It’s not exactly tapering, but the US Federal Reserve is starting the clock on withdrawing the emergency measures it deployed to support financial markets [after the covid pandemic broke out]. The central bank said late Wednesday that it would start gradually selling the $13.7 billion portfolio of US corporate debt and exchange-traded funds it amassed through its secondary market corporate credit facility, which was created during the worst of the pandemic-inspired market meltdown in March 2020. The facility marked an unprecedented intervention for the US Fed because it effectively pledged to plough hundreds of billions of dollars into company debt if no one else would. That backstop, even if it wasn’t fully used, quickly restored investor confidence, led to a ferocious rally in practically every corner of the bond market, and encouraged record-breaking amounts of debt sales from investment-grade and high-yield borrowers alike.
In fact, this one modest-sized facility, perhaps more than any other from the Fed, has most likely changed financial markets forever [at least in the West].
The secondary-market facility was the first Fed programme using the $454 billion in total equity funding from the CARES Act to get off the ground. It began buying eligible exchange-trade funds (ETFs) invested in corporate debt in May 2020, eventually ending up with positions in 16 different funds worth $8.56 billion, including some that hold deeply speculative-grade securities, according to a disclosure last month. The central bank will again start with ETFs on the way out, shedding those first before moving on to corporate bonds later this summer. The intention is to have its selling wrapped up by the end of the year.
Of course, that’s conveniently right around the time that many Fed watchers expect the central bank to start scaling back its $120 billion in monthly purchases of US Treasuries and mortgage-backed securities. A Fed spokeswoman told Bloomberg News that the portfolio unwind has nothing to do with monetary policy and doesn’t signal anything about it. But it’s easy enough to read between the lines.
What’s more difficult is understanding how the corporate-bond market moves on from here. Even if the Fed’s intervention was small in dollar terms, it has meaningfully changed the calculus for credit investors. The central bank single-handedly cut short the typical default cycle and pushed money toward companies to help them get through the pandemic. All told, US high-grade corporate bond sales totalled more than $1.9 trillion in 2020, a record, while junk-rated borrowers raised a whopping $443 billion, as data compiled by Bloomberg shows. Meanwhile, the average spread on investment-grade debt touched 84 basis points on 28 May, the lowest since 2007, while high-yield bonds offer just 301 basis points more than Treasuries, which is just about as low as any point since the 2008 financial crisis.
Is there any reason to think the Fed won’t step in again if credit markets freeze? Probably not. In fact, when Chair Jerome Powell was asked during his July press conference whether the central bank could buy stocks with its emergency powers, he didn’t exactly slam the door on the hypothetical. “Honestly, we haven’t tried to push it to, you know, what’s the theoretical limit of it. I mean, I think, clearly, it’s supposed to replace lending. That’s really what you’re doing. You’re stepping in to provide credit at times when the market has stopped functioning,” he said. But the Fed’s secondary-market credit facility did not work like that. In fact, the one that was meant to serve such a function, the primary market corporate credit facility, went entirely unused.
What’s more, the Fed’s facility may have served as something of a stealth rescue of the US mutual-fund industry. Just before it was announced on 23 March, investors pulled a record $35.6 billion from US investment-grade bond funds, a record $12.2 billion from muni mutual funds, $2.91 billion from high-yield funds and $3.45 billion from those tracking leveraged loans in the span of just a week. Can this kind of exodus happen again if the takeaway from March 2020 is that the central bank is just around the corner? And what are the risks of that kind of complacency?
So the Fed is exiting the US credit market after firms piled an unheard-of amount of cheap debt onto their balance sheets and investors were all too willing to buy bonds with yield spreads at some of the tightest levels in recent memory. To be clear, it has never been about the actual dollar amount the central bank is buying or selling. Last year, the symbolism of starting the facility was enough to revitalize financial markets. Policymakers should hope the reverse doesn’t hold true.
Brian Chappatta is a Bloomberg Opinion Columnist, covering the debt markets.
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