How extraordinary monetary policy is reshaping credit markets

As the U.S. Federal Reserve (Fed) continues to launch extraordinary policies to shore up fixed income markets, investor interest in credit is picking up. Nearly 40% of institutional investors that are adding risk are prioritizing credit, according to polling results from our weekly Market Pulse call on April 9.

On the call, Mike Pyle, Global Chief Investment Strategist for the BlackRock Investment Institute, discussed the outlook for credit broadly, opportunities within investment grade and securitized markets, and the recently expanded Term Asset-Backed Loan Facility (TALF) with Jimmy Keenan, Chief Investment Officer and Global Co-Head of Credit; Stephan Bassas, Lead Portfolio Manager for US Investment Grade Credit; and Samir Lakhani, Co-Head of the Securitized Assets Team.

Highlights of their discussion follow.

The economy is being driven by two opposing forces, a near total shutdown in activity and a record amount of stimulus. How can we expect this to play out in credit markets?

In the short term, the magnitude and breadth of the fiscal and monetary response is very impressive and very supportive of the overall credit markets, and that has helped to dampen some of the initial volatility that we saw.

From a medium-term standpoint, looking out the next six to twelve months, we expect to see more volatility come back into the market. As the economy starts to open up, the recovery is going to vary dramatically by region, by industry and by individual company, and that’s going to create both opportunities and volatility within credit markets.

Looking broadly across credit markets, what types of opportunities do you see emerging?

The extraordinary amount of stimulus that will ultimately be required to combat this crisis is going to have a significant impact on the aggregate leverage on government balance sheets and global central banks. While the stimulus is necessary in the short- to medium-term, it is probably deflationary over the long term. It’s going to place limits on broader expansionary policies and will probably reduce global growth. And that will lead to long-term pressure on global rates, likely keeping them anchored closer to zero for a very long time.

Against that backdrop, we see long-term value, broadly speaking, across both the investment-grade (IG) and high-yield markets, even though both markets have moved significantly off their lows. High yield, for example, was factoring in a 50-60% cumulative default rate over the next five years, which was overly pessimistic given the current environment and policy response, we believe. But, as we said, there is likely to be significant dispersion in returns as the economy restarts.

What themes are driving the IG market specifically and where is that creating opportunity?

The first big theme is the impact of the Fed. The Fed is trying to normalize investment grade corporate term structures, and there are opportunities to take advantage of that normalization. We think the Fed is sending the signal that a lot of the temporary drawdown in cyclical cashflows can be bridged, but we still see a lot of securities that are priced as if they will be crossing over into high yield when, in fact, they are very capable of staying investment grade. We believe that some of the cyclical and cross-over securities are still providing a decent amount of upside, and we find value in triple Bs relative to double Bs.

We also think that due to the way the Fed has engineered its recovery programs, there will be less supply of long-dated securities, which can be very attractive to long-dated investors and liability managers. We’ll probably see more of that financing happen in the five- to seven-year part of the curve, which should lead to increased scarcity at the back end of the curve.

The second theme, and we alluded to this earlier, is that we think interest rates are going to stay low for longer. But low interest rates have unintended consequences for certain rate-sensitive industries—for example, life insurance—so there are a number of industry trends that we believe we can capture here.

What is happening in securitized markets, particularly with the expansion of the TALF program?

We were very involved in securitized markets back in 2009 when the original TALF program was enacted, and there are a few lessons we learned that are applicable now. One is that you have to be quick to capitalize on the opportunity. So, we want to take the same approach today, which is to be early and to target the specific parts of the asset classes that still offer value.

That said, spreads in many securitized markets were hundreds of basis points wider in 2009 than they are today, so the opportunity set is different. Some of the plain vanilla TALF-eligible instruments don’t look particularly compelling. Instead, we are looking farther afield in areas like private student loans, large-equipment transactions, and parts of the triple A CMBS market and the static triple A CLO market.

The other lesson we learned from 2009 was that policy didn’t just heal the directly targeted instruments, it also helped other, more subordinate securities to rally in the shadow of the directly targeted securities. So as we look forward, we’re trying to build a robust portfolio of not only the TALF-eligible assets at the top part of the capital structure, but also areas that have been dislocated in subordinated CMBS, non-agency RMBS, and CLOs, that should follow suit.