- Bond markets have come under stress as investors have sold bonds to raise cash.
- The good news: The Federal Reserve has cut interest rates and instituted programs to help ensure the smooth operation of bond markets.
- Investment-grade bonds issued by corporations are benefitting from the Fed's moves though some issuers could face downgrades if economic activity remains curtailed.
- Among the hardest hit are likely to be high-yield, some BBB-rated bonds, energy industry bonds, and some municipal issues.
- Large-cap corporate issuers with credit ratings of BBB and above in the cable/telecommunications, defense, regulated utilites, and consumer staples sectors may now be undervalued.
When stocks began their plunge from record highs in February, prices initially rose for high-quality bonds issued by corporations and governments, providing some protection to investors' portfolios. But as governments began to restrict the economic activities of consumers and businesses in order to slow the spread of the coronavirus, investors sought cash and began selling bonds as well as stocks, and billions of dollars flowed out of bond mutual funds and exchange-traded funds.
Not only did investors sell riskier high-yield bonds issued by companies with lower credit ratings, they also sold the bonds of highly rated companies with ample stockpiles of cash that would be unlikely to default despite the unprecedented restrictions placed on the economy. Investors even sold lower-risk assets such as municipal bonds and US Treasurys. The disorder in bond markets while stock prices were also falling upended the familiar relationship between bonds and stocks. Historically, when stock prices have fallen, investment-grade bonds' yields have also typically fallen and their prices have risen, helping to offset losses from stocks for investors who had allocated assets to bonds as well as stocks in their portfolios.
This familiar and frequently beneficial relationship between stocks and bonds had shown signs of breaking down last year when stocks, high-yield, investment-grade, and Treasury bonds all gained in value. In late February, prices continued moving together, but downward. Jurrien Timmer, Fidelity's Director of Global Macro, calls it "a contagion among all asset classes not seen since the Great Financial Crisis of 2007–2008, with cash in dollars being the only asset class left unscathed." He points out that, "In times of crisis, all correlations go to one as all the asset classes move in the same direction—and that certainly has been true this time around."
The result of the rush to cash and the sell-off in both stocks and bonds was that, for many assets, sellers outnumbered buyers and the entire financial system came under stress in trying to meet the demand for liquidity.
Fed to the rescue
When the Federal Reserve cut the federal funds rate close to zero earlier in March, some wondered whether the Fed had used up all of its policy weapons as the battle against the financial shock from the coronavirus was just beginning. Since then, the answer to that question has become a resounding "no!" The Fed has opened its playbook to try to lessen the impact of the rush for cash amid fears of recession. "Fortunately, the Fed is throwing everything it has at the problem, and doing so much faster than it did in 2008," says Timmer. "Back then, it still had to come up with the programs that it now can rapidly re-deploy."
After it cut the federal funds rate to a range of between 0% and 0.25%, the central bank restarted its program for buying Treasury bonds that it launched during the financial crisis and which it had ended in 2014. Next, the Fed opened a lending facility to enhance liquidity in short-term credit markets by buying ultra-short-term securities, known as commercial paper, that are issued by companies and used to fund ongoing activities such as paying salaries and accounts payable.
Finally, the Fed started lending directly to corporations and buying investment-grade corporate bonds and exchange-traded funds that hold highly rated corporate bonds, as well as mortgage-backed and municipal bonds.
Why is the Fed doing this?
The Fed's actions are intended to prevent coronavirus-triggered challenges facing corporate debt markets from turning into a financial crisis in which banks would come under pressure because they could not keep up with the demand for cash. The Fed is trying to keep bond markets liquid and functioning smoothly by becoming a buyer of debt that corporations and governments are issuing to raise needed capital, and also to incentivize others to buy those bonds as well.
What does it all mean for bond investors?
High-quality corporate bonds are likely to benefit as companies are able to borrow more cheaply to sustain operations despite lower demand. "The Fed is having a major impact as markets are starting to work again after being clogged last week and the week before," says Beau Coash, Institutional Portfolio Manager with Fidelity's fixed income division. Coash adds that while corporations had been largely unable to issue new bonds as investors fled toward cash, "issuance has become robust since earlier this month and has been met with big demand."
With the Fed supporting corporate bonds, Adam Kramer, lead manager of Fidelity Multi-Asset Income Fund (FMSDX) believes that large-cap corporate issuers with credit ratings of BBB and above in the cable/telecommunications, defense, regulated utilities, and consumer staples sectors may now be undervalued as markets price in a prolonged economic recession or even depression, which he views as unlikely.
To be sure, the Fed is not diving in to rescue all floundering bond markets. High-yield bonds and leveraged loans are not getting central bank help right now. Trading in these markets remains difficult and their issuers face strained operating environments. "For lower-rated companies in challenged industries, lower economic activity could make it difficult for them to maintain appropriate liquidity," explains Coash. "Bondholders could become fearful that those companies would not be able to maintain dividend payments or meet financial obligations like paying suppliers and paying interest to bondholders." This applies to high-yield bonds issued by energy companies facing both reduced demand and low oil prices. "High-yield credit spreads are now at distressed levels, and the high-yield energy credit spread is at 2.26 percentage points," says Timmer. "At these levels, we may see casualties in the oil patch."
While the Fed's actions are adding liquidity to markets, the realities remain that corporate earnings are likely to fall due to virus-related economic contraction as well as lower oil prices.
That means there are almost certain credit downgrades coming for issuers in industries such as travel and restaurants. Rating agency Standard & Poor's has already downgraded 100 bonds—including some previous triple-As—issued by businesses including shopping malls and airlines. "The risk of downgrades depends on the industry companies are in and how much flexibility they have," says Coash. "Are they able to sell assets, reduce costs, and buy back debt?" Many companies that borrowed heavily over the past decade may find their flexibility limited by their high levels of debt.
Even some general obligation municipal bonds also face downgrades as lower economic activity reduces tax revenues. S&P has lowered Suffolk County, Long Island's, credit rating to BBB-, the lowest category of investment grade, due to lower sales tax revenue and ongoing fiscal imbalances.
What does the future hold?
"The coronavirus pandemic has disrupted the world, and it's certainly been a difficult stretch for investors," says Jeff Moore, Co-Portfolio Manager of Fidelity Investment Grade Bond Fund (FBNDX). "But I do think investors should take some comfort that we've encountered periods of very high volatility before."
Moore emphasizes it's historically normal to periodically see brief, intense stretches of volatility. In the past 25 years, for example, bond markets endured the bankruptcy of Long-Term Capital Management (1998), Y2K, the Enron and WorldCom bankruptcies (2002), and the financial crisis of 2007–2008. He explains that the most important thing is not how market uncertainty gets resolved, but when.
"Once we get more clarity on the severity and length of the economic downturn," he says, "I think market participants will figure out how to price assets and we'll be able to make more aggressive moves on behalf of shareholders."