Commentary on Political Economy

Sunday 17 January 2021


Jenga-like structure builds in credit markets

In the US, the Federal Reserve’s historic decision to begin buying corporate bonds boosted investor confidence and opened the floodgates to new lending © Marcos Alvarado/Alamy

For one influential watcher of the credit world, conditions in the corporate bond market are starting to look unnerving.

Matt Mish, who heads up UBS’s credit strategy team, likens the current state of the market to a tower of Jenga blocks. At the moment, crucial support is being provided by central bank buying across the globe, holding borrowing costs low and providing a backstop if investor demand falls. As that support is removed, piece by piece, the tower could begin to wobble.

“At some point, investors are going to realise that the Jenga puzzle is losing more and more pieces,” said Mr Mish. “It doesn’t mean the tower will definitely collapse but it has the potential to create more volatility.”

Bankers say that, while the topic may not pose an immediate risk, it is beginning to crop up in conversations with clients. How do central banks gently pare their commitment to support credit markets, and what happens if they fall short of it?

“The optimism priced into the market is substantial,” said Mark Lynagh, co-head of European debt markets at BNP Paribas. “It is very much driven by central bank support and an assumption that it will continue in parallel to a successful vaccine rollout. If there is an underwhelming aspect to any of that, it poses a risk to the credit market.”

In the US, the first Jenga block to be taken out came at the end of the year, with the wind-down of the corporate credit facilities that had come to the market’s rescue during the worst of the coronavirus-induced sell-off in March. The US Federal Reserve’s historic decision to begin buying corporate bonds bolstered investor confidence and opened the floodgates to new lending, allowing companies to plug the holes left by the economic downturn with fresh debt. 

Despite the facilities’ withdrawal, the tower remains standing, with average yields on both investment-grade and high-yield bonds remaining at or around record lows. 

The second support to be removed is expected to be a tapering of the Fed’s purchases of government bonds, to begin as early as this year, according to some predictions. Fed chair Jay Powell said this week that the central bank must be “very careful in communicating about asset purchases” because of the sensitivity among investors about the removal of support for the economy. Whatever the Fed does not buy will need to be bought by other investors and more supply, all else being equal, tends to mean lower prices and higher yields. 

When rising Treasury yields are tied to inflation, it is typically no bad thing for corporate bonds. Higher inflation erodes the value of outstanding debt and often indicates higher growth, supporting companies’ ability to repay it. However, rising real yields, which account for any inflationary effects, are an indication of higher borrowing costs for corporates. There have been glimpses of this already this year.

Still, corporate bond markets have largely not flinched. Many investors remain assured that the Fed will step in should markets falter again, bolstering appetite to buy corporate debt. Ending the corporate credit facilities is of little consequence in the current environment, so long as the Fed is willing to reintroduce them if needed. Rising real yields are less of a threat if the Fed will loosen policy again, should it come to that. 

By moving so swiftly and decisively in March, the Fed has created the assumption that it will do so again. This week, in response to signs that investors might be pricing in tapering this year, Mr Powell assured the market: “Now is not the time to be talking about exit.”

The situation is akin to the challenge faced by Fed chair Ben Bernanke after the 2008 financial crisis. In 2013, after multiple rounds of quantitative easing, the suggestion that the central bank might begin to reduce support in the future caused a sharp move higher in Treasury yields.

In the background, the Fed’s ability to repeat the actions it took last year is already being curtailed. As part of December’s relief package, the central bank is prevented from reinstating the corporate credit facilities without Congress’s approval. It means that even if the Fed maintains that it will do whatever it takes to support market functioning, the reality may be harder to implement without the support of lawmakers.

“Most investors think that the programmes could be reintroduced,” said Mr Mish. “But it’s not clear they will have the same punch.”

In turn, if the view that the Fed is less able to provide a backstop to credit markets becomes more widespread, then a reassessment of the risk of lending to companies without it will quickly follow. 

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