Fallen angels

‘Fallen angels’ of the bond world are getting a better reception than the disgraced seraphim in Paradise Lost. Pondering the power of the Fed, our head of fixed income Bryn Jones is reminded of John Milton’s epic poem.

17 August 2022

Can you imagine what it would be like to be cast out of heaven?

Of course, our great-great-great grandparents were supposed to have broken the rules and got tossed out of the Garden of Eden. That must mean that, deep down, we must all share a tiny fragment of that original feeling of loss, remorse, shame and pain

Yet while Eden was supposed to be akin to Heaven on Earth, surely it must slide into second place behind the great penthouse in the sky. Losing access to that must have been awful for the third of angels that were cast out in John Milton’s epic Paradise Lost. Such a great book. Lucifer convinces his mates to rise up against the Big Guy or Big Gal because he can’t take being a servant in heaven. “Better to reign in hell,” as he put it. A classic of hubris, malice, curiosity and the oh-so-human drive many of us have to make ourselves feel like the Big Dog, regardless of the reality we’re living in. Sometimes we even distort reality to make ourselves feel better! The book’s about stubbornness, too. About the empty power that disobedience gives you when you’re outgunned, and the petulance it can lead to.

Last week I mentioned that companies with tens of billions of euros’ worth of bonds outstanding are falling from investment grade credit ratings to high yield. They’ve been dubbed the ‘fallen angels’ of the bond world. Obviously many American bond issuers are becoming fallen angels too. About $120 billion of US investment grade bonds have been reassessed as high yield so far. Ratings agency S&P Global estimates a combined $640bn worth of bonds will fall into high yield in the US and Europe by the end of 2020. Thankfully, that’s a lot less than a third of the global investment grade market, so less pain than the original fallen angels, but at roughly 6%, not exactly great ...

Thankfully, central banks have been more merciful with fallen angels than God was in Mr Milton’s classic. The standard playbook for corporate bond quantitative easing (QE) is that when central banks create money and start buying bonds from investors in the open market, they only buy non-financial companies with investment grade credit ratings. Central bankers don’t want to help out financial firms because they get more direct support from monetary policy. And they don’t want to reward companies that played fast and loose with debt and found themselves in trouble either.

That typical stance seemed a little harsh this time round, however. It meant any well-managed companies whose credit was downgraded because the corona crisis had slashed their sales to near-zero would fall out of the QE programme. Right at the time when they need those publicly-supported lowered borrowing costs, their bonds would be dumped by many investors and their financing rates would soar. So the US central bank has amended its QE policy so that it can continue to buy companies that were investment grade before the pandemic hit. The UK and Europe have gone some way towards this generous stance as well and are expected to go further in coming weeks and months.

This has helped stabilise bond markets on both sides of the Atlantic, although the effect has been much more dramatic in the States. It comes down to the heft and the credibility of the central bank making the promises. The US Federal Reserve (Fed) hits top marks on both levels here. Yet, it’s the funniest thing. While the Fed has pledged to buy US debt hand over fist, sending US corporate bond prices soaring, it is yet to actually buy a single bond.

What I didn’t mention before was that the Fed has never before bought corporate debt (it only bought government bonds and mortgage-backed securities), so this is a massive first for the institution. The playbook for corporate bond QE purchases was written by the European Central Bank and the Bank of England. As much as we may think of them as omniscient and all-powerful, central banks aren’t God. The Fed is no exception. It is still trying to sort out the complexity of its corporate bond purchases. It has said that it should be able to buy fixed income ETFs sometime within the next week or so. But JPMorgan credit analysts believe the Fed isn’t likely to directly buy a corporate bond till June at the earliest. So why the rapid rise in bond prices if the Fed hasn’t even done anything? That’s the power of the Fed.

I reckon we haven’t seen the last of the volatility in the credit markets – something can always pop up and spook investors. Yet, longer-term, I’m listening to Mr Milton’s counsel: never pick a fight with anyone you can’t beat … Don’t fight the Fed.



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