Considering the recent period of extreme market volatility and economic uncertainty, investors are in need of some good news on valuations in an asset class so critical to financial market stability. This week’s chart compares credit spreads on corporate debt in the investment grade (IG) Bloomberg Barclays Corporate Index (the so-called cash bond market) relative to the IG Credit Default Swap Index (CDX). Credit default swaps are a form of credit derivatives that enable investors to express a view on individual bond issuers or a broad index of corporate credits without significant cash outlays.
The chart highlights the dramatic performance differential in the cash bond market relative to derivative credit market pricing during periods of extreme market stress. Cash bond spreads widened dramatically during the 2008/2009 financial crisis, the 2011/2012 Eurozone debt crisis and, most recently, the economic shock created by the coronavirus pandemic. On the other hand, CDX spreads exhibited significantly less volatility during these same stressed markets despite nearly identical underlying credit risks.
Liquidity risk, as opposed to credit risk, best explains the significant underperformance of cash bonds compared to CDX during these periods of extreme stress. The insatiable demand for liquidity arises from all types of investors seeking safety, with the greatest search for liquidity stemming from highly leveraged strategies forced to liquidate positions. The selling pressure often leads to even high-quality bonds being sold at distressed prices as bids evaporate for lower-quality or less-liquid assets.
The Federal Reserve (Fed)’s historic decision to purchase IG corporate debt as part of its recent quantitative easing was exactly the prescription needed to fix the liquidity-challenged corporate bond market. The new issue pipeline opened up quickly for high-credit quality borrowers. PepsiCo, one of the only issuers able to tap the new issue market at the height of the 2008/2009 financial crisis, was among the first issuers to come to market following the Fed announcement. March IG bond issuance reached record volumes as the IG corporate bond markets started to heal. Cash and derivative credit market pricing also started to normalize by the end of the month in another sign of healing during this health and economic crisis.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
Opinions and statements of financial market trends that are based on current market conditions constitute judgment of the author and are subject to change without notice. The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete. Statements that reflect projections or expectations of future financial or economic performance of the markets may be considered forward-looking statements. Actual results may differ significantly. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate.
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High-Yield bonds are subject to greater fluctuations in value and risk of loss of income and principal. Investing in higher yielding, lower rated corporate bonds have a greater risk of price fluctuations and loss of principal and income than U.S. Treasury bonds and bills. Government securities offer a higher degree of safety and are guaranteed as to the timely payment of principal and interest if held to maturity.
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