As most of us are probably aware, the stock market crashed in early 2020 due to uncertainty and fear surrounding COVID 19 with the S&P500 dropping almost 47% from the 10th of February until the 16th of March (S&P500´s bottom point in 2020). However, fixed income market was quite under looked back then and the fact that it dropped is surely a problematic event. It meant credit wasn’t flowing like it is supposed to. There was no incentive for indebtedness, but there was instead an urge for liquidity, so the economy would “suffocate”.
A climate of uncertainty and a negative outlook for the global economy caused credit spreads to wide too much. “According to Reuters, spreads on investment-grade credit widened to 303 points on Wednesday (18th of March), up from 101 at the start of the year and the highest recorded since July 2009.” There are three main reasons this happened:
- Riskier Cash Flows – Almost all economic activity stopped and as demand for bonds and other fixedincome products decreased as well, credit spreads rose to mitigate that effect (riskier assets have higher yields to be attractive to investors).
- High demand for liquidity -“Interest rates are the price for liquidity, and greater demand leads to higher prices
- Investors needed cash – As some investors levered themselves to buy financial products, they needed cash to compensate for some risky investments and cover up losses. So, they sold their most liquid assets like treasury bonds, causing their price to fall, so yields increased.
Wider credit spreads designate an increase in interest rates, so the cost of debt is higher, and people won´t leverage themselves. Because of that, consumption decreases even more and there is almost no incentive to start a business and invest money. That´s why the Fed and other Central Banks had to urgently intervene, with the main objective of stimulating the economy through policies to decrease interest rates
Now let´s analyze the US Treasury Debt market to understand more in-depth how fixed income transactions were heavily disrupted by the pandemic. We will look at US Treasury debt because its yield serves as a key benchmark for many other financial assets. Treasury debt yield is considered a “risk-free” rate since it is a safe and liquid asset, so it is used as collateral in trillions of dollars of loans. It is a “rainy day asset” because of these characteristics, which imply it is easy to sell treasury debt and secure some cash in turbulent times.
However, liquidity seemed to “disappear” in early 2020 because investors were rushing to sell US debt to buy depressed equities, or to pay for its liabilities for example. The point is, everyone urged to scramble some cash and the market didn´t handle it. It was hard to secure even moderate-sized transactions, transaction costs increased, and pricing became very difficult because of the market´s volatility, which reached the levels of the last financial crisis. To sum it up, credit wasn´t flowing at all, and to try to save the economy the Fed stepped in to try to stabilize the Treasury Markets(which would have its positive effects in global fixed income markets, stimulating the economy). Fed´s policies included providing unlimited cash in short term loans (collateralized by Treasuries), purchased trillions of securities, especially Treasury and mortgage-backed securities. Also, the Federal Reserve eased leverage ratios of large banks so economic transactions could flow. These measures seemed to have worked because spreads returned to normal.
To conclude this article, I think it’s fair to say the fixed income market collapsed just like the stock market, but it didn´t have enough attention and commentary surrounding it in my opinion. The difficulty in selling US debt, which is usually a liquid and safe asset, was a sign there were bigger problems than just the stock market. Creditwasn´t flowing since liabilities couldn´t be paid and no one was asking for a loan in such uncertain times. Luckily, the Fed stepped in acting as a strong demand driver for debt securities, which seemed to have worked because credit spreads went back to normal.
This article is in our October Newsletter 2020
Pedro Santos, BSc in Economics