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Performing with and without a Fed net

| May 29, 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.

Take a look at asset returns since February. Government debt and other strong credits have done well, weak credits have done poorly. The performance reflects some big macro factors. The Fed has flooded the market with support for strong credits, weak credits have remained bid largely by specialized capital and subject to a highly uncertain economy. The Fed looks committed to keep supporting strong credit while weaker credits become more complex to evaluate and trade in much thinner markets. While the most leveraged pockets of the market could regain some lost ground, stronger credits look likely to continue outperforming.

Assets with Fed support have far outperformed

Assets with government support have far outperformed assets without it. Treasury debt, agency MBS and CMBS and ABS have all delivered higher absolute return with lower volatility than private CMBS, investment grade and high yield corporate debt and leveraged loans (Exhibit 1). The Fed’s willingness to buy investment grade corporate debt and it’s $3 billion in ETF purchases so far have helped, but not enough to offset earlier damage.

Exhibit 1: Assets with Fed support have outperformed assets without

Note: Data show annualized daily returns and standard deviations of daily return on Bloomberg Barclay’s asset class indices and on the S&P/LSTA leveraged loan index. Source: Bloomberg, Amherst Pierpont Securities

These stronger credits have benefited from a tremendous flow of capital. The Fed balance sheet has jumped by $2.9 trillion since February with most going into Treasury debt and agency MBS. Bank assets have also run up by more than $2.5 trillion with most going into excess reserves and PPP loans. Government money market mutual funds have seen more than $1 trillion of inflows. Long-term fixed income mutual funds and ETFs had historic redemptions in March and early April but have seen more than $70 billion of net new inflows since with investment likely to parallel the composition of broad market indices.

Almost all of these portfolios are best equipped to hold liquid, government and investment grade risk. The likely continued flow of capital into these portfolios should continue to tighten the assets that they are best equipped to buy.

The increasing complexity of weaker credits has thinned the capital base

Buying credit since February has only become more complex, and rating agency activity reflects it. Credit has weakened, compounded by an uncertain economy. Moody’s rated 4,275 high yield issues in mid-March, for instance, and 4,035 at the end of May, the difference reflecting ratings withdrawn. The share of bonds in the highest rating category, Ba1, dropped from 22% to 13% with most of those issues dropping into the next two lower ratings (Exhibit 2). The share in the lowest categories, Ca and C, more than doubled.

Exhibit 2: Moody’s has pushed the distribution of high yield bond ratings lower

Source: Moody’s, Bloomberg, Amherst Pierpont Securities

The agencies have also marked down the quality of leveraged loans, which had a much lower ratings distribution at the outset of the coronavirus crisis. Moody’s rated 2,519 loans in mid-February and 2,340 at the end of May. The share of leveraged loans in the five lowest Moody’s categories, Caa1 and below, has more than doubled (Exhibit 3).

Exhibit 3: Moody’s has pushed the distribution of leveraged loan ratings lower

Source: Moody’s, Bloomberg, Amherst Pierpont Securities

Likely default rates in leveraged finance have shifted toward levels last seen in 2009. Using Moody’s historic default rates for speculative grade companies, the shift in the economy since February and the slide toward lower ratings conservatively suggests defaults in leveraged loans will approach 7% to 8% in the next year and continue for several years at 6% to 7% annually (Exhibit 4). High yield debt, with a stronger average rating, rises at a slower rate.

Exhibit 4: Historic default rates suggest a surge in cumulative high yield and leveraged loan defaults in the next few years

Note: Data shows projected cumulative default rates based on historical defaults in Moody’s rated bonds from 1970-2019. Default rates assume a one standard deviation 5-year stress scenario for each rating category from Ba1 to C. The analysis applies the stress scenario default rates to all bonds or loans in the corresponding rating categories on 2/15/20 and 5/28/20. Source: Moody’s, NAIC, Amherst Pierpont Securities.

The most leveraged structured products have also seen broad downgrades, poor liquidity or both. Rating agencies have aggressively downgraded speculative grade classes of CLOs. ‘AAA’ and increasingly ‘AA’ CLOs have traded frequently and well with other classes trading in wide markets.

Concern about the consumer balance sheet has led to a split between stronger and weaker credit in that sector, too. Unemployment is widely expected to approach 20% in May, and displaced workers could return to work slowly if, as was common after 2008, the economy reemerges with demand for a different set of skills. Delinquencies in some new prime MBS, such as WFMBS 2020-1,have quickly exceeded subordination to ‘AA.’ As a result, the market in ‘AAA’ private MBS has traded well and tightened while lower rated classes in many sectors, such as RPL, have seen almost no trading outside of distressed levels in March and early April.

Sensitive to an uncertain economy

The path of the economy has also complicated credit analysis since the most leveraged balance sheets, whether corporate or household, are most sensitive. The course of the coronavirus remains unclear, the willingness of different parts of the US to return to business-as-usual is unclear, and the economy is also subject to renewal of unemployment benefits, support for small businesses and eviction and foreclosure moratoriums set to expire through the summer.

Explore less liquid but fundamentally sound cash flows at wide spreads

The near term should continue to favor assets where the Fed, banks, government money market and fixed income mutual funds are best equipped to invest. The less liquid parts of these markets would be the first place to go since liquidity is almost sure to keep flowing in. In agency MBS, for example, that could include 15-year pass-throughs, ARMs and HECM MBS. In investment grade credit, that would include smaller issues that do not fall into broad indices. Some assets that border the strongest markets, such as the stronger parts of high yield or parts of structured products below ‘AAA,’ should get a lift from investors forced out of their usual habitat to find better returns elsewhere.

There is good return in assets that have to keep performing without a Fed net, but it is likely to be illiquid. The best return is the return to the information and expertise needed to parse corporate and consumer balance sheets. For example, investors can find corporate balance sheets with relatively low leverage, good margin and enough liquidity to last through coronavirus or pivot their business model in the meantime, but these balance sheets nevertheless get low ratings because the company is small relative to investment grade peers. Investors can find private MBS with high delinquencies but ample borrower equity. These assets are likely to remain underbid until fundamental performance bears out the credit and makes them a candidate for the portfolios of banks, insurers and mutual funds.

* * *

The view in rates

The rates market remains in the hands of the Fed, and the Fed has convinced the market it will keep rates low for years. Fed funds futures and OIS implied forward rates now see Fed policy near the zero-bound through the end of 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 current 0.65% rate on 10-year Treasury debt implies an average real rate of -51 bp and inflation of 116 bp. Implied inflation has run above 100 bp since mid-March.

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 neighboring debt sectors. 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. Asset with a Fed net should continue trading at generally wide spreads for now.

The view in credit

Discount pricing in leveraged loans, rating agency downgrades in that market and rising bank loan loss reserves signal a wave of distressed credit. Rising unemployment and delinquency rates in assets from MBS to auto loans show pressure on the consumer balance sheet. The course of leveraged corporate and consumer credit also depends on renewal of CARES Act unemployment benefits and support for small businesses, along with moratoriums on eviction and foreclosure.

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