We view the recent sell-off as more a liquidity than a credit concern. With decisive policy support, we don’t expect it to persist.

Thomas Kennedy
Executive Director, Head of Macro and Fixed Income Strategy, J.P. Morgan Private Bank

Afonso Borges
CFA, Fixed Income Strategist, J.P. Morgan Private Bank

 

Over the past month, the global spread of COVID-19, governments’ social distancing orders to control it and challenging liquidity conditions have set off broad-based selling that reached into even the safer corners of the market. (We highlighted the opportunities this sell-off created in municipal bonds.) Here, we detail why we view the recent sell-off as more a liquidity concern than a credit concern—making it a problem that the Federal Reserve (Fed) can help solve.

Why do we think the sell-off was driven by a liquidity crunch? First, because the market wasn’t orderly. In an orderly market, when riskier assets sell off, traditional safe-haven assets (think: gold and U.S. Treasuries) tend to rally. Yet in this market, we saw just the opposite: As the S&P 500 declined 8.8% the week ending March 13, gold had its worst week since 1983. To add insult to portfolio construction injury, 10-year Treasuries also sold off and yields rose nearly 50 basis points (bps).

Second, investors have recently set records in the volume of outflows from investment grade and municipal bond funds—among the safest of assets. When investors sell what they can, not necessarily what they want to, it screams “liquidity crunch.” Over the last four weeks, municipal and investment grade volatility spiked to seven or eight times their averages since 2006. Meanwhile, risker asset classes saw more measured increases in volatility. That is not what we’d expect to see had credit risk been the dominant concern.

The liquidity crunch pushed investment grade (IG) bond spreads, as measured by the JPMorgan U.S. Liquid Index (JULI), to the widest level since the 2008 Global Financial Crisis—and above previous recessions, such as the 2001 recession that followed the dot-com bust. From 127 bps at the end of 2019, spreads widened to 325 bps at publication time—without the kind of discriminating behavior we’d expect were investors distinguishing among different bonds rather than seeking to raise cash.

IG bond spreads haven’t been this wide since the 2008 crisis

Source: J.P. Morgan as of March 30, 2020.
Line chart shows JULI spreads (basis points) from 2000 to 2020, highlighting that during this time period, the line
Here’s how else we know the recent selling was rather indiscriminate: Bonds maturing in 2025 offer the same risk premium as those from the same issuer maturing in 2050. In other words, the IG curve has flattened across bond maturities. The sell-off has also been more or less impervious to bond ratings—spreads have doubled, on average, across ratings. If credit risk was motivating sellers, we would expect lower-rated credits to underperform. 

An indiscriminate sell-off disregarded credit ratings

Source: J.P. Morgan as of March 27, 2020.
Bar chart shows the spread by rating—AAA, AA, A and BBB—comparing across two time periods: 2/21/2020 and 3/27/2020. The chart highlights that across all ratings, the spread has increased relatively evenly between 2/21/2020 and 3/27/2020, with spreads on average doubling.
The sell-off in IG bonds has also been relatively uniform across sectors. When investor selling is motivated by credit risk, there is dispersion in different sectors’ performance. If, for example, concerns are rising about economic activity, investors differentiate between likely winners and losers. That has not been the story, so far, during this sell-off. Spreads have doubled in the last month for healthcare companies—a change similar to other sectors. Yet, arguably, a COVID-19–led downturn could be positive for the sector.

A relatively uniform sell-off seemed to ignore sector

Source: J.P. Morgan as of March 27, 2020.
Bar chart shows the spread ratio (between 2/21/2020 and 3/27/2020) across various sectors—Healthcare, Technology, Telecoms, Energy, Utilities, Banks, Basic Industries, Capital Goods and Consumer. The chart highlights that Energy and Banks have experienced the highest spread ratio during this time period.

The scope and pace of policy easing so far have been unprecedented. Policymakers around the world promptly deployed easing tools, and have made the commitment to do whatever it takes. These central bank actions suggest that the dynamic we’ve described here—an IG sell-off that has more to do with illiquidity than rising credit risk—should not persist. The record size and swift pace of policy accommodation should support risk assets and prevent illiquidity from becoming insolvency.

The Fed swiftly initiated a series of operations, some of which we’ve seen before, but never has the central bank acted so quickly. It cut rates to zero, restarted quantitative easing (QE), and has begun to provide U.S. dollar swap lines, a commercial paper funding facility and a primary dealer credit facility. The Fed is also doing something it has never done before—buying corporate credit. It is doing so using new tools: The Primary Market Corporate Credit Facility (PMCCF) will purchase qualifying bonds directly from eligible issuers, and the Secondary Market Corporate Credit Facility (SMCCSF) will buy corporate bonds that already trade in the market. The Treasury Department will provide initial equity of USD10 billion for each facility. Here are the specifications—qualifying bonds must:

  • Be issued by a U.S. company with material operations in the United States
  • Be rated IG by two or more major rating agencies (if rated by multiple agencies), or by one major agency (if only rated by one)
  • Have a remaining maturity of four years or less (PMCCF), or five years or less (SMCCF)

This announcement should bolster liquidity conditions in the IG space, and we expect it will lead to a tightening of spreads in the five-year and shorter part of the curve.

IG bonds had a problem: a sell-off largely motivated by illiquidity. We don’t expect it to persist because the Fed has moved decisively to help solve that problem, with a historical level of policy accommodation that should support risk assets. As a result, we have the confidence to selectively add exposure to short- and medium-term IG credits that we expect will weather the COVID-19 economic downturn well.