The Federal Reserve on Monday announced that it will buy Treasury and mortgage-backed securities “in the amounts needed” to support markets and the economy. The commitment to unlimited buying was new and so was a related extension of support for the corporate credit and municipal bond markets.
European and Asian central banks have seen mixed results from previous attempts to boost lending with purchases of corporate bonds – and even equities in the case of the Bank of Japan – but the Federal Reserve’s measures should help to ensure that core hedging markets at least remain functional.
Treasury liquidity may be improved, but the broader market for risk management by offsetting trades and use of derivatives is still precarious. Basis relations between similar instruments such as bonds and swaps are being tested by a sharp rise in volatility across asset classes, as well as uncertainty about the ability to close or value different legs of hedges.
A dislocation between Treasuries and futures in the approach to the Fed move alarmed interest rate traders and fuelled concern that asset managers were trying to dump liquid holdings in a desperate dash for cash.
A much sharper rise in credit derivative volumes compared to corporate bond trades raised the spectre of a repeat of the 2008 basis breakdown between the two markets that created enormous losses for banks and hedge funds.
And fears grew about the efficacy of hedges for the Asian and European equity structured product markets, where moves below pre-set barriers for stock indices can trigger massive directional moves in trading of volatility hedges.
Strategies that are designed to balance risks across separate asset classes did not have an encouraging start to the current crisis.
Bridgewater, the world’s biggest hedge fund and a primary exponent of risk parity investing, admitted that it had failed to anticipate the potential impact of the coronavirus and suffered losses.
Ray Dalio, founder of Bridgewater, which had around $160 billion of assets before the current downturn, was able to keep the market for positive sentiments liquid. He observed on Twitter that transcendental meditation has enhanced his open-mindedness, higher-level perspective, equanimity and creativity, adding: “It helps slow things down so that I can act calmly even in the face of chaos, just like a ninja in a street fight.”
This is a valuable lesson for ninjas everywhere, but the jury remains out on the extent to which risk parity trading can protect against losses by balancing equity exposure with fixed income hedges that are typically leveraged to reach a desired volatility target.
The Federal Reserve’s move to support the credit market might well promote confidence in the use of corporate debt exposure as an anchor for cross-asset trades.
The move by central banks to support credit markets should be applauded during this crisis and the extension in scope of relatively secure hedging instruments is also welcome
The main credit markets felt stressed as the current crisis developed, with primary issuance closing down temporarily. But investment grade bond spreads to government benchmarks did not widen nearly as far as during the 2008 downturn. US investment grade spreads rose to roughly 300 basis points over Treasury yields just before the Monday Fed announcement, which was around half of the peak of nearly 600bp over government securities that was seen in 2008.
European investment grade spreads hovered around 250bp over the benchmark Bund yield, which was also around half the peak seen in 2008 and well below levels of 350bp that were hit during the regional debt crisis of 2012.
The experience of the European Central Bank (ECB) in recent years indicates that corporate bond buying does not have to be especially large to keep spreads contained. Analysts expect that the revived ECB buying of bonds may result in around €40 billion of future monthly purchases, which does not sound like much in the context of the threat posed to the creditworthiness of European companies but could at times push up prices for deals that are not liquid.
The Federal Reserve said it would provide up to $300 billion of new financing with its move to support the credit markets. It intends to back primary issuance of bonds and loans, and also to conduct secondary market buying of existing investment grade paper and exchange-traded bond funds.
The addition of corporate bonds to Treasuries and mortgage-backed securities on a list of relatively safe instruments with a government buyer of last resort may increase confidence in market hedges.
It could also create distortions by emboldening dealers. The use of credit trades to fund the purchase of equity market put options could have added appeal if corporate bond spread widening is seen as less likely, for example. This is the type of hedge that a seasoned trader might consider carefully before trying in a market where liquidity is uncertain.
Some investors may also attempt to arbitrage the difference between bonds that are eligible for Fed purchases and high-yield deals that are not, or the spread between separate bonds that are technically investment grade but have different risk profiles. This type of arbitrage often has a superficial logic but can be disrupted by broad moves in prices. It would not be a surprise if additional support for lower-rated companies eventually emerges, for example.
Successful execution of arbitrage trades will also remain dependent on liquidity and even the presence of a government buyer is not a guarantee of stability.
One lesson of the 2008 crisis is that market dislocations can occur in waves, with successive government interventions attempted, before confidence is fully restored. This can be a prolonged process, with losses of surprising magnitude from under-the-radar basis trades along the way.
One of the more bizarre trading moves during 2008 was a spike in the value of Volkswagen ordinary shares when it emerged that Porsche had secretly built an option position giving it the right to buy much of the outstanding paper on the market, for example.
Many hedge funds were running arbitrage positions between Volkswagen ordinary and preference shares and suffered billions of euros of losses when there was a short squeeze in what had seemed the more liquid side of the bet. The squeeze had a significant impact even against a backdrop of plunging global equity prices in the wake of the bankruptcy of Lehman Brothers.
Other shocks from unexpected sources may be seen during the current turmoil. The move by central banks to support credit markets should be applauded during this crisis and the extension in scope of relatively secure hedging instruments is also welcome.
But traders and risk managers who are tempted to try to get smart about the second order effects of government moves to support markets would be well advised to keep in mind a simple question: is it safe?