The Federal Reserve fired its facilities on Monday to directly buy corporate bonds from the companies themselves, completing its bond purchase program as the central bank continues to combat the economic consequences of the COVID-19 crisis.
Since May, the Fed has already intervened in the corporate debt market, raising billions in ETFs from corporate bonds and, lately, buying individual bonds on the secondary market as well. On Sunday, the Fed announced the “broad market index” that will guide its individual purchases, including known names like Apple, General Electric, and Comcast.
As of June 24, Fed purchases had only reached $ 8.7 billion, a drop in the bucket when you consider that the Fed could control its purchasing power to acquire up to $ 750 billion in assets. Launching their line of credit to buy debt directly from issuers, Fed officials said they expect limited use of the line of credit, adding that corporate credit markets appear to have passed the liquidity shortfall of mid-March. which manifested itself in the form of expanded spreads.
Still, the Fed’s corporate bond intervention raises questions about how the Fed will make purchases and why it needs to support the corporate credit market.
The Fed groups its purchases into two categories: Corporate Bond ETFs and Individual Corporate Bonds.
Corporate bond ETFs are corporate debt baskets grouped by issuers like Blackrock or Vanguard, and sold to investors. There are several types of corporate bond ETFs that target different maturities (i.e. short or long-term) or credit quality (i.e. investment grade or junk rating). As of June 16, the Fed had purchased around $ 6.8 billion in 16 different ETFs, most of which in Blackrock’s LQD and Vanguard’s VCSH and VCIT.
Starting on June 16, the Fed also began buying individual corporate bonds on the secondary market. Its first round of disclosed purchases included about $ 429 million in bonds, including debt holdings of Abbvie, AT&T and UnitedHealth Group.
Its operations so far have been part of its Corporate Secondary Market Line of Credit (SMCCF) since the ETF and individual bond transactions are conducted on the secondary market. But the Fed announced Monday that it had fully launched its Primary Market Corporate Line of Credit (PMCCF), which will buy qualified bonds and parts of syndicated loans or bonds on issue.
When the economy got out of control in the second half of March, the Fed announced that it would support the corporate credit markets. At the time, the concern was that a dramatic tightening of financial conditions would leave companies with nowhere to turn if they needed to issue debt to survive the crisis.
The Fed announced both the PMCCF and the SMCCF, committing up to $ 750 billion in purchases when it released the term sheets for the programs in early April. But the Federal Reserve did not lift any of the facilities until May 12, at which time conditions in the corporate finance markets seemed to decrease.
Fed President Jerome Powell has faced questions from Capitol Hill as to why the Fed still feels the need to enter the corporate debt market if funding pressures have been eased.
“I don’t see us wanting to go through the bond market like an elephant doing things and turning off price signals or something. We want to be there if things go wrong in the economy, “Powell insisted in testimony from Congress in mid-June.
The Fed has hired Blackrock as its investment manager and State Street as its custodian for its corporate bond programs.
For the SMCCF, the Fed has said from the outset that it wants its purchases to have “broad exposure” to the corporate debt market, mistrusting the view of favoring certain industries or companies over others. But criticism of the Fed buying a large chunk of its ETFs in funds issued by Blackrock may have led the central bank to a different approach: building its own portfolio.
In mid-June, the Fed announced that its purchases would be guided by a “broad and diversified market index.” On Sunday, the New York Fed released the index for the first time, which detailed the 794 companies it plans to buy corporate debt in, along with weightings of how significant those investments will be. The Fed insists that it will update the index every four to five weeks.
The Federal Reserve’s “broad market index” would be more weighted across these ten companies, as disclosed on June 5. Source: Federal Reserve Bank of New York
Unlike the SMCCF, the PMCCF will not involve the Fed in the market to buy corporate bonds. Instead, companies will have to obtain certification from the New York Fed before selling bonds to Fed facilities.
The Fed has said it will primarily focus its purchases on investment-grade corporate debt, with the “rest” going to some high-yield bonds (or less free, “junk”). Through both the PMCCF and the SMCCF, the Fed will only take on junk debt if the issuer had investment grade ratings before March 22 and subsequently faced a downturn. So-called “fallen angel” companies include companies like Ford and Delta. The idea behind the March 22 cut: identify companies that were facing financing problems as a result of the COVID-19 crisis.
As of June 5, the Fed was targeting only 2.8% of its index on junk-rated (BB) bonds. The Fed expects to have about 54.8% of its index in investment grade bonds (BBB) and the remaining 42.4% in high credit quality bonds (AAA / AA / A).
The Fed has said it is targeting ETFs that are listed in the US with exposure to US corporate bonds, but the Fed’s broad index includes foreign names like Toyota, Volkswagen and Daimler. But the Fed’s disclosure makes clear that the central bank is targeting debt purchases issued by its incorporated subsidiaries in the United States.
For example, the Fed is not targeting Volkswagen debt issued by its German parent company, but debt issued by its United States-based Volkswagen Group America.
In any case, the large weights of US subsidiaries of foreign automakers may reflect the importance of their manufacturing plants and auto loan portfolios in the United States.
Both facilities will buy assets until September 30, 2020, but the Fed could extend that schedule if necessary.
It is not so clear how the Fed will exit its holdings.
Bonds purchased through the SMCCF can have a remaining maturity of up to 5 years and bonds purchased through the PMCCF can have a maturity of up to 4 years. The Fed says it can back the facilities to maturity (at which point the asset would go out), but said it could also sell the bonds on the open market.
The Federal Reserve’s plan for its ETF holdings is also unclear.
