(Shaokun Chen, Jack Boswell & Jack Williams)
In recent months, capital markets have been warped by the coronavirus pandemic, and the US market for junk bonds has not been exempt from pronounced volatility. In March, US high-yield bonds plunged at their fastest pace in history as investors exited the market through fear of widespread corporate defaults arising from months of lost revenue. Despite the historic sell-off, the market has recovered dramatically and saw its best monthly return since 2011 in July. A resurgence in investor confidence, driven by Federal Reserve intervention and accelerated by the current state of the equity market, has helped increase demand for these riskier fixed income instruments.
Central Bank’s stimulus of bond market
The Federal Reserve has rolled out a wide range of unprecedented stimulus packages following the economic damages caused by Covid-19. The main objective of these programs, of course, is to mitigate recession and to maintain the healthy functioning of the credit system. By looking at the Fed’s response to Covid-19, some of the increase in current demand for high-yield bonds can be explained.
The Fed’s immediate response as the pandemic took hold of the US economy was to slash Federal Fund Rate, the benchmark for short term borrowing between financial institutions, by 1% to 0 to 0.25% at the start of March and to launch a 700 billion quantitative easing program (Market Watch 2020). The rate of emergency lending at the discount window was also reduced by 1.25% to 0.25% and the loan term increased to 90 days. This move is paramount in the Fed’s role as the ‘lender of last resort’ as it ensures that companies and financial institutions who require emergency liquidity can have easier access to credit (CNBC 2020). Another central bank instrument used immediately was forward guidance on the future path of the Fed rate (Brookings Institution 2020). The Fed announcing that it will be keeping the interbank rate low has placed downward pressure on longer-term rates and flattened the yield curve. All of these steps seek to reduce the cost of borrowing and increase the flow of credit within the economy.
In April, the US central bank announced that they will roll out a $2.3 trillion package to support the high yield corporate debt market (Reuters 2020). This includes a primary market facility that will lend to ‘fallen angels’, junk status companies previously rated BBB (the lowest tier of investment grade bonds), which have since been downgraded to BB- (highest tier of junk grade bonds) and a secondary market facility (Federalreserve.gov 2020). The secondary market element of the package has had a far greater significance for investors as it facilitates the purchase of exchange traded funds that back the junk bond market, thus massively increasing companies’ access to credit in these difficult times. This is a step that no other central bank has taken before.
By the start of June, the Fed’s balance sheet reached an all time high of over $7.16 trillion, due to the $2.8 trillion package as well as the Fed’s pledge to purchase an unlimited amount of government debt and government-guaranteed mortgage-backed securities (FT 2020). There was a $4 trillion increase in total assets from mid February to June- an unprecedented monetary expansion even compared to post-2008, which only saw a $1.3 trillion increase. Analysts at Deutsche Bank have speculated that the balance sheet could rise to over $20 trillion within a decade (FX Street), which is the size of the entire US economy (calculated using GDP) today.
Current Outlook in Equity Markets
Before looking at the cause for the demand for higher yields and junk bonds it’s important to provide the context of current equity markets.
The S&P 500 fell by 20% in Q1 of 2020 (Patriot, 2020) which, naturally, forced investors to look for different sources of investment. With investors turning away from stocks, demand for bonds increased which subsequently drove up prices and decreased yields.
Having fallen in March, the stock market reached new highs as of late-August, with the S&P reaching an inter-day record of 3426.99 percentage points, being up 0.7% as of lunchtime in New York City, soaring 55% from its low in March. Tech has taken up the majority of this rise, with the tech-heavy Nasdaq up 0.6%, also setting an inter-day record. Other markets have lagged behind, being worried about the macro environment (FT, 2020).
Despite the rising stock market, dividends have entered bear market territory having fallen more than 20%. The fall in return from dividends is one of the reasons investors are moving towards junk bonds, as income stocks provide dampened returns and have therefore increased demand for junk bonds and decreased their yield.
Dividends are expected to be slashed by 25% to 50% across the globe this year compared with 2019. This is a rarity and there has only been one other bear market of dividends occurring since the end of World War II. In the UK alone 450 public companies have cancelled, suspended or cut their dividends for the year. Dividend payments were at a record high last year, paying out 1.37 trillion dollars and some payout ratios, including those of HSBC, Shell and BP, were well above 50 percent. Therefore, there was already talk about dividend payments being unsustainable. This pandemic has forced this conversation onto firms, with heavy social pressure on firms not to pay dividends and maintain employment (FT, 2020).
Details about movement into high yield bonds
In July, investors in the US junk bond market experienced their best month since 2011, as monthly returns on US high yield corporate bonds reached 4.78%. Average yields in the junk bond market fell from 6.85% to 5.46% (FT, 2020) from the start of the month to the end. This meaningful decrease accounts for the biggest monthly drop in yields since May 2009 during the resurgence of the markets after the financial crisis.
Market support from the Federal Reserve has helped bolster investor confidence in riskier bonds and drive up demand for these higher-yielding assets. With backing from the Fed, investors, whose returns are constrained in safer corners of the bond market, feel more confident investing in higher-yielding bonds. The increased confidence among investors has contributed to a continued phase of falling yields and increasing prices since March’s historic market sell-off, and the US junk bond market as a whole has positioned itself as an increasingly viable option for yield-starved investors. This unprecedented intervention from the Fed has allowed the market to recover to such an extent that high yield bond returns are now only marginally negative for the year.
In addition to the intervention, the record low yields offered by investment grade bonds are pushing investors toward riskier investments. Alphabet set record low coupons with their issuance of 3-, 7- and 10-year US investment-grade corporate bonds in early August, having undercut Amazon’s record low July offerings. Alphabet agreed to pay just 1.1% per year on new 10-year debt last week (FT, 2020). As investment grade bonds continue to offer record low coupons, investors are neglecting risk and seeking investments in triple C rated bonds in their pursuit of higher yields. The additional yield above US government debt on corporate bonds with a triple C rating or lower has fallen more than 1 percentage point to 12.38% over the past month, as elevated demand pushed yields lower (FT, 2020). The increase in price and fall in yield is indicative of the readiness of investors to venture into the riskiest companies that have shown little recovery from March and have consistently underperformed the wider market.
Investors’ desire for greater returns in the junk bond market is exemplified through aluminium can maker Ball Corporation securing the lowest-ever borrowing costs for a US junk-rated company. Ball Corp raised $1.3bn with a 10-year bond that offered an annual coupon to investors of 2.875% (FT, 2020), which is a record low for a BB+ rated junk bond. The increased demand for junk bonds has allowed some of the highest-rated companies within the market, like Ball Corp, to secure exceptionally cheap funding. The willingness of investors to be exposed to these historically low coupons highlights the extent of their desperation for higher yields and their indifference to the associated risks.
The outlook on the US junk bond market depends on the extent of dividend recovery. The future outlook for dividend payments based on historical data does not look bright, with the bear market of dividends lasting much longer than their total return (growth and income) counterparts. On average lasting 4.8 years as compared to 1.5 years (Lamont 2020, Schroders).
With a never seen before lockdown, it could be a different recovery for dividends. A relaxation of lockdown rules in 2021 would lead to substantial recovery of the economy and result in dividends returning, however, we are unlikely to return to anything like ‘business as usual’ for some time.
In line with this view, dividend future contacts, financial instruments based on investor views of the future path of dividends are pricing in further declines in dividends in 2021. 2022 looks more promising with an almost 10% dividend growth for the US market overall, however, it is important to note that this is still almost 20% below their level in 2019. It is not until 2027 when these dividends are expected to reach 2019 levels (Lamont 2020, Schroders).
If dividends continue to be slashed and investment-grade bonds continue to produce record low coupons, there is no doubt that demand for US junk bonds will continue to rise. With little alternatives for high fixed interest payments, yield-starved investors will be forced to resort to junk bonds as a means of garnering returns.
It is also clear that the Fed’s future involvement in the market will heavily affect its future outlook. Governments across the world want to make sure businesses receive the credit they need to survive, so it is likely the Fed will continue with action to support the low rated bond market. If support continues throughout the remainder of the imminent global recession, it is clear that investor confidence and demand within the junk bond market will remain high.
- Capital Markets – Capital markets refer to the places where savings and investments are moved between suppliers of capital and those who are in need of capital.
- Junk Bonds – A junk bond is debt that has been given a low credit rating by a ratings agency, below investment grade.
- Yield – The earnings generated and realised on an investment over a particular time period.
- Bear Market – Represents a general downward trend of the value of stocks.
- Stimulus package- A tool used by the central bank to increase economic activity
- Bond credit rating (eg BB, Triple C) – A way of measuring the creditworthiness of a bond, which corresponds to the cost of borrowing for an issuer.
- Future Contract – A standardized agreement to buy or sell the underlying commodity or asset at a specific price at a future date.
- Dividend payout ratio – The ratio of the total amount of dividends paid out to shareholders relative to the net income of the company.
- Federal Fund rate- also known as the interbank lending rate, the interest charged on short-term loans made between financial institutions
- Central Bank Balance Sheet- contains the total assets and liabilities of the central bank
- Discount window- A tool used by the Central Bank to allow financial institutions to borrow directly from the Central Bank in order to meet their liquidity requirements
- Quantitative Easing- Where the central bank buys long dated government bonds in order to encourage lending and increase money supply
- Mortgage backed securities- Mortgage loans are repackaged and sold as a security on the market.
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Featured Image: Rennison, J. (2020). US junk bonds notch up best month since 2011. Financial Times. Courtesy of Ice Data Services.