In the early days of the COVID-19 pandemic, the Federal Open Market Committee (FOMC) announced corporate bond purchasing programs in the first and secondary markets in response to severe market and economic dislocations. The aim of those initiatives was to facilitate firms’ access to credit and improve liquidity in the first and secondary corporate bond markets.
The programs had an almost immediate impact on liquidity and valuations within the investment grade market, where purchases were concentrated. And although the Federal Reserve only purchased token amounts of fallen angels and high-yield exchange-traded funds (ETFs), these actions also helped stabilize the high-yield market. Over the course of this system, investment grade (IG) and high yield (HY) firms could gain access to primary markets in record amounts to refinance their debt at historically low rates of interest.
The Fed’s backstop also boosted investor confidence in the company bond market and caused spreads on the IG and HY indices to quickly decline to pre-pandemic levels. The programs were so successful in restoring investor confidence that the Fed ultimately purchased only $13.7 billion in corporate bonds and ETFs out of a secondary market purchase commitment of as much as $250 billion.
While these and other Fed responses to the pandemic prevented far worse market and economic outcomes, the company bond purchasing program has drawn criticism. Some imagine that interventions in the company bond market have permanently modified pricing, as investors could now assume that firms are shielded from future economic shocks. Having crossed a longstanding red line and buying credit instruments, the Fed is for certain to achieve this again in future recessions or financial crises. At least that is the logic.
Even if this seems to not be the case, the expectation of future interventions can still influence corporate credit rankings, a minimum of until that expectation is dissatisfied. The lower cost of borrowing for firms could subsequently result in excessive debt, which could well lay the muse for a future crisis.
Fed intervention stabilizes financial markets
Source: Bloomberg
Other investors may imagine the hurdle for Fed intervention in credit markets is higher. This implies that it could take an extreme event resembling a serious financial crisis for the central bank to reintroduce corporate acquisition facilities. Nevertheless, even in normal times, this expectation could impact the compensation for assuming long-term credit risk and result in a brand new, lower equilibrium for credit risk compensation.
In addition to financial stability concerns, the perception of a Fed backstop on corporate loans could impact investment strategy. And these impacts are of immediate importance as each the United States and the Eurozone are expected to experience recessions next 12 months. For example, investors who typically underweight corporate bond markets late within the economic cycle based on expectations of spread widening may as a substitute find that activating a company purchase program prevents spreads from widening as much as they otherwise would the economy weakens. Alternatively, such investors may gain advantage if market assumptions of a “Fed put” in credit markets prove improper. Therefore, it would proceed to be necessary for credit investors to know the extent to which market valuations currently reflect expectations of future central bank intervention and under what conditions the Fed might actually intervene within the event of future shocks.
In this series, we first examine corporate bond purchasing activity under the Fed’s lending programs in the course of the pandemic. In the second part we are going to discuss corporate bond purchases within the euro area, where the European Central Bank’s (ECB) authority to buy corporate bonds is clearer and more independent of the political process. Comparisons with bond purchases within the euro area are also helpful for our evaluation of spreads, model-based valuations and option prices. For example, if investors now assume that the Fed will permanently insure corporate loans, U.S. bonds could also be permanently repriced relative to corporate bonds within the euro area, where corporate bond hedging has long been in place. We may even provide a legal framework for the Fed’s corporate credit purchases in addition to the policy context of the purchases, as these considerations will influence the potential for future interventions in credit markets. In contrast, our evaluation may even include a discussion of the legal framework for the ECB’s purchase of corporate bonds.
After our review of corporate bond purchasing activity within the United States and the euro area, we come to the core of our evaluation: the seek for evidence that credit market interventions have left a everlasting “footprint” on the valuation of corporate debt. Our focus is on spread levels, credit index pricing relative to model valuations, and options pricing. Comparing current spreads with valuation models in addition to options bias may also help us understand whether the Fed and ECB’s purchase of credit instruments continues to influence pricing.
Finally, we are going to summarize our findings and determine whether there is evident evidence that the Fed and ECB’s purchases of corporate bonds have permanently modified the pricing of corporate credit risk.
A glance back at corporate purchases: The Fed
Asset purchase programs as we all know them became an integral a part of U.S. monetary policy in 2008 in response to the housing crisis and the resulting financial crisis. On November 25, 2008, the Fed announced it could purchase as much as $600 billion in mortgage-backed securities (MBS) and agency debt. On December 1, 2008, then-Fed Chairman Ben Bernanke informed the general public of details of this system, which officially launched later that month on December 16, 2008. On March 18, 2009, the FOMC announced that it could expand purchases of MBS and agency debt to an extra $850 billion and buy $300 billion of U.S. Treasury securities.
As the table below shows, these announcements caused a big decline within the returns of varied assets, including people who weren’t on the Fed’s buy list. However, options adjusted spreads (OAS) generally widened on the news. This was likely on account of expectations of an economic downturn and a possible increase in default risk, or a minimum of to impaired liquidity conditions on the time.
The Fed followed up this primary attempt at quantitative easing (QE) with two additional purchasing programs because it recovered from the worldwide financial crisis (GFC). During the pandemic, the Fed resumed its asset purchases on a big scale and didn’t reduce them until November 2021. The Fed’s balance sheet continued to grow, albeit at a decreasing pace, through the primary quarter of 2022 and has begun to shrink just just a few months for the reason that second Times for the reason that global financial crisis, in an try and tighten financial conditions to combat inflation.
The Fed’s announcements alone can influence the market
Buying long-term corporate bonds is latest within the United States and, as with previous announcements, there was a direct market response. When the Fed announced a program to buy investment-grade corporate bonds and ETFs on March 23, 2020, financial markets reacted immediately. In fact, the Fed only began buying bonds in June, however the announcement alone was enough to revive calm to an otherwise fragile market. The Secondary Market Corporate Credit Facility (SMCCF) was authorized to buy as much as $250 billion in corporate bonds and ETFs, a paltry sum in comparison with the $10 trillion corporate bond market. Still, as with all other facilities, the market likely assumed that the Fed would do every little thing it could to revive liquidity to credit markets and expand programs if ever obligatory.
Fed Balance Sheet: Securities which are fully owned
Sources: Bloomberg, US Federal Reserve
The expansion of the SMCCF to New Fallen Angels and High Yield ETFs on April 9, 2020 helped the market interpret the “whatever it takes” policy response.
The Fed ended up buying nearly $14 billion in bonds and ETFs, but its mere presence quickly restored order to the markets. However, this episode alone shouldn’t be enough to determine the existence of a Fed push. We need evidence of a more sustainable impact. If the Fed were to open Pandora’s Box, we might expect more muted volatility, tighter spreads and fewer downside risk than market participants have experienced up to now.
In future parts of this series, we are going to search for evidence of this using the ECB’s experience with corporate bond purchases and US markets.
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Photo credit: ©Getty Images/ Hisham Ibrahim
