Fixed Income and Structured Products

In light of COVID-19 related market dislocations, SIFMA Research tracked daily market metrics (rates, spreads, indexes) across various fixed income and structured products markets, as well as issuance trends. This report is the culmination of that work, analyzing market trends from the start of the year through mid-June.

• Market performance has been a mixed bag, varying by asset class & across subcategories within
• One commonality is that improvement in market fundamentals is directly linked to Fed operations
• Peak issuance $3.3T in April, +126% to 2019; long-term issu. $1.0T each in March/April (+51%/+50%) 

Setting the Scene

Background

The emergence of the global pandemic COVID-19 in the first quarter of 2020 caused severe economic and capital markets shocks. In an unprecedented move, federal, state and local governments purposely shut down economic activity to prevent the spread of the virus. Everything from restaurants to theme parks to manufacturing plants closed, and people holed up in their homes. The world as we knew it stopped. By April, economic statistics painted a bleak picture. The U.S. lost over 23 million jobs, with the reported U3 unemployment rate at 14.7%, according to the Bureau of Labor Statistics (BLS). The U6 statistics¹ provided a more accurate, yet more negative, measure of true unemployment: over 36 million unemployed, 22.8% unemployment rate.

Then the May unemployment report provided a surprise to the upside. Total nonfarm payroll employment rose by 2.5 million, and the unemployment rate declined to 13.3%. Many states had reopened by June. However, we are not fully out of the woods. In June, Federal Reserve (Fed) Chairman Jerome Powell tempered investor enthusiasm when he indicated that interest rates would remain near zero through 2022, citing continued economic uncertainty. And now we are experiencing a resurgence of the virus in several states/cities/counties.

This report analyzes market trends from the start of the year through June 15. The COVID-19 led economic and market shocks created enormous one-way flows from risk to safe assets, and the flows were beyond the capacity of the financial system. The volatility was exacerbated by dealer balance sheet constraints, caused by post global financial crisis regulations, which limited balance sheet capacity and the ability to fully support customers under extreme market stress and to act as an intermediary between the official sector and the economy. This created substantial liquidity constraints in many fixed income and structured products markets. The early signs of the market turmoil began in the first few weeks of March in the repurchase agreement market (repos; used to aid secondary market liquidity for the cash markets like U.S. Treasury securities/UST and provide funding to dealer market making operations). The secured overnight financing rate (SOFR), a reference rate for the U.S. based on the overnight repo markets, moved outside of the fed funds rate range, a rare occurrence and a sign of stress in the repo markets.

Then, the UST market started to show liquidity stresses, particularly in longer dated (10-year, 30-year) and off-the-run securities. In a flight to safety move, investors moved into the short end of the UST curve – these instruments are considered the closest financial assets to cash – from the long end, draining more liquidity from longer-dated securities and causing a spike in longer term interest rates. Stresses spread into the mortgage-backed securities (MBS) space. All sectors of MBS and asset-backed securities (ABS) experienced significant stress in March and April. The turmoil continued to flow into corporate bonds (corporates), particularly in high yield instruments, and municipal securities (munis). Essentially, all risk assets in the fixed income space showed illiquidity and weak demand. And the commercial paper (CP) markets froze, limiting access to another source of short-term funding.

¹ Unemployed plus all persons marginally attached to the labor force and total employed part time for economic reasons

Where Are We Now?

• Rates and Repo: The functioning of the Treasury market, including Treasury repo, has improved considerably since mid-March. In a sign of the improvement in the repo markets, the Fed discontinued three month repo operations, specifically citing more stable conditions (continuing overnights every day and one-month repos once a week).
• MBS and ABS: The MBS and ABS recovery has been uneven across segments. Direct purchases by the Federal Reserve (Fed) calmed the agency MBS market, while off-the-run, specified pools of structured products and collateralized mortgage obligations (CMO) took longer to reach equilibrium. Non-agency RMBS (residential MBS) and CMBS (commercial MBS) markets remain somewhat fragile, as dealers continue to be reluctant to take on risk. Credit risk transfer securities (CRT²), particularly the oldest vintage of transactions, still have pockets of stress, and the ABS recovery varied by sector. While these markets have calmed, not all segments have recovered fully to pre COVID-19 levels.
• Corporates: There is still stress in some areas of the credit markets, as the Fed’s latest program to purchases the bonds themselves (announced in June) is not quite operational. High yield bonds continue to show stress, while most of investment grade has recovered. Looking at issuance trends as an indicator, investment grade issuance was strong in March through May (+178% to 2019 levels on average); high yield essentially stopped in March (-85% to 2019 levels) but had recovered well by May (+60% to 2019 levels).
• Munis: In munis, the Fed programs are having an impact on the front end, while liquidity in longer dated munis remains challenged. The new issue market continues to improve, particularly for high-grade issuers. Significant large deals have been able to come to market. Demand is still thin for high-yield issuers, particularly in the secondary market for long-term bonds.
• CP: Responding to the Fed program directed at them, issuance has resumed as markets normalized (with varying trends across sectors).

To date, the COVID-19 crisis has been a liquidity event, not yet a solvency event. However, should the virus resurgence cause a mass resumption of lockdowns, and these shutdowns last longer, unemployment will remain high and we will move closer to a solvency event. Companies in highly impacted sectors could (and have) experience credit rating downgrades, which increases a company’s cost of borrowing, and potentially defaults. This would exacerbate the country’s economic stresses.

The financial system and market infrastructure have been very resilient, withstanding record high turbulence in not just measured volatility but extreme 1,000 point intraday price swings in the equities markets and extreme moves in sectors of the Treasury market. As a sign of resiliency, we point to corporate bond issuance. Issuance increased 107% to the 2019 monthly average in March ($245 billion) and then peaked in April ($316 billion, +168% to 2019 levels). And most of this occurred prior to the Fed programs being stood up, i.e. market conditions improved on just the announcement of a Fed program. Had markets not been resilient, issuance at these levels would not have occurred.

The goals remain: (1) flatten the virus curve; (2) flatten the economic decline curve; and (3) maintain stability in financial markets. But what if people don’t follow social distancing and the second wave takes over or a vaccine takes significantly longer than anticipated? We go back to square one, and we could have a second round of turmoil in the markets.

On a positive note, we have an unprecedented number of Fed programs and a Fed that continues to vow to use all of its tools to maintain market liquidity and help the economic recovery. Throughout the crisis, the mere announcement of a Fed program has been enough to aid in market recovery.

The U.S. Treasury Department and Congress followed up Fed actions with multiple phases of fiscal stimulus (ex: the $2 trillion CARES Act, including the Paycheck Protection Program) to provide liquidity to individuals, small businesses and corporations in COVID-19 impacted sectors, all to support the economy. Market participants expect another round of fiscal stimulus in July.

² Created in 2013 to transfer a portion of risk associated with credit losses within pools of conventional residential mortgage loans from government sponsored enterprises (GSE; Fannie Mae, Freddie Mac) to the private sector

Executive Summary

Market performance in fixed income and structured products has been a mixed bag, varying by asset class and across subcategories within sectors. Moving through the analysis time period of January 2 to June 15, we highlight:

• Volatility: ICE BofA MOVE Index began the year at 57.20; it peaked at 163.70, +186% to the start of the year; now at 58.09, it is 2% above the start of the year and down 65% from the peak
• Rates & Repo:
  • All UST rates have recovered but remain well below pre COVID-19 levels; short-end rates troughed at -0.105 for the 13-week & -0.088 for the 3-month (remain -1.340 & -1.364 from Jan. 2); long-end troughed at 0.521 for the 10-year & 0.967 for the 30-year (remain -1.168 & -0.882 from Jan 2)
  • The 7 UST indexes we tracked fell 0.9% at their troughs; now +6.7% from the start of the year
  • Repo rate troughed at 0.010 and remains -1.430 from the start of the year; SOFR troughed a day later at 0.010 and remains -1.450 from the start of the year
• Corporate Bonds (Corporates):
  • The 12 indexes we tracked fell 13.4% at their troughs, -0.2% from the start of the year; all high yield indexes remain below start of the year levels (now -3.7% on average vs. -18.6% at the trough)
  • CDX spreads were +171% on average at their peaks (max spread widening); remain +50% on average from the start of the year
• Mortgage-Backed & Asset-Back Securities (MBS & ABS): 3 indexes we tracked fell 0.8% at their troughs; now +3.3% from the start of the year
• Municipal Securities (Munis): All tenors of the rate curve spiked on March 20 (ex: 1-year at 2.854, +1.810 from Jan 2); while rates settled back down, all tenors are now well below start of year levels, -0.698 on avg
• Issuance trends varied by asset class as well
  • Total Fixed Income: Peak issuance of $3.3T in April, +126% to 2019 monthly average; issuance for only long-term instruments had a strong March & April, $1.0T each (+51% & +50% to 2019)
  • Increased: UST and corporates peaked in April, +148% and +168% to 2019; MBS peaked in May, +76% to 2019; and agency debt peaked in March, +121% to 2019 (but was essentially flat in May)
  • Decreased: Munis troughed in March, -47% to the 2019 monthly average; ABS troughed in May,
    -76% to 2019
  • CP: Issuance spiked in March to $90B (+13% to 2019), but settled by May ($78.5B, flat to 2019)
• Concerns around Potential Defaults: Companies in highly impacted sectors could (and have) experience credit rating downgrades, which increases a company’s cost of borrowing, and potentially defaults. This would exacerbate the country’s economic stresses. We assess outlook changes and downgrades in this section.

 

Author

SIFMA Insights
Katie Kolchin, CFA
Director of Research

Related Resources

• SIFMA Insights

  COVID-19 Related Market Turmoil Recap: Part I

  Equities, ETFs, Listed Options and Capital Formation

• SIFMA Insights

  US Fixed Income Market Structure Primer