Corporate bond market malfunction during COVID-19 and lessons from the Fed’s response

The investment grade corporate bond market, which performed well during the global financial crisis, did not perform during the COVID-19 crisis and required aggressive emergency response from the Federal Reserve. The corporate bond market is an important source of financing for companies. Non-financial corporations borrow more in the corporate bond market ($ 6.5 billion) than they borrow directly from banks ($ 1.4 billion). Significant disruptions in corporate bond markets that have resulted in the closing of new bond issues could cause companies to downsize and downsize.

The COVID-19 crisis triggered sharp declines in the prices of investment grade corporate bonds, proportionately more than high yield bonds, which was surprising as high yield bonds are riskier, less liquid and more sensitive to deteriorating economic conditions. perspectives. Measures of market liquidity, such as bid-ask spreads and the impact on prices, deteriorated to such an extent that it was equally or more expensive to trade a higher-quality bond than a long-term bond. high efficiency.

Rising and Falling Spreads on Investment Grade and High Yield Corporate Bonds During the Pandemic

This paper shows that significant structural changes in the financial sector since the global financial crisis have dramatically increased the demand for liquidity from corporate bond investors beyond the capacity of markets to provide it in a crisis. It draws on a rich set of articles to document the turmoil and the market’s response to the Fed’s actions. He documents the acceleration of large repayments of investment grade corporate bond mutual funds, which have put downward pressure on the prices of investment grade corporate bonds. The use of treasury securities by these funds for liquidity risk management also contributed significantly to the investor ‘rush for money’ during these volatile weeks, when investors also worried about the cash flow. ability of markets to function when traders began to work from home.

The paper suggests areas for further study to increase the resilience of corporate bond markets to future shocks, reducing the systemic consequences of the liquidity mismatch of corporate bond mutual funds and improving the market making ability of brokers. Regulators have been concerned for some time about the ‘shadow’ liquidity offered by bond UCITS which offer daily liquidity when the underlying assets are less liquid, but they have mostly focused on this liquidity mismatch in bond funds. high yield or bank loan funds. But a lesson from March suggests that high-grade bond mutual funds deserve attention, given the surprisingly large redemptions and whether they are considered “near-liquid products” because they have collectively become large and large. their behavior is strongly correlated.

Another lesson from March is that the success to date of the Fed’s corporate bond program in calming markets does not suggest that reforms are unnecessary. Instead, reforms are even more crucial, as the Fed’s actions have likely raised expectations of such interventions in the future. It is important that the Fed, through financial reforms or by clarifying its own intention for future emergency actions, reduce any perception by private entities that they would not have to bear the costs of their own risk taking. .

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