A Seminal Event

By David Botbol, CFA, Managing Director

A seminal event: when the Fed buys $305 million worth of corporate debt ETFs

Hallway Of The Federal Reserve Bank

On Tuesday the 12th of May 2020 – the first day of The US Federal Reserve's historic intervention in the U.S. corporate debt markets – official data shows that it bought $305 million of Corporate Debt Exchange-Traded Funds (ETFs).

The US Federal Reserve started purchasing those eligible corporate debt ETFs from investors through its $250 bn Secondary Market Corporate Credit Facility (SMCF). While the $500 bn Primary Market Corporate Credit Facility (PMCCF) will be launched in the near future. Under the latter facility, debt will be purchased directly from issuers. This seminal event makes it an interesting moment to bring clarity to the current state the US High Yield - US HY – debt market.

The best place to start: Markit CDX High Yield Index. Markit CDX North America High Yield Index is composed of 100 non-investment grade entities, distributed among 2 sub-indices: B, BB. All entities are domiciled in North America. Markit CDX indices roll every 6 months in March & September.

The 5-year CDX High Yield Index – the most liquid of the “family” - currently trades at 685 Basis Points wide, meaning:

• High Yield US debt investors are ready to pay an annual 6.85% insurance premium to insure their credit investments against bankruptcy risk

• Using ISDA assumed HY Market 70% Loss Given Default (LGD), the US High Yield Credit Market predicts that 40% of its 100-corporate universe will default within the next 5-years

  • This 40% cumulative 5-year default rate is what is implied by the high average credit spread of the 100 issuers in the CDX High Yield Index

  • To approximate how this 40% Probability of Default (PD) is computed one can use the following equation: ( LGD x PD ) / Spread Duration = Annual CDS Premium ... PD = (6.85% x 4.08) / 0.70 ... PD = 40%

To put this in perspective:

• 40% is double the amount of corporate default the US High Yield Credit Market was predicting before COVID-19 Crisis.

• 40% is also more than double the average historical amount of realized defaults of speculative-grade corporates over a 5-year cycle.

• According to S&P Global Market Intelligence’s Credit Pro, from 1981 to 2018, the realized cumulative default of speculative-grade corporates over a 5-year cycle was 16.18%.

• 3.69% for “BB+“ rated corporates

• 27.4% for “B-“ rated corporates

• 48.2% for CCC/C rated corporates

Will the dire scenario that is reflected in market prices materialize? The one thing we can be certain about is that economic uncertainty is currently very high.

David Botbol, CFA

Managing Director