As COVID-19 has cast a shadow over company profitability and solvability, the US Federal Reserve has embarked on credit spread management, which, so far, has benefitted equities more than corporate bonds. This is likely to continue as long as credit spreads refuse to come down from their elevated levels which makes the case for favoring equities over corporate bonds – because what’s the point of fighting the Fed?
As the Fed has upped its game by targeting the credit spread to keep struggling companies afloat, the corporate bond market has become the single most important indicator when it comes to assessing the economic story of the COVID-19 crisis.
Here is why. Judging by various market indicators, the current state of the economy resembles its state before the novel coronavirus struck. Not only the term and TED spreads, as indicators for the economic outlook and liquidity, are back to their January levels but also the dividend yields, as proxies for valuation levels are close to pre-crisis levels. There seems to be only one exception: the credit spreads. These indicators are still elevated and haven’t decreased significantly despite the Fed and other developed market central banks falling over themselves to snap up corporate bonds with the goal of preventing credit markets from drying up. As long as credit spreads remain above desirable levels, the Fed and other central banks are unlikely to relent and will keep injecting liquidity into ailing market segments.
Bonds are held back by their fixed-maturity term
When the crisis had fully unfolded in developed markets at the beginning of March, corporate bonds faced a more severe sell-off than equities, measured in terms of volatility units, and have so far been slower to respond to the massive central-bank stimulus that is directly targeting their markets. This is because bonds are fixed-term-maturity securities, which makes them much more sensitive to a shutdown of the economy and less dependent on long-term growth rates than equities.
This is related to how assets are commonly valued, i.e. by discounting cash flows back to the present. As equity securities have no expiry date, they, in theory, have a perpetual life. This is why, for calculating their value today, their cash flows in the nearest future have much less weight than the terminal value that comes from projecting these cash flows into eternity and discounting them based on the long-term economic growth rate. This valuation portion makes up the majority of the total equity value.
For bonds, the opposite is true. Since they mature at a fixed date in the future, bonds derive most of their value from near-term cash flows - in other words from interest and principal payments that are due in the near future. As corporate bonds have typically an average maturity of a few years, this future is rather short-term so their valuation hinges on their ability to service the debt now. Therefore, disruptions threatening the solvency of a company has a huge impact on them, which is reflected in higher credit spreads.
Equities depend on the long-term growth rate
For equities, the flip side of the coin is that they are almost entirely dependent on the long-term growth rate remaining intact. Already small growth rate revisions can trigger substantial losses. So, even though equity markets are buoyed by central bank actions, there are a few caveats. First, only markets equipped with resourceful central banks with strong firing power will be able to keep struggling companies above water for a prolonged period of time. Second, only companies operating in sectors with robust long-term growth rates beyond the corona crisis, will be able to withstand the potential downward adjustments of global growth rates after the full damage done by COVID-19 will have emerged. The current equity rally led by tech giants, like Amazon, Google and Microsoft, is a noteworthy reminder of how powerful perpetuity in valuation is. However, this also means that companies which cannot rely on untampered growth projections will feel the brunt of weakening consumption long after the virus has gone.
The global economy’s future trajectory is still unclear and the winners and losers have yet to emerge. However, there is an old investor saying which proclaims it to be advisable to invest in ways that align with the Fed’s policy. The way things stand at the moment, investors must know that if they are not in equities right now, they are fighting the Fed which, essentially, is a mug’s game.
