Record QT and big rate hikes are fine: Corporate bond market distress index falls to its lowest level since before the Fed started tightening.
Written by Wolf Richter of Wolf Street.
The New York Fed’s weekly Corporate Bond Market Distress Index (CMDI) update released today highlights how volatile liquidity remains from years of mega-QE, and despite the Fed’s hike in policy. It shows how the search for yield has returned this year. Despite his highest QT ever, interest rates reached his highest level in 22 years.
The corporate bond market distress index has fallen to 0.13 over the past two weeks after spiking early in the tightening cycle. This is the lowest level since before this tightening cycle began.
“The index identifies ‘recession’ periods when a number of individual indicators of market functioning indicate deteriorating conditions in both the primary and secondary markets for corporate debt,” the New York Fed said.
“The corporate bond market appears to be functioning in a healthy manner, with month-end market-level CMDI below the historical 20th percentile,” the New York Fed said.
“Market functioning improved in both high-yield and investment-grade sectors during August,” the New York Fed said.
In other words, while the corporate bond market had some initial wobbles, it easily adapted to much tighter monetary policy and returned to La La Land.
One reason to track pain The key is to see how far the Fed can tighten before it does too much damage to the corporate bond market. And this index shows that compared to other damaging moments, even small ones like the euro debt crisis or the US oil crisis did no harm. The index is now back in its historical comfort zone.
Even the junk bond market remains in a safe zone. The New York Fed also offers distressed sub-indexes for the investment-grade and junk-rated (high-yield) segments of the corporate bond market. High Yield CMDI targets junk bonds rated below BB+ and above CCC/C, so it does not include the lower end of the junk bond market (see here for a table of corporate credit ratings by rating agencies) .
This high-yield CMDI fell to 0.16 today, returning to its comfort zone after two brief spikes.
To combat the worst inflation in 40 years, The Fed has attempted to “tighten” financial conditions by raising interest rates and QT. Tighter financial conditions will make it harder and more expensive for businesses and consumers to borrow, creating further pain for borrowers, especially those with weaker credit, such as junk-rated companies, and resulting in a negative impact on the economy. Investment and demand will fall. It can take some of the inflationary pressure off. This theory holds true.
During this tightening cycle, the New York Fed devised the CMDI to track the impact of this tightening on the corporate bond market. It complements a number of indices that seek to measure financial stress, but specifically addresses stress in the corporate bond market.
And initially, the results were as promised. In late 2021, when the Fed started talking about tapering, rate hikes, and QT, financial distress in the corporate bond market began to rise from historic lows in anticipation of what was to come. By November 2022, when rate hikes and QT were in full swing, the CMDI had risen to 0.28, its highest level since November 2020, when we were emerging from the lockdown shock.
But they have since fallen, suggesting the corporate bond market is less anxious now than it was before the Fed started tightening.
CMDI includes primary market indicators from the Mergent Fixed Income Database (FISD), such as issuance volume, primary market pricing, and issuer characteristics. This includes secondary market indicators, such as trading data from TRACE, and indicators that reflect central trends and other aspects of the distribution, such as volume, liquidity, non-traded bonds, spreads, and default-adjusted spreads. included. We also include quoted prices from ICE Bank of America to track differences in secondary market conditions for traded and non-traded bonds.
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