Fed-backed credit market gives investors a reason not to worry even as volatility returns to stocks

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The credit market, which seized up during the start of the coronavirus turmoil in the financial markets, is now one of the few things equity investors can take solace in as volatility returns.

As scary as the stock market’s wild ride has been, the distortion in the debt market was arguably more dangerous to the economy and the financial system that has relied on free-flowing credit for years. Now with the credit market stabilizing thanks to the Federal Reserve’s unprecedented backstop, many Wall Street analysts believe all will be well in other corners of the financial world.

The central bank announced Monday it is broadening its corporate bond buying approach to include single issues on top of exchange-traded funds and high-yield securities. The move lifted stocks into the green after an alarming pullback last week triggered by signs of a coronavirus resurgence.

“This is yet another sign the Fed is going to do everything under their power to help liquidity,” said Ryan Detrick, senior market strategist for LPL Financial. “Worries over a second wave? No worries, the Fed is here.”

Even during the brutal sell-off last week — the worst weekly performance for the S&P 500 since March — the credit market shrugged off the pandemic scares, leading many to believe stock traders were overacting.

“Actual credit costs didn’t budge and in the case of BAA [rated corporate bond] yields, actually declined,” said Dennis DeBusschere, macro research analyst with Evercore ISI, in a note on Monday. “That is important to keep in mind and if credit costs remain low, that would reduce market downside risk.”

Credit spreads have tightened to nearly pre-coronavirus levels since the Fed stepped in. Investment-grade spreads narrowed to about 2.3 percentage points over Treasuries, after jumping to the highest level since 2009 in March. High-yield spreads also stayed at the 6 percentage point range over Treasuries after rising to above 11 percentage points in March.

“The pullback from recent highs has not been associated with a material breakdown in credit markets or liquidity indicators, ” Michael Darda, chief economist and market strategist, said in a note on Monday. “As a recovery gets underway, Fed policy will automatically become more supportive if there is any abatement of downward pressure on the neutral interest rate/velocity of money.”

Investors are piling into bond funds at a historic pace on the back of the Fed’s commitment to support the credit market. U.S. investment-grade mutual funds and ETFs experienced another week of strong inflows at more than $11 billion in the week ending on June 10, the second highest ever and following the record $14.8 billion inflow the prior week, according to Bank of America.

The iShares iBoxx $ Investment Grade Corporate Bond spiked to a 52-week high on Monday in the wake of the Fed announcement. The Fed bought more than $300 million worth of the ETF last month as part of the Secondary Market Corporate Credit Facility.

Flanked by the Fed’s backstop, companies have also raced to issue new debt, which has surpassed $1 trillion this year, double the pace of last year.

“We think that going forward the macro will be sufficiently positive for some to take credit spreads tighter,” said Hans Mikkelsen, Bank of America’s credit strategist.

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