Fed’s Actions Overshadow Jobless Claims

Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

For the second week in a row, new jobless claims of 6.6 million well surpassed Wall Street consensus. Over the past three weeks alone, new jobless claims total 16.6 million, representing approximately 10% of the U.S. workforce. However, all of the attention across the U.S. markets this morning was centered around the Federal Reserve's announcement that it created new lending programs and was expanding its existing facilities to be able to provide up to $2.3 trillion worth of loans to support the economy. We had recently reviewed the existing programs in "Fed Initiatives Show Signs They're Working as Intended."

Among the new programs, the Fed will loan up to $500 billion to state and local municipalities by leveraging a $35 billion contribution from the Treasury. The Fed also acknowledged that there had been a disruption in the normal liquidity and trading levels for municipal bonds and noted that it will monitor that market and, if warranted, will develop additional measures to intervene in the municipal-bond market.

In order to assist its efforts for small businesses, the Fed will provide term financing to those banks that are originating new loans under the SBA’s Paycheck Protection Program. For medium-size companies, the Fed will utilize a $75 billion equity contribution from the U.S. Treasury to provide up to $600 billion of loans through the Main Street Lending Program. The Main Street facility will offer four-year loans with principal and interest deferred for the first year to companies with up to 10,000 employees or with revenues of less than $2.5 billion. In order to obtain these loans, companies must commit to making reasonable efforts to maintain payroll and retain workers and will be subject to the same restrictions that apply to direct loans under the CARES Act.

Among the existing facilities that the Fed is expanding, the TALF program, or Term Asset-Backed Securities Loan Facility program, was expanded to now include the AAA rated tranches of both outstanding commercial mortgage-backed securities and newly issued collateralized loan obligations. More important for individual investors, though, was that the corporate bond purchasing programs were revised to now include below-investment-grade bonds. The definition of eligible issuers was changed to include those issuers that were rated investment-grade as of March 20 but that have subsequently been downgraded to high yield, so long as they are still rated at least BB-/Ba3. In addition, the Fed changed the definition for eligible ETFs to include those whose objective is to invest in high-yield corporate bonds.

One of the overhangs in the corporate bond market has been that there is an estimated $600 billion worth of debt rated BBB-, which is only one notch above junk. That compares with the $1.2 trillion worth of existing high-yield debt. If a considerable amount of these BBB- rated bonds are downgraded, that volume of new supply as compared with the amount of existing high-yield debt outstanding could cause spreads to widen meaningfully across the high-yield sector.

Many of the existing BBB- rated bonds were issued to pay for debt-funded acquisitions, which increased the amount of leverage on the balance sheet. For a significant number of these transactions, the debt leverage was higher than typical for a BBB- rated bond, but the rating was predicated on the assumption that these firms would quickly be able to deleverage by improving operating margins with synergies from the acquired company and paying down debt with cash flow. However, with the economy in a tailspin, these assumptions will need to be re-evaluated by the rating agencies. The market is concerned that the high-yield sector will be swamped by a wave of fallen angels (bonds of issuers that were rated investment-grade that have been downgraded to junk).

The expansion of the Fed's corporate bond purchasing facilities should help alleviate much of the pricing pressure in this segment of the corporate bond market. Both investment-grade and high-yield exchange-traded funds surged higher at the open this morning. For example, the iShares iBoxx $ Invmt Grade Corp Bd ETF LQD traded up over 3% and the iShares iBoxx $ High Yield Corp Bd ETF HYG traded up over 6%. Even though corporate credit spreads have tightened since we first opined that investors were being well compensated for the risk in "Corporate Bonds at Second-Widest Level in 20 Years," we continue to think that for investors able to withstand additional market volatility, now is an opportune time to rebalance fixed-income portfolios and layer in additional corporate credit fund exposure.

As measured by the Morningstar US Market Index, the equity market opened higher, and we continue to see significant value for investors. Across our equity coverage, the ratio of the price to fair value for the median stock under our equity research group's coverage is 0.88 as of April 8. While the ratio had been as low as 0.70 when the markets bottomed out on March 23, we continue to see significant value in the equity markets. For specific investment ideas, visit our page dedicated to the coronavirus impact on the markets and economy.

Disclosure: This article has been written on behalf of Morningstar, Inc. and is not the view of DBRS Morningstar.