Commentary on Political Economy

Wednesday, 2 June 2021

 

Fed Exits the Credit Market It Changed Forever

The central bank’s corporate-bond facility encouraged a record amount of debt sales and pushed yield spreads to the tightest since 2007. 

Jerome Powell stands ready to step in again if necessary.
Jerome Powell stands ready to step in again if necessary. Photographer: Susan Walsh-pool/Getty Images

It’s not exactly tapering, but the Federal Reserve is starting the clock on withdrawing the emergency measures it used to support financial markets during the Covid-19 pandemic.

The central bank said late Wednesday that it would start to gradually sell the $13.7 billion portfolio of U.S. 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 Fed because it effectively pledged to plow 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.  

The secondary-market facility was the first Fed program using the $454 billion in total equity funding from the CARES Act to get off the ground. It began buying eligible 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 published last month. The central bank will again start with ETFs on the way out, shedding those first before moving on to corporate bonds later in the summer. The intention is to have the 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 U.S. 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 monetary policy. 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, U.S. high-grade corporate bond sales totaled more than $1.9 trillion in 2020, a record, while junk-rated borrowers raised a whopping $443 billion, data compiled by Bloomberg show. Meanwhile, the average spread on investment-grade debt touched 84 basis points on May 28, 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 secondary-market credit facility didn’t work like that. In fact, the one that served 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 mutual-fund industry. Just before it was announced on March 23, investors pulled a record $35.6 billion from U.S. 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 credit market after companies 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 up the facility was enough to revitalize the financial markets. Policy makers have to hope the reverse doesn’t hold true.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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