So, in rough terms, the Fed has enough firepower to purchase $4.9 trillion in corporate bonds, roughly half of all U.S. investment-grade bonds, high-yield bonds and leveraged loans combined. Given the scale of that liquidity, we can assume the liquidity premium has compressed. Therefore, if we assume investors are now compensated for a 1% liquidity premium in high yield, this implies the market is actually pricing in an 8.7% default rate for the market, slightly above our forecast. Stirring this together, we think that the market is pricing in both an elevated default rate and continued support from the Fed in the year ahead. While we directionally agree with that, it places an increased importance on credit selection to mitigate default risk today, given the skinnier cushion in spreads.
Dispersion
As of June 30, the average credit spread on the Bloomberg Barclays Global Aggregate Corporate Investment Grade and the Bloomberg Barclays Global High Yield indices was 156 basis points (bps) and 646bps, respectively. However, it is becoming more difficult to find an “average” bond. For example, less than 25% of the high-yield index trades within 100bps of the average (560-760 range). Exhibits 2 and 3 illustrate the dispersion of credit spreads across these two markets. As economic uncertainty has increased, the dispersion has widened noticeably. This distribution illustrates the market’s differentiation of the universe based on potential risks, including the risk of downgrade, default, or anything else.
We believe such a wide distribution of prices also creates opportunity for an active manager. A wider distribution can allow for the construction of a portfolio with very different risk and return characteristics than a broad index.
Global central banks have been actively supporting corporate bond markets. In the U.S., the Fed is even purchasing some high-yield bonds. This has helped create strong technical support for the market. While central banks can help to solve the liquidity issues markets were facing earlier in the year, they cannot cure solvency issues. Downgrade and default risk will remain heightened if economic re-openings are slow and uneven.
As a result, the market now reflects a risk premium that is higher and more widely distributed than last year. This creates an opportunity for strong credit research to sift through noisy data and identify companies that can weather the storm. With risk-free rates likely to remain low for the foreseeable future, the opportunity to generate income from a risk-managed credit allocation remains compelling.
Gene Tannuzzo is deputy global head of fixed income at Columbia Threadneedle Investments.