firms, but detail was absent from the original Fed announcement.
Second, the virus' spread was picking up pace in the U.S., portending a long period of economic stress resulting from having to establish stronger containment efforts, which would make it more difficult for weaker borrowers and industries to generate revenues.
Indeed, the quick onset of a recession in the first quarter, which was estimated to be especially deep and would likely include high unemployment and little to no revenues for many firms, drove our speculative-grade default forecasts significantly higher (see chart 4).
Therefore, it was clear that while the Fed's original announcement dramatically improved investor sentiment and jumpstarted the investment-grade market, other critical corporate funding markets remained under stress.
How has the Fed's April 9 announcement changed corporate funding conditions?
The key features of the announcement (see table) can be broken down into three themes. First, the Fed made a clear commitment to underpin market liquidity through both the amount ($750 billion) and tenor (five-year secondary market duration) of the facilities. Second, the expansion of the Fed facilities for the first time ever to include speculative-grade issuers, in the form of recent fallen angels, and third through the expansion of the original decision to purchase ETFs, to include speculative-grade ETFs, brought a smaller, but rapidly expanding, part of the fixed-income market onto center stage.
The inclusion of fallen angels is particularly noteworthy as the Fed is demonstrating its willingness to purchase debt from speculative-grade companies. This step, which runs counter to the approach other central banks have taken, has indirectly and temporarily softened the funding border that traditionally exists between investment-grade and speculative-grade corporates.
Fallen angels already account for $237 billion in debt and, when combined with roughly $240 billion of 'BBB' debt--which we estimate is more vulnerable to downgrades to speculative grade before the end of 2020--means nearly $480 billion of debt could move into the speculative-grade category before the end of the year (see "'BBB' Pulse: U.S. And EMEA Fallen Angels Are Set To Rise As The Economy Grinds To A Halt," April 8, 2020). The Fed's decision to purchase debt from fallen angels is very important as it should alleviate market fears that the speculative-grade market, which is approximately 25% of the overall size of the investment-grade market, will be able to subsume fallen angel debt without triggering sharp volatility and downward price movements.
While the Fed will only purchase fallen angels that meet its eligibility criteria, and despite the Fed excluding purchases of all other speculative-grade debt, speculative-grade markets have to date reacted positively to the Fed's decision. For speculative grade, funds have experienced record weekly inflows, ETFs have performed strongly, and U.S. issuance has solidly picked up since the Fed's announcement.
The Fed's decision to include speculative-grade debt is not, in itself, a panacea for issuers that are or were already struggling to meet their debt obligations, but it has quickly strengthened and solidified market confidence and significantly reduced market volatility.
Apart from the PMCCF and the SMCCF, the Fed's Main Street facilities will offer low-cost loans to small and medium-size firms, which could act as an alternative to conventional fixed-income markets. Borrowing costs for these facilities are particularly attractive, at SOFR (Secured Overnight Financing Rate) plus 250 bps-400 bps. With SOFR effectively zero, these rates are competitive with those found by some of the most highly rated issuers. Therefore, issuers may seek to access these facilities instead of the capital markets or seek, where possible, to use available Fed facilities to partially repay capital market issuance.
|Details Of The Primary Market Corporate Credit Facility And The Secondary Market Corporate Credit Facility|
|The Primary Market Corporate Credit Facility (PMCCF)||Through a special-purpose vehicle (SPV), the Fed will purchase new issues of bonds and loans from U.S.-based companies currently rated investment grade or that were rated investment grade as of March 22 and are rated no lower than 'BB-' at time of issuance.||$750 billion* combined with the SMCCF||Maximum four years||The facility may purchase eligible corporate bonds as the sole investor in a bond issuance or as part of a syndicated facility as long as the purchase does not exceed 25% of any loan syndication or bond issue.|
|The Secondary Market Corporate Credit Facility (SMCCF)||Through an SPV, the Fed will purchase bonds from U.S.-based companies currently rated investment grade or that were rated investment grade as of March 22 and are rated no lower than 'BB-' at time of issuance. In addition, the Fed will purchase eligible U.S. listed exchange-traded funds (ETFs) with a "preponderance" toward investment-grade ETFs.||$750 billion* combined with the PMCCF||Maximum five years||The maximum amount of bonds that the facility will purchase from the secondary market of any eligible issuer is also capped at 10% of the issuer’s maximum bonds outstanding on any day between March 22, 2019, and March 22, 2020. The facility will not purchase shares of a particular ETF if, after such purchase, the facility would hold more than 20% of that ETF’s outstanding shares.|
|Note: Table provides a summary of key measures of the PMCCF and SMCCF criteria. *The maximum amount of instruments that the facility and the SMCCF combined will purchase with respect to any eligible issuer is capped at 1.5% of the combined potential size of the facility and the SMCCF.|
What have been the common themes for recent speculative-grade issuance?
Speculative-grade markets were far slower to reopen following the Fed's announcement, which was not unexpected given the initial announcement focused exclusively on investment -grade issuers. Traditional post-crisis market roadmaps typically indicate that investment-grade primary markets need to find a stable footing before speculative-grade issuance can return in any meaningful volume. U.S. speculative-grade markets have now reopened, with issuance exceeding $20 billion this month (through April 21), including $8 billion in bond issuance from Ford Motor Co. Despite this recent speculative-grade bond issuance, primary loan markets remain largely shuttered.
We've seen a number of common threads in terms of pricing, duration, and structure that are evident across most, but not all, of speculative-grade issuance in recent weeks. Pricing unsurprisingly has widened materially for those that can access the market, with average new issue yields of approximately 7.3%, over 200 bps wider than corresponding precrisis February levels.
The increase in financing costs has influenced the second trend--namely the shorter duration of recent speculative-grade issuance, with most new issues typically being structured as five-year debt with a two-year non-call period. The shorter duration in the current environment facilitates investors who wish to reduce duration in uncertain credit markets and provides issuers the option to refinance earlier than they would otherwise have been able to, if credit conditions stabilize and financing costs fall.
Issuers' focus on shorter duration and flexibility has also probably been influenced by the third recent theme--the level of secured issuance. Unsurprisingly, given the level of current market stress and the challenging economic conditions ahead, secured issuance has risen to 58% of speculative-grade bond issuance (month to date in April), from 20% in February.
Why did the Fed include high-yield exchange-traded funds, as opposed to speculative-grade bonds, as eligible investments?
By including high-yield ETFs, the Fed can provide immediate support to the liquidity of the overall corporate bond market in an impartial manner. Over 95% of corporate bond ETFs are index-based, meaning individual securities are determined by transparent rules, ensuring the Fed is not picking winners and losers by growing its portfolio through individual investments.
Also, the ETF market allows for immediate access to the high-yield market, rather than relying on an asset manager to select individual bonds. If the Fed were to purchase speculative-grade debt directly, it would likely have to work through an asset management intermediary. This would take more time to set up, dampening its potential effectiveness. It also removes the uncertainty and perceived conflict of interest between asset managers and their own holdings. The accessibility of high-yield ETFs is readily available through exchanges, as opposed to the high-yield market, which trades on appointment.
While the Fed will purchase high-yield ETFs, it has made clear that its primary focus will be on investment-grade ETFs, and it will also restrict purchases to 20% of any single ETF. Therefore, purchases of high-yield ETFs will be limited. But, by committing to buying both above and below investment grade, the Fed can ensure broad-based commitment to the corporate market, supporting both the efficiency and liquidity of the overall corporate bond markets, without further increasing the gap between investment- and speculative-grade issuers.
What will it take to reopen primary loan markets in a meaningful manner?
Loan primary markets are largely shut, with the exception of a handful of deals that have been brought forward this month to provide immediate liquidity to businesses hit hard by the economic impact of COVID-19. Those deals have priced with yields in the low- to mid-teens, reflecting the steep premiums required to attract buyers away from opportunities in the secondary market.
As of March 31, the secondary weighted average bid implied a discounted spread to maturity of LIBOR plus 814 for 'B' issuers and L+433 for 'BB', much higher coupons than usually seen for new issue deals. High coupons may keep many prospective borrowers from tapping loan markets given the highly uncertain economic outlook and need to protect balance sheets.
For sustained primary market deal flow to return, the differential between secondary and primary yields will need to decline. Additionally, for secondary prices to improve, more clarity on the length of business closures and the demand impact for specific businesses is needed, giving investors the ability to determine a rational price for credits.
Likewise, demand for the loan asset class needs to improve. Collateralized loan obligations (CLOs) are grappling with large numbers of loan downgrades, which are critically embedded in their investor protections. If the portfolios become too distressed, eventually CLOs are unable to buy new paper and cease to be liquidity providers to the loan market. Retail flows from the loan asset class since early March are north of $10 billion, weighing on demand.
Beyond these technical factors affecting demand, there also needs to be good reasons for leveraged loan issuance to occur in the first place. LBOs will certainly slow until at least the second half of 2020 as companies need to be revalued. Likewise, private equity firms looking for a return on equity will be cautious in taking on debt that would consume excessive portions of portfolio companies' free cash flows. The lack of a significant maturity wall for loans in 2020 also means there is limited incentive to issue refinanced debt.
What is likely to dictate corporate funding conditions for the remainder of 2020?
While the Fed has stepped in with programs to support immediate liquidity in the capital markets, the two main determinants for corporate financing conditions for the remainder of this year are the health and economic crises. Economic stabilization and recovery depend on the mitigation and treatment of COVID-19. As it stands, we expect the sharp and sudden global recession to be followed by a U-shaped economic recovery, with some permanently lost output--meaning that, for example, the U.S. economy wouldn't get back to its year-end 2019 level until the second half of next year. And the economic damage associated with the outbreak is nonlinear--the longer the containment lasts, the greater its impact on investment decisions and GDP prospects.
We think a return to more favorable credit conditions for borrowers would depend heavily on data showing the economic recovery has not just taken root, but has settled into a rhythm. Again, this depends greatly on the health outcome.
While there are signs that the growth of COVID-19 confirmed cases has slowed recently in Europe and North America (see chart 8), short of a vaccine or highly effective treatment, the current outbreak could linger or worsen, and subsequent waves of infections could happen. This is complicated by the fact that even if the spread of the virus were to stop tomorrow, residual effects are likely, especially if social distancing becomes a new normal or business and consumer spending doesn't bounce back.
That said, credit markets could remain fragile, particularly for borrowers in sectors hurt most by containment measures and those with low ratings.
Now that the Fed's programs have injected much-needed liquidity into the financial markets, the focus is shifting to the real economy. Even as we enter an earnings season where we clearly expect most corporates to report severely diminished (if not outright absent) earnings, we think the macro and health outlooks are more important to financing conditions than companies' first-quarter results.
While the path of the pandemic remains uncertain, what is clear is that most public companies suffered greatly, especially at the end of the first quarter. So, while equity markets may react to what will almost certainly be horrific numbers, the results are more likely to be baked into expectations among credit-market participants.
This report does not constitute a rating action.
|Primary Credit Analysts:||David C Tesher, New York (1) 212-438-2618;|
|Patrick Drury Byrne, Dublin (00353) 1 568 0605;|
|Ratings Performance Analytics:||Nick W Kraemer, FRM, New York (1) 212-438-1698;|
|Evan M Gunter, New York (1) 212-438-6412;|
|Credit Markets Research:||Sudeep K Kesh, New York (1) 212-438-7982;|
|Contributors:||Brian D. Luke, CFA, S&P Dow Jones Indices, New York (1) 212-438-8013;|
|Marina Lukatsky, Leveraged Commentary & Data, New York (1) 212-438-2709;|
|Alexander Saeedy, Leveraged Commentary & Data, New York (1) 212-438-0485;|
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