Defined, normalisation means “the process of bringing or returning something to a normal condition or state”. COVID-19 has left credit markets in anything but a normal state. This current lack of normalisation is characterised by wide bid/offer spreads, lack of intermediaries preparedness to provide any liquidity at all and a significant blowing out of credit spreads (in the case of corporate credit).
In my article of last week, after a shock like the GFC or COVID-19, the contention was that credit markets need help and time to normalise and that the normalisation process is akin to a house: government credit markets, being the foundations of corporate credit markets, need to normalise first, and then corporate credit markets, investment grade (IG) and sub IG, normalise thereafter. Normalisation can be given a hurry up and central banks are not averse to this in government credit markets as we have recently seen in most Western democracies.
Having stepped into US Treasuries, mortgage backed securities (MBS) and IG corporate bond markets, the Federal Reserve (FED) has really brought out the bazooka by even stepping in to buy sub IG, BB rated, corporate bonds as well as Exchange Traded Funds (ETFs) holding sub IG bonds. Support for these markets are part of the FED’s USD 2.73 trillion emergency funding to main street businesses, municipalities and credit markets over and above “doing whatever is takes” in US Treasuries and MBS. Sub IG buying is not unprecedented: the European Central Bank owned 4% of Eurozone BB rated corporate bonds. The clear rationale for intervening in BB corporate bond markets is not so much to provide beneficial interest rates to BB issuers, but to enable sub IG corporates to obtain funding most likely in the absence of other alternatives and a potential default with an obvious implication for unemployment. Interesting question: who gets FED participation in BB issues and who doesn’t?
Graphs are most instructive. From below you can see the BofA US High Yield Index Option-Adjusted Spreads.
Download the Deloitte Corporate Bond Report
There has been a dramatic contraction in spreads. Similarly for the Australian iTraxx (you’ll recall 25 IG Australian issuers).
Normalisation of credit markets is inevitable, albeit in the medium term ,with primary issuers needing to accept higher credit margins. Overtime those margins ought reduce.
FIIG is steadily building its primary issuance pipeline with a handful of transactions in pre-issue phase. With curves flattening and the world now thinking about going back to work, we ought to see corporate credit markets normalising sooner rather than later.