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The market impact of a very certain Fed

| May 1, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The market has largely priced in the predictable effects of the Fed on the US Treasury and agency MBS and CMBS markets but still has room to run as the Fed refines its efforts on credit. Stronger balance sheets in high yield and leveraged loans stand to gain the most. Agency MBS has upside from rising levels of forbearance.

The Treasury market at this point should know what to expect from the Fed: good liquidity, low rates and stable-to-rising implied inflation. Steady QE has largely restored normal liquidity after the bid-ask spread on 30-year on-the-run bonds, for instance, went from 1/32 on February 28 to more than 5/32s in mid-March to 2/32s by the end of March and lower since then. The price gap between on-the-run and off-the-run has moved back toward normal. The yield curve is down since mid-March by between 16 bp and 40 bp depending on maturity, and implied forward rates suggest limited movement for the next year or two. If there is opportunity in the Treasury curve, it’s in rising breakevens if the economy bounces more than expected later in the year.

The agency MBS market knows it can count on steady Fed support. Fed QE has brought the average option-adjusted spread on 30-year MBS down from a peak of 133 bp in mid-March to 54 bp lately, only a few basis points wide of the average of the last 20 years (Exhibit 1). The Fed has set a floor on MBS valuations.

Exhibit 1: MBS OAS has returned to the average of the last 20 years

Source: Bloomberg, Amherst Pierpont Securities

MBS still has upside from a surge in forbearance offered to borrowers by Fannie Mae, Freddie Mac and Ginnie Mae. Forbearance should materially dampen prepayments in all agencies, improving convexity and value. The situation is still fluid, but at this point forbearance stands to reach 10% in Fannie Mae and Freddie Mac MBS and 20% in Ginnie Mae, with the FHA component of Ginnie Mae possibly reaching 30%. Elsewhere in this issue, my colleague Brian Landy estimates forbearance should add between 6/32s and 34/32s to the value of different TBA contracts, with the most value coming in Ginnie Mae’s higher coupons. Go overweight MBS.

Credit markets have also felt the impact of the Fed. Spreads on investment grade and high yield debt have tightened since mid-March to levels consistent with the 2001 recession and well below the 2008 recession (Exhibit 2). This has helped trigger record issuance in investment grade and high yield debt. The $300 billion in net investment grade issuance has already matched the annual numbers from 2018 and 2019. The $128 billion in net new high yield debt, helped by a heavy supply of fallen angels, has exceeded any full year since 2013. Although supply normally might limit potential for tighter spreads, in this market it signals a healthy build-up of cash for companies that will need it to weather economic uncertainty. Access to liquidity has made most of these issuers better credits on balance.

Exhibit 2: Corporate spreads have returned to recession levels

Note: The ICE BoA US Corporate Index referenced IG debt. Source: Federal Reserve, Amherst Pierpont Securities

All of the response in credit markets comes before the Fed has even fully deployed the different facilities intended to support corporate balance sheets. The Primary Market Corporate Credit Facility and the Secondary Market Corporate Credit Facility have not taken their first dollar of risk. At this point, it is not even clear the facilities will take substantial risk since the market has volunteered all the liquidity that borrowers want. Again the Fed has set a floor on corporate valuations.

The market is just starting to see the outlines of potentially the Fed’s most significant effort to support credit, the Main Street loan facilities. These facilities would make the Fed a direct lender to smaller but more highly leveraged companies. More than half of the $1.2 trillion in outstanding leveraged loans meet the leverage standards of the facilities although a range of questions remain around the Fed’s ability to scale up the program, existing lenders’ willingness to take on more debt and borrowers’ willingness to accept the Fed’s terms. These programs nevertheless are likely to help the stronger leveraged balance sheets in part by encouraging banks to ramp up the flow of their own debt capital to borrowers temporarily impaired by the economic effects of COVID-19. This sets a floor on risk for the most viable part of leveraged finance.

The base case for fixed income markets looks like low rates, a steeping yield curve and tightening spreads across all but the most leveraged categories of credit. That may not mesh with the tremendous uncertainty around the path of the economy over the next year. It clearly meshes with the path of a very certain Fed.

* * *

The view in rates

The current 0.61% rate on 10-year Treasury debt implies an average real rate of -45 bp and inflation of 106 bp. Implied inflation has run slightly above 100 bp since mid-March. Futures and OIS curves continue to imply policy rates near the zero-bound into 2023. QE along with other monetary and fiscal interventions of historic magnitude should keep concerns about inflation on the market agenda and keep the yield curve biased to steepen.

The view in spreads

Spreads markets with Fed or fiscal support should continue tightening, and the impact of scarcity, broad liquidity, falling default and prepayment premia should tighten other debt sectors, too. Those markets now include Treasury and agency MBS, agency CMBS and investment grade corporate debt, a wide range of ABS, legacy CMBS and ‘AAA’ static CLOs.

The view in credit

The immediate risk in credit is from companies with high fixed costs and a sharp drop in revenue from current efforts to avoid coronavirus infection. Rating agencies have started downgrading companies and related structured products, CLOs in particular, at a record pace. Companies with the highest leverage are first in line. Until the arrival of pandemic, the consumer balance sheet has been extremely strong. The coming sharp rise in unemployment should change that, although the CARES Act could help cushion the blow. Nevertheless, delinquencies and defaults on mortgage and consumer loans have already started to climb quickly.

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