by Bryan Perry

August 18, 2020

On June 29, CNBC reported that the Fed disclosed that it had purchased bonds in speculative-grade companies as well as junk bond ETFs, including the SPDR Bloomberg Barclays High Yield Bond ETF (JNK), a fund in which the Fed reported holding a $412 billion position as of seven weeks ago (June 30).

When this data was released, nary an eyebrow was raised, nor was much media mention made of it; but relative to the size of the junk bond market, this position is very significant. This is akin to the Fed going “whole hog” into junk bonds, and with unprecedented speed. The main motivation for this swift and unprecedented action from the Fed was what they must have deemed a market about to fully lock up.

On March 23, the day the market bottomed, the Federal Reserve announced the launch of their Primary Market Corporate Credit Facility (PMCCF) and Secondary Market Corporate Credit Facility (SMCCF), allowing them to buy up to $750 billion of corporate bonds and corporate bond exchange-traded funds.

The SMCCF officially began buying ETFs on May 12th and individual corporate bonds on June 16th. After the investment grade corporate bond market fell by 16% from peak to trough and the high yield market plunged by 22%, the Fed stepped in with full force to stop the hemorrhaging in the bond market.

Bond Markets Graphs Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

This is a big deal because, as of early April, it was reported that the junk bond market in the U.S. was valued at nearly $1.2 trillion. After growing rapidly over the past 10-15 years, high yield bonds now comprise roughly 15% of the overall corporate bond market, which is estimated at roughly $8.1 trillion, trailing the U.S. Treasury market ($12.7 trillion) but eclipsing the municipal bond market ($3.7 trillion).

The appetite for yield coming into 2020 was running high, even as the junk default rate in 2019 rose to 3.3%, the highest level in three years and well above the non-recession norm of 2.4%, according to Fitch Ratings. Those defaults amounted to $38.6 billion, a 32% surge from 2018. Energy, which had a default rate of 9.5%, was well above the 4.4% norm, although below the all-time peak of 19.7%, set in January 2017. Energy is the largest high-yield sector, although its share of the market is diminishing over time.

More concerning, the share of BBB bonds that were downgraded to below an investment-grade rating has been on the rise since 2019. As of June 16, 2020, 5.2% of the S&P U.S. High Yield Corporate Bond Index came from the S&P U.S. Investment Grade Corporate Bond BBB Index, the highest since 2009 and 2016. These fallen angel bonds from the BBB rating alone have added $88 billion of supply to the high-yield bond universe so far this year.

High-Yield Bonds That Transitioned from BBB Rating Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

According to Citigroup, U.S. credit-rating firms have downgraded $144 billion of bonds from investment grade to junk, with some projecting at least $200 billion total in downgrades over the course of 2020, this bigger number being reported by Citi implying billions of bonds being dropped from single A or higher straight to junk status, thereby bypassing a BBB rating altogether.

While the stabilizing forces of the Fed have supported and fomented a rebound in high yield prices, BlackRock notes that some longer-term “fallen angel” projections are as high as $700 billion – and BlackRock is the Fed’s primary corporate bond broker. Most of these dire predictions occurred before June, when coronavirus conditions were looking pretty bleak.

History shows that “fallen angel” spread-widening typically occurs well ahead of any rating downgrades, so investors that are invested in high-yield should pay close attention to this potential canary-in-the-coal-mine scenario. Current market sentiment is fully of the view that the Fed’s “QE Forever” policies will provide whatever liquidity is required to sustain the credit markets.

Fallen Angel Bonds Bar Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

I don’t think the markets have priced in those businesses whose swelling debt loads going into the pandemic were not built to withstand such an economic shock – which for many companies will suffer long-term impact from the virus. The positive news is that with interest rates at historic lows, the opportunity to refinance current debt via new bond offerings could be the golden goose for cash-strapped companies that need time to get beyond COVID-19.

If there is a sweet spot in the high yield market, it lies with the fallen-angel bonds found in funds like the VanEck Vectors Fallen Angel High Yield Bond ETF (ANGL) that sports a 5.06% current yield and pays out dividends monthly. Average duration is 6.2 years with the average yield to maturity at 5.96%, meaning that most of the 329 issues it holds within its $2.8 billion in assets trade at a slight discount to par. When economic growth is restored, those fallen angel BB bonds could easily regain their BBB investment grade status, where the average yield is around 2.9% when using the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) as a comparable asset. If so, closing the spread between ANGL and LQD would imply price appreciation for shares of ANGL.

Treasury and investment grade bond markets look priced to perfection with some bloom already coming off the rose last week. The broader high yield market, represented by the biggest ETF, iShares iBoxx $ High Yield Corporate Bond ETF (HYG), yielding 5.05%, is also in my view priced to perfection as 42.2% of the fund is rated below BB.

If there is an upside trade left in the universal corporate bond market, it likely exists with the BB fallen angels.

I have no position in any of these funds, but if I did, it would likely be the one with Angel wings…

All content above represents the opinion of Bryan Perry of Navellier & Associates, Inc.

Please see important disclosures below.

Also In This Issue

A Look Ahead by Louis Navellier
A Weak Dollar is Generating a New Round of Inflation

Income Mail by Bryan Perry
It’s High Noon for High Yield Bonds

Growth Mail by Gary Alexander
Sleep Better with “Rip van Winkle” Investing

Global Mail by Ivan Martchev
Could Mortgage Rates Go Lower Than the Last All-time Low?

Sector Spotlight by Jason Bodner
Jesse’s Secret: Sitting on Your Winners

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About The Author

Bryan Perry

Bryan Perry

Bryan Perry is a Senior Director with Navellier Private Client Group, advising and facilitating high net worth investors in the pursuit of their financial goals.

Bryan’s financial services career spanning the past three decades includes over 20 years of wealth management experience with Wall Street firms that include Bear Stearns, Lehman Brothers and Paine Webber, working with both retail and institutional clients. Bryan earned a B.A. in Political Science from Virginia Polytechnic Institute & State University and currently holds a Series 65 license. All content of “Income Mail” represents the opinion of Bryan Perry

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