Corporate bonds

Fed must say ‘it won’t buy corporate bonds anymore’ to break ‘feedback loop’, says bond CIO

Say it, if you mean it.

Brad Tank, director of fixed income investments at Neuberger Berman, believes the Federal Reserve will have a hard time telling investors the party is over, even if it never plans to support the corporate bond market again. US $ 10.7 trillion.

“There now appear to be two types of assets in financial markets: those eligible for major central bank purchases, and those that are not,” Tank wrote in a market note to the asset manager. of $ 402 billion.

He estimates that US corporate bonds, by a number of metrics, still fall in the “eligible” camp, even though the Fed said in early June that it would start selling its nearly $ 14 billion. corporate debts accumulated during the pandemic.

Read: Is the Fed’s “tightening cycle” already underway?

Most of the central bank’s recent asset purchases have focused on US Treasury debt TMUBMUSD10Y,
and mortgage bonds from FNMA agencies,

while his balance sheet reached a record $ 8,100 billion to help stabilize the economy throughout the pandemic recovery.

A year ago, Fed Chairman Jerome Powell said the Fed was not an “elephant” roaming corporate debt markets, while insisting it was supporting to credit markets to limit the potential damage to companies facing liquidity shortages during the crisis.

But Tank still sees investors doubting the Fed’s intention to give up corporate debt for good, especially with the sector’s volatility “collapsing” over the past 15 months as the central bank backed down. launched into the purchase of corporate debt for the first time in its history.

Spreads collapsed last week to a new post-2008 low of 87 basis points on the ICE BofA US Corporate index, above the risk-free Treasury rate, as stocks sold, the dollar soared and Treasury yields fell.

The potential problem is that when “confidence grows that a price insensitive buyer is ready to support the investment grade market in the event of a sell-off, cash flow tightening, or increased volatility, we think that investors lower the price a bit. -sensitive and a little less concerned about downside risk too, ”Tank wrote.

Additionally, the more volatility remains at bay in an asset class, the more investors, including buyers using leverage, often end up increasing their allocation to a sector, he said. “Remember this is a feedback loop” where a larger buyer base can translate into even less volatility, he added.

While corporate bonds have been mostly flat, fluctuations in equities have accelerated of late, particularly in the Dow Jones Industrial Average DJIA,
which marked its best day since March on optimism about the economy on Monday, but recorded its worst weekly drop since October last week.

The rout was largely attributed to the fact that Powell signaled that the full spectrum of central bank support may not be in the cards for as long as expected, with Fed officials predicting two interest rate hikes in 2023. and noting that discussions have started on when to potentially scale back its bond buying program.

Even so, as financial markets face the possible tightening of an extremely favorable monetary policy, not everyone thinks corporate bonds will stay safe from the jitters.

“We continue to argue that no one has seen this movie before,” Hans Mikkelsen’s credit team at BofA Global Research wrote in a client note on Friday of his forecast for a modest sell-off of the bonds. quality business over the next six months, triggered by stumbles with the economic reopening or potentially a faster path to higher rates after the first rate hike.

“We expect spreads to widen to 125bp from the current level of 87bp, towards the wide range of the spread range expected for 2021 of 90 to 113bp,” the BofA team wrote of quality US bonds.

Neuberger’s Tank believes the feedback loop of low volatility and increased allocations would be difficult to derail, but not impossible.

“It’s hard to see what can break this loop beyond an explicit statement from the Fed that it will no longer buy corporate bonds (which seems unlikely, given the disruption this could cause). cause) or that the central bank lose control over inflation, ”he wrote. .