In recent weeks we have seen spreads tighten across credit markets. In normal economic periods it would be safe to assume that conditions within the credit markets have improved. However, given the extraordinary period that we find ourselves in, there is more to it than meets the eye as spreads are only one indicator that measures the health of credit markets.
The fall in yields and subsequent spread compression seen in recent weeks is mainly due to the support that the corporate debt markets are receiving in the form of asset purchase programmes launched by central banks rather than improving economic or business conditions.
The two main central banks, The Federal Reserve (“FED”) and The European Central Bank (“ECB”), have sought to improve conditions within the credit markets by purchasing corporate bonds in vast quantities. The increased demand for corporate debt from central banks has the effect of increasing bond prices, decreasing yields (and compressing spreads), enabling corporations to raise capital by issuing bonds via the public markets at viable financing terms and most importantly improve the liquidity within corporate bond markets.
In March, the FED launched two programmes to address the worsening conditions within the U.S. corporate bond market. Namely, the Primary Market Corporate Credit Facility (PMCCF) and the Secondary Market Corporate Credit Facility (SMCCF) with a total combined size of $750 billion. The ECB on the other hand has added a supplementary envelope of €120 billion on the 12th of March to its already existing Asset Purchase Programme which already included the purchase of Euro area corporate bonds. Moreover, on 18th March, the ECB launched the Pandemic Emergency Purchase Programme (PEPP) with a total size of €750 billion. The same securities eligible under the APP are likewise eligible under PEPP.
So, while conditions in recent weeks have improved within credit markets, they have not yet reverted back to the levels last seen before the outbreak of the pandemic. The health of credit markets isn’t solely judged by the widening or tightening of credit spreads alone. Other widely followed indicators are the issuance of new debt via public markets, the change in credit ratings (upwards, constant or downwards) and the rate of corporate defaults.
Bond issuance has increased significantly in recent weeks following the launch of bond buying programmes by the two major central banks. Data shows that on a year to date basis, the U.S. and Eurozone investment grade bond issuance has outpaced the levels seen last year during the same period. This indicator is generally viewed in a positive light, but given the current circumstances of worsening business conditions, it could be argued that corporate debt profiles are worsening as corporations add more debt to their balance sheets in hopes of having sufficient liquidity to survive the pandemic’s negative effects.
Given the negative outlook in the majority of industries and the looming possibility of worsening credit profiles and bankruptcies, credit ratings have generally moved in a downwards pattern with issuers seeing their ratings downgraded. Recently, the likes of Airbus, Rolls-Royce, IAG and Renault have all had their credit ratings downgraded.
The rate of bankruptcies since the outbreak of the pandemic has been increasing as businesses struggle to cope with the challenging environment. So far, the largest casualty has been the rental car company Hertz when it filed for Chapter 11 on the 22nd of May.
Therefore, in summary, while we have seen credit markets recover significant ground from the lows seen in mid-March, a closer look would reveal that the corporate credit market has still a long way to go to be out of the woods.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.