Last week saw withdrawals of nearly $56 billion from taxable bond funds, the next highest weekly outflow was just over $15 billion in 2015. Most of these outflows came from corporate bond funds, as investors began to doubt that some corporations will be able to continue servicing their debt over the near-term. Corporate balance sheets were encumbered by record high levels of leverage coming into this crisis, enabled by a prolonged period of record low interest rates. Additionally, half of investment grade debt outstanding was rated BBB, the lowest rating considered to be investment grade and one downgrade away from being labeled high yield or “junk”. In November 2019, the Federal Reserve noted the following in its Financial Stability Report about the extensive amount of BBB debt, “In an economic downturn, widespread downgrades of bonds to speculative-grade ratings could lead investors to sell the downgraded bonds rapidly, increasing market illiquidity and downward price pressures in a segment of the corporate bond market known already to exhibit relatively low liquidity…” Well, the economic downturn is here, and bond market participants are preparing for this scenario to play out. Last week, we saw many investment grade corporate bond funds underperform their high yield peers as investors began to speculate on widespread credit rating downgrades coming from ratings agencies. This highlights some structural market illiquidity concerns and why the possibility of a massive wave of downgrades has spooked bond market participants and induced widespread selling.
Moreover, the stress within bond markets has exacerbated the liquidity and volume differences between fixed income ETFs and their underlying holdings. These differences in trading volume have resulted in wide dislocations between price and underlying net asset value of fixed income ETFs. For instance, on March 12th, the ishares iBoxx Investment Grade Corporate Bond ETF (LQD) traded 90,000 times while its top five underlying holdings traded an average of 37 times. As a result, LQD closed the day at a price 4.5% below its fair value as measured by net asset value. In other words, the ETF is worth less than the basket of securities it represents. The market price of ETFs such as this normally reflect the net asset value of the underlying bonds, with minimal premiums or discounts to that value. The chart below illustrates another example of a significant discount seen between market price and net asset value for Vanguard’s Total Bond Market ETF (BND).
Since these ETF’s trade with meaningfully more frequency than the underlying holdings, their current market prices are seen as a leading indicator of where the underlying bonds should be trading given the current environment.
The issues discussed thus far are just a few reasons for the massive amount of stimulus coming from the Federal Reserve. To date, the Federal Reserve has announced or undertaken multiple measures aimed at providing ample market liquidity, ensuring businesses have access to capital, and easing financial conditions. As part of this stimulus, the Fed announced they would be re-launching their quantitative easing program, which seeks to increase the money supply and lower interest rates by purchasing a variety of debt securities. Initially, the program sought to purchase $700 billion in assets, but recently they effectively removed that upper limit by stating they would purchase assets, “…in the amounts needed to support smooth market functioning and effective transmission of monetary policy to broader financial conditions and the economy.” Furthermore, they have established several asset purchase facilities that will act as the counterparty to trades involving government debt, agency mortgage-backed securities, municipal debt, investment grade corporate debt, and other securities. These facilities aim to inject some much-needed liquidity into debt capital markets to ensure they continue to function properly, addressing the liquidity/volume dislocation discussed above. Earlier this month, the Fed cut their target range for the Federal Funds rate to 0%-0.25% to ease servicing costs on newly issued debt and to encourage borrowing. Finally, on Monday of last week, the Fed made the unprecedented decision to extend credit directly to U.S. businesses to make sure they survive this crisis. The Fed is now acting as the lender of last resort to the real economy as opposed to just the financial system, reflecting the gravity of the shock the U.S. is facing. Ultimately, the amount of stimulus needed to keep the financial system afloat and properly functioning through this crisis is unknown, which is why the Fed is throwing the full weight of their resources at these issues. However, the tools being implemented, and the measures being taken are to mitigate the fallout rather than directly address the economic crisis. Therefore, the market is primarily fixated on the recently passed fiscal stimulus, which will have a more direct impact on the real economy.If you still have questions or concerns regarding this topic, reach out to our retirement plan team experts—we would be happy to help.