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“We will continue to use these powers forcefully, proactively, and aggressively until we are confident that we are solidly on the road to recovery . . . I would stress that these are lending powers, not spending powers. The Fed is not authorized to grant money to particular beneficiaries. The Fed can only make secured loans to solvent entities with the expectation that the loans will be fully repaid.”
- Federal Reserve Chairman Jerome Powell, speech to Brookings Institute on 4/9/2020, the same day the Fed announced “additional actions” – italics as shown in original transcript1
On April 9th, a Federal Reserve press release announced “additional actions” to support the economy that included “expanding the size and scope of the Primary and Secondary Market Corporate Credit Facilities.”2 The term sheets attached to the press release contained a zinger that caught the market and economists by surprise – the Fed’s purchases would drift down the quality spectrum into high-yield corporate bonds (a.k.a., “junk bonds”)!
In terms of mathematical expectation, such purchases contradict Chairman Powell’s declaration the very same day that the Fed “can only” make loans “with the expectation that the loans will be fully repaid.” But, mathematics aside, exactly what is needed for the Fed to comply with protecting taxpayers from losses and not aid failing companies is open to interpretation . . . clearly. To add more entanglement, the Treasury has made an “equity investment” into the Fed’s bond buying program that could absorb a degree of losses.
Here’s where the restrictions come into play . . . for both the primary and secondary markets, the Fed is only buying high-yield (“HY”) corporate bonds that were rated at least BBB- as of 3/22/2020 and at the time of buying are rated at least BB-. So, the HY component is primarily a program to provide funding and liquidity to these “fallen angel” companies that were investment grade before the virus outbreak hit and have since fallen but not too far.
Additionally, the Fed has allowed for limited buying of ETFs whose primary focus is “U.S. High Yield Corporate Bonds.” These purchases are capped at 20% of an ETF’s shares. Other than these ETF purchases, the Fed is not buying HY corporate bonds that prior to March 22nd were designated as such.3
The Treasury has made a combined $75B “equity investment” in the current primary and secondary market facilities that the Fed can lever up 10-to-1, 7-to-1, and between 3-to-1 and 7-to-1 for purchases of investment grade corporate bonds, “fallen angel” corporate bonds, and other eligible assets (e.g., ETFs), respectively. So, for practical purposes, an amount somewhere in the range of $500B to $700B depending on the mix of investment grade versus “fallen angel” and HY ETFs that the Fed purchases. The Fed has not set out targets for these individual components, other than for ETFs to say, “The preponderance of ETF holdings will be of ETFs whose primary investment objective is exposure to U.S. investment-grade corporate bonds, and the remainder will be in ETFs whose primary investment objective is exposure to U.S. high-yield corporate bonds.”4
Probably yes and probably no. These Fed measures mean that the HY market will be less prone to liquidity shocks from what is expected to be a massive amount of downgrades from BBB to non-investment grade BB associated with the virus outbreak. At present, BBB rated U.S. corporate bonds outstanding are around $3 trillion, and projections are for hundreds of billions of that to be downgraded over the coming quarters. In addition to a sentiment boost from the Fed support, some of the credit sector rally on the news came from a collective relief by a market that was bracing for the impact of downgrades. So, in terms of fallen angel risk and liquidity shocks, there is support.
But, liquidity shocks are not the only consideration. Defaults and solvency are even bigger concerns, at least over the medium term. The HY corporate bond space in the U.S. is just over $1 trillion and the ETF space for HY corporates that the Fed is targeting looks to be only in the $50B range5. If the Fed maxes out the 20% cap then investments will total about $10B in a $1T market in the existing high-yield corporate space (excluding the post-outbreak deluge of “fallen angels”). While HY sentiment may get a short-term boost, for practical purposes, 20% of the HY corporate bond ETFs plus a buck fifty will get you on the subway, now with extra legroom. So, looking past the initial excitement, we see this as an opportunity to pare back non-investment grade credit risk.
Here it gets tricky. The Treasury could easily make a greater “equity investment” allowing the Fed to buy in even greater quantities. The Fed extending deeper into the HY corporate market beyond “fallen angels” and minority positions in ETFs, however, looks fraught with controversy. Per Dodd-Frank regulations, the Fed is not supposed to be in the business of aiding firms whose solvency is questionable. Chairman Powell’s statement atop this piece affirms this clearly. Also, the Fed’s announced foray into HY corporate bonds has quickly resulted in calls of unfairness – the Fed supporting Wall Street rather than Main Street,6 a bailout to private equity firms,7 and high-yield corporates getting unfair preferential treatment relative to municipal bonds.8
In general terms, the Fed can and will continue to expand its balance sheet and support financial markets broadly. But further steps into the HY space would increasingly take the flavor of bailouts and picking winners. The Fed is already finding itself in a tough spot to defend its actions on multiple fronts – actions that were taken while the market was rallying no less! Also, while not yet a major concern, gold’s break out and rally on the news (exceeding the move up in equities for the day) probably also caught the Fed’s eye. Gold’s surge could have various explanations, but most of them include a less than complete faith in something.
Overall, we don’t rule out an even deeper foray into high-yield, but odds are that it would only come if the market were undergoing more severe stress. But, as we learned in 2008-2009, in a crisis these actions become very difficult to predict. And that wasn’t an election year.
On a risk-reward basis, we recommend trimming non-investment grade credit into this recent rally that has taken the space (bank loans and high-yield corporate bonds) within striking distance of its pre-outbreak levels.
3 Interestingly, the Fed’s term sheet states, “high-yield corporate bonds” rather than a more general “high-yield debt,” which is perhaps why high-yield corporate bond ETFs (e.g., HYG) were up about twice as much as bank loan ETFs (e.g., BKLN) on the day of announcement.
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