Bond Investors Beware: Fed Support Won’t Erase Risks
If the pandemic accelerates, current optimism about an economic recovery will likely start to fade.
Like the stock market, the U.S. bond market is benefiting from intervention by the Federal Reserve but future performance will depend also on the trajectory of the COVID-19 pandemic, its economic impact and fiscal policies.
Treasury bond yields remain well under 1% even on the long end–up to a 10-year maturity–and corporate bond spreads have narrowed substantially since the market liquidity crunch in mid-March.
The consensus view is for the economy to recover somewhat in the second half but yields remaining constrained as the Fed continues its massive economic support through near-zero interest rates, asset purchases and multiple credit facilities that support corporate and muni bonds as well as small and medium-sized businesses.
“On the whole, the rest of the year looks likely to be a slow healing process,” wrote Brad McMillan, chief investment officer of Commonwealth Financial Network, in a recent note. “The second quarter will be terrible. … The third quarter will likely show some recovery, offset by reduced stimulus. And, hopefully, the fourth quarter will see an economy that has recovered back to levels close to the start of the year.”
But if the current wave of the pandemic continues to accelerate — at least 21 states are reporting an increase in infections, including many with increased hospitalizations — and a second wave follows across the nation, optimism about an economic recovery will likely start to fade.
Such a retrenchment would likely boost Treasury prices but not necessarily those of corporate bonds although Fed Chairman Jerome Powell has said the Fed “will continue to use these [emergency] powers forcefully, proactively, and aggressively we are confident that we are solidly on the road to recovery.” The Fed recently began to purchase individual corporate bonds as part of its secondary market corporate credit market facility, replacing corporate bond ETFs.
Stick With Quality
Those purchases and others through the Fed’s liquidity facilities have played a key role in the fixed income market, shrinking yield spreads to Treasuries despite an influx of new supply, which would normally weigh on prices and widen yields, and increasing downgrades and defaults.
New issues of investment grade bonds top $1.1 trillion year-to-date, approaching the level for all of last year, for example, but spreads have narrowed from between 500-600 basis points over Treasuries since March to around 100 basis currently.
Given this backdrop, Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research, recommends that investors stick with high quality corporates with maturities of five years or less “because that is where the Fed is buying” on the yield curve. She suggests that investors limit exposure to lower-rated corporate bonds and “focus on issuers with stronger balance sheets that can weather the ups and downs of the recovery.”
Patrick Leary, chief market strategist at Incapital, is a little more daring. He says investors can afford to own even lower quality corporates of five years or shorter maturity because the Fed won’t necessarily support AA-rated issues more than BBB. (The Fed is also supporting fallen angels that were investment grade as of March 22.)
Leary notes that today’s corporate bond market “is not reflective of the underlying fundamentals that exist in the economy right now. Follow the Fed and be ready to make adjustments as the outlook changes.”
Jones agrees, but notes that the the Fed’s intervention “doesn’t change the risk/reward calculator. It doesn’t eliminate risks.”
That’s especially true in the muni market, which is filled with issuers subject to large budget shortfalls because of declines in revenues and increases in spending due to the pandemic and waiting for more federal emergency aid. The Fed’s muni liquidity facility cannot provide the fiscal report state and local governments need.
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