Back to business in the bond market
August 19, 2020
The March disruption in the capital markets was particularly evident in the bond market, as a “flight to liquidity” drove investors out of risk assets into cash. The Federal Reserve noted the broken “plumbing” of the fixed income market and pledged unprecedented support through direct bond purchases and several aggressive liquidity programs. These announcements rapidly steadied the market, bringing yield spreads on investment-grade and high-yield indexes to below historic averages.
The combination of Fed assertiveness and plunging Treasury yields have dropped borrowing costs to record lows, despite rising delinquencies and stressed corporate balance sheets. The borrowing cost for the average investment-grade borrower is just over 1% today, versus 1.6% in March and 3.6% in late 2018. High-yield rates average roughly 6% right now, compared with 9.3% in March and 8.0% in late 2018. (See Chart 1 above.) While the Fed has slowed its asset purchases, there’s no indication this is impacting demand.
The advantage for corporate borrowers can be seen not only in lower costs, but also in higher issuance. High-yield issuance was essentially shut down in March, but that window has opened materially since then; high-yield bond issuance is on pace to reach $385 billion in 2020, eclipsing the previous record of $332 billion in 2013. Investment-grade issuance never really slowed, with $264 billion of new bond issues in March alone. Investment-grade issuance could potentially reach $2.2 trillion in 2020, nearly double the level of 2019. (See Chart 2 below.)
While the apparent disconnect between fundamental uncertainty and an accommodative market is good for borrowers, it puts pressure on investors to assume greater risk, as investment-grade funds now have a negative yield when adjusted for inflation. Additionally, the low yields on corporate bonds decrease the opportunity cost to invest elsewhere, likely driving investor appetite for stocks and gold.
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