When Selling Becomes Viral: Disruptions in Debt Markets in the COVID-19 Crisis and the Fed’s Response

By the end of this reading, you should be able to:

• Describe the evolution of bond and CDS prices during March-April 2020. 
• Compare the developments in debt markets during the Great Financial Crisis of 2008-2009 and the COVID-19 crisis. 
• Explain the effects of frictions and arbitrage limitations on price movements in debt markets during March-April 2020. 
• Explain the Fed’s interventions in debt markets during March-April 2020, as well as the rationale for and effects of these interventions.

Evolution of Bond and CDs Prices During March-April 2020

Bond markets were distressed in March 2020 as the COVID-19 crisis impacted financial markets. The evolution of the bond and CDS prices is described in detail below:

Bond prices significantly plunged in March. Even for extremely safe firms such as Google, their bond prices dropped significantly. For instance, during this time, Google’s bond spread increased rapidly by around 150 basis points compared to a spread of just 25 basis points in February. The CDS spread, on the other hand, barely moved.

The cumulative return on investment-grade corporate debt dropped to -20% as a result of a number of disruptions in the debt market. These disruptions were as follows:

• The CDS-bond basis for a basket of investment-grade bonds widened to around 300 basis points. This was occasioned by a large decline in the price of corporate bonds.
• Bond ETFs (ETFs exclusively invested in bonds) were trading at a price that was significantly below their net asset values (total value of individual bond holdings). However, liquid high-yield ETFs were the most hit because when bond investors got into trouble, they turned to their most liquid assets in a bid to put some more money in their pockets. This put pressure on prices.

In early March, the Federal Reserve sought permission from the U.S. Congress to buy investment-grade corporate bonds as part of its open market operations. The Fed’s goal in this request was to limit the deterioration in the corporate financing arena that had been witnessed since the Covid-19 crisis began. Corporates were finding it increasingly difficult to raise funds.

The U.S. Congress granted this request and on March 23rd, the Federal Reserve announced it would be buying investment-grade corporate bonds worth more than $250 billion. Immediately after the announcement, investment-grade bond prices rose by 7%. This price increase meant that yields fell. The Fed’s decision had the strongest effect on two categories of bonds:

• Shorter maturity bonds with less than five years to maturity. These registered a 200 bps decline in yields.
• Investment-grade bonds in the uppermost tier, i.e., bonds with the lowest credit risk. 

The announcement also reduced the CDS-bond basis.  However, there was no notable effect on the prices of other assets.

On 9th April, the Federal Reserve expanded the offer to include the so-called fallen angels, i.e., junk bonds. This time, the price of both investment-grade and high-yield bonds rose, and there was a notable effect on the prices of other assets as well.

Comparing the Developments in Debt Markets during the Great Financial Crisis of 2008-2009 and during the COVID-19 Crisis

The magnitude of the debt market disruptions during the COVID-19 crisis was large compared to the Great Financial Crisis. However, the 2020 experience is different in the following dimensions:

• A rapid market decline: The Great Financial Crisis occurred between 2007 and 2009 and the disruption in the market persisted throughout this period. On the other hand, the market volatility during the COVID-19 crisis happened quickly – in a matter of days, not months, but also disappeared as fast thanks to the Fed’s timely interventions.
• Price deterioration: During the 2020 Covid-19 crisis, corporate investment-grade debt experienced the most serious price disruption. But during the financial crisis, it was high-yield, illiquid assets that suffered the most.

Although there hasn’t been a concrete enough explanation for the apparent differences, some have cited the fact that whereas the financial crisis was most concentrated in the banking sector with banks being the primary culprits, the covid-19 pandemic had the potential to bring about a worldwide disaster because it was affecting just about everyone in the community. Investors weighed the situation and concluded that this time, even the most secure of corporate bonds would be affected. Others have argued that in the days of covid-19, investors were faced with a more urgent need for cash and therefore turned to their most liquid assets.

Effects of Frictions and Arbitrage Limitations on Price Movements in Debt Markets During March-April 2020

We know that distress within the financial sector partly drives price movements, in that the market naturally experiences price disruptions. These disruptions may create arbitrage opportunities as well as other relevant frictions.

Exchange-traded funds (ETFs) Arbitrage Mechanism

Exchange-traded funds (ETFs) have an arbitrage mechanism that helps keep share prices in line with the underlying value of assets or securities. Arbitrage refers to the process of taking advantage of price differences in two or more markets.

The following are key points to remember about arbitrage trading and ETFs:

• Shares of exchange-traded funds (ETFs) can be redeemed or created in large blocks by authorized participants (AP), usually financial institutions.
• Arbitrage is used to balance the trading price of an ETF. That is, the trading price and value of underlying shares of an ETF are announced every day; therefore, if the ETF price had deviated from the value of underlying shares, arbitrageurs swing into action. For example, when the underlying assets or securities are trading at a lower price than the exchange-traded funds (ETF) shares, arbitrageurs usually buy the underlying assets or securities, redeem them for creation units and finally sell the exchange-traded funds (EFT) shares in the open market for a profit.
• On the other hand, when the underlying shares are trading over the exchange-traded fund (ETF) market value, arbitrageurs buy the exchange-traded fund (ETF) shares on the open market and form creation units. They then redeem the creation units to get the underlying shares and sell the shares in the open market for a profit.

Note: Investment-grade bonds, high yield bonds, municipal bonds, and treasuries have one common disadvantage; they lack a matched mutual fund. Therefore, in attempts to arbitrage, net asset value (NAV) must use a different approach through an authorized participant (AP). It means that, when an investor does not own the mutual fund, to capture the spread of when the exchange-traded fund (ETF) trades at a discount, an authorized participant (AP) must administer an arbitrage process. The authorized participant must be an investor allowed to create and redeem shares, where primary dealers mainly carry out bond exchange-traded funds (ETF). The approved investor would purchase the exchange-traded fund (ETF) and acquire the securities’ underlying portfolio, which they would then sell.

Frictions and Limitations in the Arbitrage Mechanism

1. Selling an illiquid asset consumes a lot of time during which prices may change. The authorized participant may not sell the bond at net asset value (NAV), i.e., NAV may be based on stale bond prices because the only prices available for some bonds are a few days old. For instance, in March 2020, liquidity stress affected fixed income ETFs since some corporate bond ETFs traded with large discounts compared with the underlying assets. In such scenarios, the selling pressures on the ETFs shares failed to be reflected in the underlying market (stale bond prices), resulting in the EFTs share prices falling by more than the value of the underlying assets, leading to a discount. This points to a potential dysfunction of the ETFs arbitrage mechanism, with the illiquidity of the underlying assets causing friction in the arbitrage process. Especially, we find that, during mid-March, the treasuries net asset values (NAV) had a substantial deviation as compared to ETF, suggesting that the exchange-traded funds traded at lower prices than the less liquid assets.

Alternatively, these developments can be considered as:

• Discontinuation of price discovery.
• An indication that ETFs were able to price assets in a worsening liquidity environment, with ETF prices reflecting market dynamics more quickly than the prices of the underlying assets.

2. More illiquidity for bonds results in the arbitrage requiring large balance sheet space that may be expensive at this point. For instance, during the week from March 9th to 15, when the 10-year Treasury yield increased sharply, direct Treasury holdings of primary dealers remained almost flat, while their reverse repo lending increased. The increase in reverse repo lending ceased after that, suggesting a somewhat tight balance sheet constraint faced by dealers. The Fed offered $1.5 trillion repo funding to primary dealers on March 12th, meaning they could access the funding at a low repo rate, but the taking was appallingly low.

3. Providing liquidity to investors expose authorized participants to volatility risk and adverse selection.

Fed’s Interventions in Debt Markets during March-April 2020

According to what was done in 2008, most of the early Fed announcements in March-April, 2020 were targeted at short-term funding markets:

March 15th: Swap lines with core central banks.

March 17th: Commercial paper lending facility and Primary Dealer lending facilities.

March 18th and 20th: Money market lending facility.

March 20th: Swap lines with periphery central banks.

March 31st: Certification of large foreign institutions to repo treasuries with the FED.

April 1st: Exclusion of treasuries and deposits from the leverage calculation for holding companies. The rationale for these interventions mainly targeted money markets and, to a large extent, were classic liquidity operations. The actions were meant to enhance dollar liquidity around the world through existing dollar swap arrangements

March 23rd Announcement: The Fed announced that it would purchase investment-grade bonds on primary and secondary markets. It went beyond the strategy used in 2008 (with an equity backup plan provided by the treasury) by announcing structures that specifically take on credit risk by directly purchasing the corporate debt of investment-grade, asset-backed securities, and short-term municipal securities.

The announcement raised the investment-grade bond prices by 7%, with virtually no impacts on other asset prices, suggesting an implied decline in yields. This intervention’s impacts were most concentrated at lower maturities and lower credit risk and significant effects on the safer end of the investment-grade spectrum in credit rating. This decline came partly through a default risk channel because of the lowered CDS spread and substantially through enhancing liquidity (i.e., shrinkage of the CDS-bond basis).

The March 23rd announcement had the largest impact on safer short maturity bonds with the largest price distortions. Also, we notice that the maturity effect is consistent with the bonds directly targeted in the program.

April 9th Announcement: The Fed announced it would buy some municipal bonds and expand corporate bond-buying programs to include some riskier debt. It increased bond purchases and extended the scope to include ‘fallen angels.’ This led to the rise in prices of both investment-grade and high-yield bonds and broader effects on other asset prices. The April 9th announcements had broader effects on the credit market than what was directly targeted.

Practice Question

Which of the following is true about the evolution of bond and CDS prices during March-April 2020?

A. Bond prices significantly plunged apart from extremely safe firms such as Google.

B. The net return on investment-grade corporate debt was around -20 percent.

C. The CDS-bond basis of investment-grade companies dramatically decreased.

D. All of the above.

Solution

The correct answer is B.

During that period, the investment-grade decreased, corresponding to disruptions in the debt market. The net return on investment-grade corporate debt was -20 percent, approximately the same as the aggregate stock market over the same period.

Option A is incorrect: Bond prices significantly plunged, even for extremely safe firms such as Google.

Option C is incorrect: As corporate bond prices fell, the CDS-bond basis, i.e., the difference in spread implied by the CDS and bond prices, for a sample of investment-grade companies dramatically grew to around 300 basis points