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Central Banks, Credit Markets, And The Catch-22 Taper

Central banks undoubtedly rescued financial markets with unconventional policies when the pandemic did its worst. But those very same actions now leave central banks joined at the hip with credit markets, and market participants more reliant upon their support. One year on from the peak of the crisis, this represents a Catch-22, not just for central banks but also for investors. How do central banks continue to support the recovery while also developing an exit strategy that doesn't undermine market stability? And, how will investors, who prize stability but also seek higher yields, react if and when central banks step back from providing direct market support?

Central Bank Actions: Evolution Or Revolution?

Chart 1

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While some of the Federal Reserve's measures to restore financial stability--most notably its rollout of asset purchase programs for corporate credit--garnered most of the headlines last year, the breadth of its interventions can sometimes be overlooked. Concerted actions had the desired effect, with U.S. investment-grade composite spreads dropping steadily from late March and primary markets reopening. However, keeping spreads on a downward trajectory required sustained actions, particularly during the second and third quarter.

Although there was no one silver bullet action, traditional tools in the form of rate cuts, access to cheaper financing, and increased Treasury purchases did not seem to have the desired effect at the start of the pandemic, as they failed to arrest the spike in spreads or the slump in issuance. It was only the Fed's announcement that it would become an investor in primary and secondary corporate credit markets, alongside other expanded measures on March 23, which signaled to markets that the Fed would do whatever it takes. This announcement coincided with the peak in U.S. investment-grade spreads (see chart 1).

Chart 2

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The European Central Bank (ECB) started from a different position from the Fed. At first, it was unable to deploy rate cuts as a meaningful tool, but it was able to draw upon existing tools, such as credit-easing measures and asset purchases, using the flexibility of its own balance sheet. However, like in the U.S., European markets only began to stabilize after the ECB expanded existing funding and asset programs, introduced the new pandemic emergency purchase program (PEPP), and implemented U.S. dollar swap lines.

Speculative-grade markets took longer to recover in Europe than in the U.S., which may in part be because speculative-grade credit was not eligible for purchase by the ECB. However, the ECB began accepting fallen angels, or assets that recently lost their investment-grade rating, in the pool of assets as part of its funding operations on April 7, triggering euro-denominated bond spreads to start narrowing. The role of liquidity supports in the form of the various targeted programs provided by the longer-term refinancing operations (TLTROs) and government guarantees cannot be underestimated. But once again, it is hard to ignore the important role played by nontraditional credit-easing measures in restoring market stability.

The Fed and ECB had less room for maneuver with conventional rate cuts, forcing them to go deeper with nonconventional tools. It is uncertain whether conventional tools are now less effective in restoring market confidence in times of stress, or whether the unusual nature of the pandemic required a precision strike of support to corporate bond issuers, the most vulnerable sector. The widespread use of asset purchase programs could simply have been the last in a long line of measures that finally brought market stress under control. Or it could also represent a recalibration in how active and forceful central banks need to be in a crisis. At the very least, their extreme actions have set a new precedent in terms of market expectations, which will be difficult to ignore in times of future stress.

Central Bank Support Stabilized Primary Corporate Borrowing Costs

While central bank actions had a significant impact on tightening spreads in secondary markets, they also contributed to normalizing primary debt markets. Market participants considered both central banks' policy actions and communications guidance in anticipating prices for newly issued bonds. However, one should not mistake this as a corollary relationship because a multitude of factors were at play, including point-in-time market appetite, global flows, the speed of monetary channels, and the supply-demand dynamics for the instruments themselves, among others. Nevertheless, the role of central banks, in this case the Fed, is quite stark, as charts 3 and 4 illustrate.

Chart 3

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Chart 4

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Before the central bank interventions, the rush to hold high-credit-quality issuance translated into lower yields at higher rating categories, which signified the extremely limited appetite for new capital in the first place, though it was also influenced by investors' risk aversion for borrowers with weaker creditworthiness. This was especially pronounced for lower speculative-grade issuance, with little or no investor interest in issuance rated below 'B'. Moreover, investors were less selective when investing in higher-rated offerings--a feature of capital markets with strong, somewhat binary, risk aversion.

After the central bank interventions, the cost-of-capital curve normalized, resulting in more differentiation across rating categories. This reflected both investor confidence in the risk premium being offered as well as differentiation among instruments and issuers. Normalization took several months to achieve, and appetite for investment-grade issuance returned much sooner than that for 'BB' category issuance, later followed by renewed interest in issuance rated 'B' and below. This not only led to a return to normalcy but also one of the strongest surges in corporate bond issuance in history.

The central banks' actions have increasingly allowed lower-rated and higher-risk issuers to access the capital markets, which provided them with much-needed liquidity to combat the economic downturn. In fact, 'CCC' rated issuance from U.S. issuers has risen steadily to date this year on the back of the economic outlook and the Fed's continued support of financial markets. While this is positive for lower-rated issuers, it also presents questions. For example, it's not certain whether some of these issuers would have been able to access the markets without the Fed's indirect support. It is also necessary to consider whether their ability to do so will create future problems when the Fed eventually decides to rein in support.

A Catch-22 For Credit Markets

Central bank actions, alongside unprecedented fiscal supports, restored financial stability in 2020. This hard-won restoration required extensive quantitative easing (QE) and new or extended interventions, particularly into corporate credit markets. Through a combination of rate-setting, financing, and widespread QE, central banks now play a more pivotal role. Although central banks have announced they have no plans to end support anytime soon, the extent and success of their actions last year have arguably created new challenges for 2021 and beyond: How do markets return to a more independent footing, less reliant on central bank support, and how do central banks continue to support the recovery while also developing an exit strategy that doesn't undermine market stability? And, finally, how will investors, who prize stability but also seek higher yields, react if and when central banks step back from providing direct market support?

Central banks: A critical investor in many markets

The task for central banks is complicated given the continued need to support the economic recovery. Global debt was forecast to peak at 267% of GDP at year-end 2020 (see chart 5), and it is not forecast to decline significantly, particularly as government issuance is likely to continue given the requirement to fund fiscal supports. The central banks have been a cornerstone investor in many transactions, providing governments, and corporates to a lesser degree, with certainty of low-cost funding. As chart 6 shows, net purchases by the ECB increased by approximately 40% since the pandemic began, and these purchases were heavily weighted toward sovereign investments.

Chart 5

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Chart 6

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The continued purchase of sovereign debt is unlikely to change in the medium term, and it will likely increase, at least temporarily. The ECB has indicated that its debt purchases in the second quarter will be conducted at a significantly faster pace than in the first. In Europe, the stock of long-term government bonds outstanding has already increased about 25% since 2015, although the free float has fallen in the same period (see chart 7). The reason for the fall in the free float is the sharp increase in bonds held by the ECB. While the situation is far less acute in the U.S., with the Fed holding less than 20% of Treasury debt, it illustrates the difficulties some central banks may face when they seek to reduce market reliance upon their investment and financing programs.

One future risk is not that central banks will suddenly start to divest their substantial holdings, sending prices downward, but that concentrated ownership could negatively impact market structure and liquidity. The European covered bond market has already experienced similar effects, with the ECB now holding about one-third of all eligible bonds outstanding. A reduced market free float could drive out active investors, increase volatility, and impede price discovery in times of stress.

Chart 7

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Chart 8

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Central banks hold a materially lower share of corporate debt, but their influence in this market should not be underestimated. The ECB holds approximately €280 billion of corporate bonds under its two QE programs, primarily under the asset purchase program. The ECB has stated that it will continue corporate reinvestments under the PEPP until at least 2024, and any rolloff thereafter is likely to be incremental. As the ECB's corporate bond portfolio has an average duration of seven years, this means that the ECB is likely to remain a key investor in the corporate bond market for at least the next decade, and therefore, it is also likely to influence financing costs over the same time.

Central banks are clearly in this for the long haul. The Fed recently indicated that it would continue to increase its holdings of Treasury and mortgage-backed securities, essentially until economic prospects improve, and the ECB has expressed similar intentions. But what is their long-term plan? Central banks could maintain QE, as the Fed has suggested and the ECB has done in the past, but protracted QE can be difficult to unwind and could keep interest rates lower than they might otherwise be. Alternatively, they can seek to dial back QE, which would require a delicate balance and clear communication to avoid unnerving markets participants, still mindful of the taper tantrum of 2013. Irrespective of which course central banks ultimately take, market participants will continue to pay close attention to the question of tapering in the quarters and years to come.

Investors: No place to run

The fate of fixed-income investors, in terms of performance, is also inextricably tied to future central bank decisions. Low rates and sustained monetary stimulus have contributed to a surge in issuance but have also made it difficult for fixed-income investors to generate target returns. As chart 9 illustrates, this challenge is pronounced with approximately 90% of global bonds trading at a yield below 2% at year-end 2020.

Chart 9

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Central bank support remains critical to the global economic recovery, and while yield-curve steepening has provided some respite, the longer it remains in place, the greater the challenge it poses for fixed-income returns. Low credit yields, partially because of central bank interventions, are forcing investors to accept lower returns, with consequences for pension funds and future retirees, for example. Investors are also chasing higher yields by taking on new risks, longer-duration risks, or increased credit risks, which could ultimately destabilize the system that central banks worked so hard to calm.

Bonds with longer durations, a feature at the forefront of recent benign issuance conditions triggered by central bank interventions, are particularly vulnerable to the impact of inflation expectations, which have risen, particularly in the U.S. Even so, investors continue to purchase new, long-duration issues (see chart 10). Low yields are also forcing some investors to take increased credit risk. Indeed, leveraged loan issuance by 'B-' rated borrowers has hit a record high, according to a Feb. 24 report by S&P Global Market Intelligence's LCD, while borrowing costs have fallen to their lowest point since the financial crisis. Central banks are not responsible for investment decisions, but the longer the support continues, the riskier the search for yield may become.

Chart 10

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Chart 11

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Investors have benefited significantly from central bank interventions--and the corresponding stability they have brought to credit markets. Pandemic-related defaults are even lower to date than initially feared by many market participants. But investors now face a new dilemma: On one hand, they benefit from the stability and confidence central banks have helped restore, but on the other, the continuation of low rates and monetary stimulus poses significant challenges for future returns. Although these two sides are not necessarily mutually exclusive, the year ahead is likely to be marked by stability and uncertain financial returns, both a result of continued central bank interventions.

Writer: Rose Marie Burke. Editor: Christa Corrigan. Digital Design: Joe Carrick-Varty.

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