Fed’s High-Yield ETF Buying Defies Explanation
(Bloomberg Opinion) -- Multiple Federal Reserve officials have used the phrase “building a bridge” in recent days to describe the central bank’s unprecedented actions across U.S. bond markets. In their minds, it’s the Fed’s job to do whatever it takes to keep credit flowing through the financial system while the economy is largely shuttered.
For the most part, I support that. And yet, there’s one part of the central bank’s April 9 announcement that still makes little to no sense. To borrow their language, the Fed buying high-yield bond exchange-traded funds feels like a bridge to nowhere.
Keep in mind, I’ve opposed the Fed backstopping junk bonds from the start. But I do concede that the difference between low triple-B and high double-B ratings is a somewhat arbitrary cutoff. So when the central bank said it would purchase bonds from “fallen angels,” as long as the debt was still rated double-B and had an investment grade as of March 22, it seemed like a reasonable compromise. “The ratings agencies aren't taking a few months off, but as far as the Fed is concerned they are, because the Fed has decided to ignore their post-March-22 decisions,” my Bloomberg Opinion colleague Matt Levine noted last week.
Indeed, Fed Vice Chair Richard Clarida made a similar point in a Bloomberg TV interview with Tom Keene and Michael McKee on Monday:
“Several important companies in the U.S. were investment grade up until this crisis hit,” he said. “And what we said in our programs if they’ve been downgraded after the date of the crisis they will have access to these new facilities.”
He also played down the threat of moral hazard — of the Fed encouraging risky behavior in the market by providing support that shields investors from loss.
“I think moral hazard in past circumstances, when its been associated with financial excesses or private sector excesses, is obviously something to assess and think about, but in this case this is an entirely exogenous event,” Clarida said. “Businesses aren’t closing and people aren’t unemployed due to any fault of their own. And I think this is a clear as possible case that those aren’t relevant considerations.”
None of Clarida’s comments directly justify the Fed buying high-yield ETFs. For one, the largest such fund, BlackRock Inc.’s $15.8 billion iShares iBoxx High Yield Corporate Bond ETF (ticker: HYG), had roughly one-third of its assets invested in single-B rated debt and 11.3% in securities rated triple-C or double-C as of April 9. Those hardly qualify as crucial American firms. (As a reminder, BlackRock will manage assets for both of the Fed’s corporate credit facilities.)
Clarida is right that the coronavirus pandemic is an exogenous event that’s wreaking havoc on businesses and causing an unprecedented spike in unemployment. But how exactly do high-yield ETF purchases help Americans get jobs or pay rent? It’s one thing for the Fed to acknowledge that Ford Motor Co. and Macy’s Inc. lost their investment grades during the crisis, and for the central bank to then use its power to create a smoother path for those brand-name companies to get past this demand shock. It’s quite another to pledge to buy up to 20% of a fund almost entirely made up of businesses that carried junk ratings during the longest economic expansion in U.S. history.
Granted, even if the Fed bought its self-imposed maximum of HYG and the SPDR Bloomberg Barclays High Yield Bond ETF (ticker: JNK), that would still come out to just $5 billion. By contrast, its credit facilities have a combined firepower of as much as $750 billion. The Fed also isn’t supposed to buy when ETFs trade at prices that “materially exceed” their net asset value, and both HYG and JNK saw their biggest premiums in more than a decade on Monday.
Still, it’s hard to interpret the high-yield ETF inclusion as anything other than taking a flamethrower to the somewhat frozen high-yield market and propping up prices. Junk-bond spreads tightened the most since 1998 in percentage terms on Thursday, while HYG itself surged 6.6%, the biggest rally since 2008. On Monday, bankers rushed to take advantage of the sudden shift, bringing deals on behalf of Burlington Coat Factory, Cinemark, Ferrellgas, Sabre and TransDigm.
That’s not how healthy markets are supposed to work. Investor appetite for risky debt was already growing organically before the Fed’s artificial intervention, with investors pouring a record $7.1 billion into high-yield funds in the week through April 1 and then another $214 million in the following week. Companies still had to pay steep borrowing costs, sure, but they mostly got more favorable rates than what they initially offered.
In retrospect, they were punished for thawing the junk-bond market themselves.
Consider the case of Nordstrom Inc., which has the lowest investment grades from Moody’s Investors Service and S&P Global Ratings. The department store chain sold $600 million of bonds on April 8, the day before the Fed’s move, to yield 8.75%. The securities traded this week at a 7.1% yield.
Carnival Corp. and Wynn Resorts Ltd., two companies ravaged by the coronavirus, also stomached unusually high costs. “This offering is both proactive and opportunistic,” a Wynn representative told Bloomberg News last week in an emailed statement. Perhaps not: Wynn’s debt priced at 7.75% and now yields 6.3%. Carnival’s securities, marketed at a 13% yield, are down to about 10%. That difference equates to tens of millions of dollars in higher interest expenses for those companies, not because of any fundamental economic shift, but just because investors have decided to “buy what the Fed is buying.”
Fed Chair Jerome Powell said in a webcast Thursday that the central bank would put its emergency tools away once “private markets and institutions are once again able to perform their vital functions of channeling credit and supporting economic growth.” Aside from elevated risk premiums relative to recent history, it’s not entirely clear what gave him the impression that credit markets were broken enough to merit even stronger action. Carnival, Nordstrom and Wynn suggest private investors were already up to the task of discovering the right interest rate for at-risk companies. U.S. investment-grade issuance just clobbered its previous weekly record, with more than $110 billion worth of deals pricing in the week ended April 3. If that’s not the definition of channeling credit across Corporate America, what is?
The Fed deserves a lot of praise for its nimble reaction to this escalating economic crisis. It slashed short-term rates, ramped up repo operations and scrapped limits on its purchases of U.S. Treasuries. Every time the central bank extended beyond its post-2008 measures, it did so gradually and deliberately.
Including high-yield bond ETFs, on the other hand, was haphazard at best, and leading the Fed down a slippery slope at worst. Unfortunately for Powell, Clarida and other policy makers, it’s the missteps that garner the most attention.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.
©2020 Bloomberg L.P.