Central Bank Liquidity Induces iRate Roid Rage
This year, for the first time since World War II, the United States will owe more than its economy can produce¹. This is because in response to the COVID-19 crisis, the US Federal Reserve (the “Fed”) lowered its policy rate back to near zero and introduced liquidity through a series of credit facilities, such the Money Market Mutual Fund Liquidity Facility
, the Primary Dealer Credit Facility
(bond issuance) and the Commercial Paper Funding Facility
(short-term “line of credit” draw down funding), to support the flow of insolvency prevention credit to households and businesses. Subsequently, the Fed launched the Secondary Market Corporate Credit Facility
so it could also act as a liquidity backstop by buying certain issued corporate bonds in the secondary market, adopting a “whatever-it-takes”
stance inclusive of investment grade right down to junk issuances.
Within three months of its expanded mandate, the Fed added $3.0 trillion to its balance sheet, compared with ~$1.3 trillion in Q4 2008.
Despite recent positive results from clinical trials of COVID-19 vaccines, the US Center for Disease Control and Prevention
explains that there may not be enough doses for all adults until late 2021 and young children may need to wait until more studies are completed. Therefore, a return to pre-pandemic GDP output will likely be uneven and slow. The downward force on interest rates will persist for a very long period of time as we described in our prior publication
. Stephen Poloz, former Governor of the Bank of Canada said more recently, “current low interest rates may last a generation
The markets research firm, FACTSET, in its November 6, 2020 report
forecast an earnings decline for the S&P 500 companies of 14.8% in 2020. The Fed “risk-free” liquidity (put) was so massive and swift that despite the decline in earnings, the yield on investment grade bonds dropped from 4.88% in March 2020 to 1.44% today. The High Yield
and Leveraged Loan
markets also showed similar “risk-free” yield movements. A trendline between leverage and yield (grey line) demonstrates the risk/reward profile in the more liquid fixed income market, however, middle market private credit has not followed.
The Fed’s liquidity programs are not geared for or available to mid market and smaller private companies creating a yield gap of up to 500 bps when compared to the trendline above. Moreover, well-meaning commercial bank regulation (Basel III) has changed capital requirements reducing both bank credit supply to the small and middle market companies and competition in this market niche.
Investors who can accept private credits’ lower liquidity can enjoy meaningful yield premia over investment grade bonds for similar levels of leverage. Accessing private credit is more difficult than hitting “buy” on your trading screen. The private credit market is fragmented and there are a limited number of private credit fund managers in the space who have experience navigating multiple major swings in economic and credit cycles.
¹Federal Reserve Bank of San Francisco, November 2020
About Bond Capital
Bond Capital is an award-winning private credit fund. As a direct lender, Bond Capital provides advice and money across the entire risk curve. Bond Capital structured credit financing enables business owners to maintain control ownership in exchange for yield and capital preservation. Across multiple cycles and for nearly 20 years, Bond Capital has advanced secured investment quality credit to lower middle market companies throughout North America.