Since the start of the COVID-19 pandemic in March, financial markets have experienced levels of disruption not seen since the Global Financial Crisis of 2008. After bid-ask spreads widened dramatically in March across a broad array of fixed income sectors—including off-the-run U.S. Treasuries!—a series of Federal Reserve programs has restored investor confidence and liquidity, and spreads have narrowed significantly.
The new Fed programs are complex, and they are wide-ranging in their scope and in the segments of the fixed income market they affect. To help institutional investors better understand these emergency measures, and how they have affected various parts of the market, Callan has developed this guide explaining the programs with significant market impact, and the status of each.
The Federal Reserve has committed to open-ended purchases of U.S. Treasuries, agency mortgage-backed securities (agency MBS), and agency commercial mortgage-backed securities (CMBS). Asset-purchase programs like these are designed to enhance liquidity within the targeted markets. So far the Fed has purchased roughly $2.2 trillion of these securities.
The Fed’s purchase of agency MBS had an immediate and measurable effect on spreads and liquidity, helping to restore confidence in this important and traditionally liquid segment of the fixed income market. Spreads for residential mortgage-backed securities (RMBS), for instance, widened significantly in March amid worries over liquidity and homeowners’ ability to make mortgage payments. The Fed’s purchases pushed yields down, helping to keep mortgage rates low and benefiting home buyers and the residential real estate market.
Spreads on agency MBS also reflected the effects of these purchases, tightening almost back to the levels they experienced at the beginning of March (as measured by the Bloomberg Barclays US MBS Index).
Primary Market Corporate Credit Facility (PMCCF): The Fed will purchase loans or bonds (as a sole investor) from qualifying companies. The Fed will also buy “fallen angels,” or bonds downgraded from investment grade to high yield after March 22. Purchases will continue through Sept. 30, 2020, unless extended by the Fed and U.S. Treasury. At this point the PMCFF is not operational.
Secondary Market Corporate Credit Facility (SMCCF): The Fed will purchase corporate bonds and ETFs in the secondary market subject to specific rules. Bond purchases are expected to create a portfolio that tracks a broad market index. Purchase amounts of both bonds and ETFs depend on market conditions, and if market dislocations return to pre-COVID-19 levels, they could stop entirely. ETF purchases began on May 12, and the first corporate bonds were purchased on June 16.
The combined size of both facilities can be up to $750 billion.
These programs are meant to maintain the flow of credit to companies to help them keep functioning and limit layoffs. Further, purchases are meant to ensure that the rates at which companies borrow remain reasonable. The mere announcement of these programs has done much to restore investor confidence. New corporate bond issuance has been robust and spreads have narrowed; the Bloomberg Barclays Credit Index is up roughly 15% since March 23. Similarly, the Bloomberg Barclays Crossover Index (a proxy for fallen angels) was up nearly 28% for this period. The index includes bonds that are “split-rated,” referring to fixed income securities that have an investment-grade rating from one ratings agency and a below investment-grade rating from another.
Term Asset-Backed Loan Facility (TALF):This program enables the issuance of a wide array of highly rated asset-backed securities, including those backed by student loans, auto loans, credit card loans, loans guaranteed by the Small Business Administration (SBA), and others. Spreads have tightened significantly since its announcement. The first subscription date for TALF program occurred June 17, on which $252 million in loans were requested. The TALF program will initially make up to $100 billion of loans available.
TALF is designed to support credit issuance in the asset-backed market, which is a critical component of the supply of credit to consumers. Investors may find risk-adjusted returns attractive for TALF-eligible securities given the low-cost loans provided by this facility. Since the announcement of the program on March 23, the Bloomberg Barclays US ABS Index has returned more than 4% through mid-June.
Municipal Liquidity Facility (MLF): The facility will purchase up to $500 billion of short-term notes directly from U.S. states (and the District of Columbia), and counties. Recently, the Fed expanded eligible entities for this facility to include revenue-generating issuers such as public transit and airports. As of June 4, the State of Illinois was the only entity to have tapped the facility, receiving a $1.2 billion one-year loan.
This facility provides funds to municipalities to help them meet cash-flow needs. Municipal bonds were under pressure due to liquidity challenges as well as concerns over the economic impact of COVID-19 on states, cities, and counties. The yield ratio, which is the yield on AAA-rated five-year municipals relative to the yield on five-year U.S. Treasuries, spiked from roughly 80% to nearly 650% in late March. As of mid-June, it was about 100%, only slightly wider than historical averages.
COVID-19 sent shockwaves through the financial markets. Worries over the depth, severity, and length of the economic downturn induced widespread selling that contributed to liquidity challenges and price declines. The Fed’s swift and broad-based announcements have made a significant impact on the fixed-income markets, and have done much to restore confidence. While the long-term success of these programs is yet to be seen, the effect on performance so far has been notable. Institutional investment portfolios have exposure to these markets. Investors should assess how their portfolios reacted to the pandemic-induced market sell-off, and how they were subsequently affected by the Federal Reserve’s actions.