Some fans of letting markets work things out are skeptical of the Federal Reserve Board’s new interventions in U.S. asset markets.
Mark Heppenstall, an investment analyst with the asset management arm of The Penn Mutual Life Insurance Co., says the Fed’s decision to start buying investment-grade corporate bonds has clearly helped stabilize the market for corporate bonds.
- A copy of the Penn Mutual corporate credit blog is available here.
- An article about bond market liquidity concerns is available here.
Heppenstall, the chief investment officer at PennMutual Asset Management, talks about the Fed’s new corporate bond purchase program in a commentary posted Thursday.
Life insurers hold trillions of dollars in corporate bonds in their investment portfolios.
The Fed started the bond purchase program in an effort to keep the bond market from freezing up simply because the investors selling corporate bonds have a hard time finding buyers.
Heppenstall contends that, as of March 27, the U.S. corporate bond market was showing signs of extreme stress, and that the Fed move to serve as a bond buyer helped ease the effects of that stress.
The Bond Spread Index and the Bond Default Index
A bond is a security that a company or other issuer uses to borrow money from investors.
A bond issuer pays “interest” to rent money from the lenders.
Shakier borrowers usually have to pay higher interest than safer-looking borrowers pay.
One indicator of bond market health, the investment grade Bloomberg Barclays Corporate Index, is a measure of the “spread,” or gap, between the interest rates that respected corporate borrowers pay on their bonds and the rates that the U.S. government pays on comparable bonds.
The Barclays investment grade corporate bond spread index has bounced between about 100% and 200% most of the time between 2004 and the present.
The corporate bond spread index soared to 600% at the worst point during the 2007-2009 Great Recession.
In March, Heppenstall says, worries about the COVID-19 pandemic pushed the corporate bond spread index up to about 400%, or about two-thirds of the Great Recession peak.
Heppenstall compared the Barclays corporate bond spread index with another index: the investment Grade Credit Default Swap Index.
A credit default swap is a derivative arrangement that gives the purchaser the ability to place a bet on whether the issuer will make its debt payments. When investors think a bond issuer is likely to default, the cost of buying a credit default for that issuer’s bonds goes up.
The investment Grade Credit Default Swap Index for 10-year notes has bounced between about 75% and 150% for most of the past 15 years. The index spiked above 200% during the Great Recession.
The credit default swap index spiked up to about 150% in March.
The credit default swap index moved in the same, grim direction as the corporate bond spread index, but not nearly as much.
Why the Spread Index Rose More than the Default Index
Heppenstall says the corporate bond spread index probably rose much faster that the credit default swap index rose because the spread index reflects how much investors want to trade their bonds for cash, in addition to how likely they think the issuer is to default.
“The insatiable demand for liquidity arises from all types of investors seeking safety, with the greatest search for liquidity stemming from highly leveraged strategies forced to liquidate positions,” Heppenstall writes. “The selling pressure often leads to even high-quality bonds being sold at distressed prices as bids evaporate for lower-quality or less-liquid assets.”
In late March, after the Fed announced the decision to buy investment grade corporate bonds, high-quality borrowers were suddenly able to issue new bonds again, Heppenstall says.
Companies were able to issue a record level of new bonds, and the bond performance benchmarks began to return to normal levels, Heppenstall says.
— Read Former Fed Chair Yellen Worries About a Deepening Recession, on ThinkAdvisor.