To every age its revolution. In Paris during the 1920’s and 30’s rival designers Coco Chanel and Elsa Schiaparelli tore down the age-old conventions of women’s couture. Working entirely independently they cast off the corseted-silhouette formality of another age in favor of styles that emphasized comfort, practicality and freedom of movement. It was a sublime moment in fashion as their ideas embraced either flamboyance or simple and chic aesthetics, but always with stylish creativity and outstanding innovation in material and design: Knitwear and wrap-dresses in the case of Schiaparelli (who was also one of the first designers to incorporate visible zippers); jersey fabric, the eponymous tweed suit and ‘little black dress’ in the case of Chanel. The world never looked back.
Not content with leading a couture revolution that would redefine fashion, these ladies also found the time to lead full (and rather colorful) lives. To follow contemporary accounts is to be dazzled by a supporting A-list cast of actors, artists, surrealists, musicians, composers, anarchists, aristocrats, reactionaries and revolutionaries who romp across a catwalk of life that stretches from Paris to the French Riviera and beyond. When Schiaparelli chose ‘Shocking Life’ as the title for her memoirs it was a decision as inspired as any of her creations.
In contrast to the world of haute couture, it is the nature of central banks to prefer not to shock anybody; but the times may still demand a policy revolution nonetheless. In the immediate aftermath of the market panic earlier this year, the US Treasury and Federal Reserve (Fed) launched a combined US$ 750 billion in support facilities for primary and secondary corporate credit markets. The goal was to boost corporate bond market liquidity through buying bonds and ETF's. In effect the Fed promised to be the buyer or market-maker of last resort for qualifying corporate bonds.
Investors are already familiar with the concept of central banks acting as the lender of last resort; the idea that, in a crisis, the central bank will guarantee liquidity to commercial banks that are otherwise solvent, but face short term cash problems. In fact the lender of last resort function is the one consistent role of central banks through history. Independent responsibility for monetary policy often came later.
But now even the lender of last resort function seems overdue a style makeover. Increasingly it is markets, and not commercial banks, that allocate savings across the economy. So when credit markets seized up in March, as the full impact of COVID-19 on corporate earnings became clear, it posed a grave danger to the efficient allocation of capita
When the Fed intervened, it sent a clear message to investors and borrowers; the Fed would ultimately backstop secondary market liquidity and qualifying corporate borrowers could count on the Fed as lender of last resort. The effect was dramatic; corporate bond prices recovered very quickly and the market for new issuance exploded back into life.
What is most interesting about this episode is that the Fed spent relatively little to achieve a lot (the holy grail of the lender of last resort function – credibility without spending the cash). At the end of October this year, Fed purchases of corporate bonds and ETFs in the secondary market have totalled just USD 13.3 billion0 and it had not spent a single dollar in the primary market. This is out of a combined spending power of USD 750 billion.
The message should not be lost on investors; in a market where liquidity concerns have shaped thinking about the merits of the asset class, the Fed has adapted its lender of last resort function to assuage some of those concerns. In fact the emergency lending and liquidity support facilities are due to expire on 31st December 2020 and, in an unusual public spat between the US Treasury and its central bank, will not be immediately renewed. However, so successful was the initial intervention and so important are credit markets to the allocation of capital in the modern economy, it seems likely the program, or something like it, will be rebooted in future panics.
The European Central Bank’s (ECB) Asset Purchase Programme (APP) was launched in 2014 with a much wider ambition than merely supporting market liquidity. The ECB wanted to use credit markets to support the whole monetary policy transmission mechanism. In effect corporate bonds, and other assets, were made a monetary policy tool. In March 2020 the APP was joined by the even larger and more flexible Pandemic Emergency Purchase Programme (PEPP) and the expansive scope was made explicit. According to the press release at the time "…The Governing Council will do everything necessary within its mandate. The Governing Council is fully prepared to increase the size of its asset purchase programmes and adjust their composition, by as much as necessary and for as long as needed…"1
Under this rather extensive ambition (suggestive of unlimited and price insensitive buying power) the ECB now holds nearly Euro 250 billion of corporate bonds (over 20 times the equivalent in Fed holdings). This is equal to about 25% of the eligible universe of corporate bonds2; a level of intervention on a dramatically different scale to the Fed.
But central bank interventions are not an unmitigated good. Even if they might generate enormous relief in a crisis, there are consequences. I wrote in June that, partly in reaction to central bank action, corporate bond yields and spreads had fallen to very low levels3. This has driven strong gains in the short term but requires careful attention by investors to ensure they are being paid adequately for the economic challenges ahead. The trends have accelerated since then. Chart 1 highlights how yields on typical indices have now reached record low levels; corporate bond investors have rarely been paid so little in aggregate.
Chart 1 - Corporate bonds effective yield and duration from 1997 to 31 October 2020
US corporate index
Euro corporate index
While government and corporate bond yields have fallen, corporate bond index durations - the sensitivity of prices to changes in yields - have increased. (Mathematically, lower yields always mean higher duration). This duration extension has been intensified as a lot of the new debt raised in 2020 was in longer maturity bonds as corporates try to lock in low cost long term funds. Chart 1 again shows the duration changes in US and European credit indices over time. The point is that now very small increases in yield can lead to some sizeable mark-to-market losses. To put that in some context for the US credit market, a 1 basis point (0.01%) increase in the yield would mean a USD 7 billion fall in the value of the market as a whole4.
So while we still believe there certainly are attractive opportunities in global credit markets, investors must tread with increasing care. And this is despite the levels of support central banks continue to provide that have assuaged some concerns around market liquidity and depth. Downside risks are growing with the new fashion for record low yields, record high durations (yield sensitivity) and average credit quality that has fallen over the past 20 years. A case in point - bonds with negative yields now comprise 33% of the Bloomberg Barclays Eurozone Corporate Index (a bond universe tracked by many investors). It is worth repeating that such bonds guarantee losses for investors, before inflation, if held to maturity.
Chart 2 - Percentage of negative yielding debt in the Eurozone corporate bond universe
That said, investors can still potentially earn attractive returns by adopting an active approach to managing the credit and duration risks inherent in many typical credit indices. Thoughtful consideration of the pros and cons posed by central bank intervention in markets combined with extensive credit research will be required to earn good returns in the long run.
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