The decisive speed and forceful magnitude of actions/announcements taken by the Federal Reserve to restore liquidity and confidence to financial markets over a decisive four week period from mid-March through early April has established the foundation for the credit market recovery which continues as we enter the re-opening phase of economic activity with the unofficial start of summer in the US.
Credit markets have settled into a trading range where subsequent spread movements should be more gradual and based on shifts in fundamental economic and earnings expectations.
But the overall trend is expected to be toward tighter spreads in the second half of the year and into 2021.
A number of Fed actions have not yet commenced but the anticipation of such programmes has preemptively achieved the desired intent of easing conditions for the directed asset classes.
Financial markets have recovered substantially ahead of the real economy, posing risks of a pullback from a number of factors such as a second wave and shutdown, failure to pass phase two of fiscal stimulus, or re-escalation of trade barriers with China.
Yet such setbacks are likely to delay the timeline of eventual recovery rather than imperiling it.
Tighter credit spreads, lower volatility
Since the inflection point in credit spreads on 23 March with the Fed's announcement to include investment grade (IG) corporate bonds in its asset purchases, the vast majority of the spread tightening since then had taken place prior to actual commencement of purchases of bonds and ETFs.
And critically, the immediate impact of the announcement was a deluge of new issuance by investment grade corporates as they sought to bolster their liquidity positions to weather plunging economic conditions.
March saw record-high IG issuance that was followed by a new record monthly issuance in April. Robust high yield (HY) bond issuance also commenced in April albeit primarily in senior-secured format.
The deluge of supply has temporarily abated the spread tightening but as new issue supply slows down, credit spreads will grind tighter.
Investment-grade spreads have declined from the mid-300s to +175 levels; high yield spreads peaked at 1100 and have now breached below +700 barrier; and loans peaked at 1300 but have dropped to the high-700s.
Some areas had lagged the spread compression in April but have commenced strong tightening in May, including emerging market (EM) corporates, HY sovereigns, and collateralised loan obligation (CLO) mezzanine tranches.
The lag was due to a combination of perceived and real fundamental risks along with a technical component, including the fact that policy stimulus and central bank purchases are not targeting those asset classes.
Meanwhile, fiscal stimulus is ratcheting up throughout the world. Outside of the US, Canada, Japan, and other nations globally have launched significant fiscal plans, and the EU is still discussing a potential support program, spearheaded by cooperation between Germany and France.
Countries that have not been as aggressive include some emerging markets, including China and India, but we do expect additional stimulus will be forthcoming and will dampen the negative impact on credit spreads.