credit Markets

It’s The Klonopin, Pat. (Let’s Talk About The Fed’s Corporate Bond-Buying)

An anecdote.

Over the past couple of days (weeks, really) market participants of all shapes and sizes, and even some US lawmakers, have questioned the need for the Fed to follow through on its pledge to backstop the corporate credit market.

“I worry that [broad-based corporate bond buying now and including setting up yet a new index] starts to look a lot like fiscal policy, or it starts to look a lot like the goal is to lower spreads, despite the fact that nominal rates are incredibly low”, Senator Pat Toomey mused, during Jerome Powell’s tele-testimony on Tuesday.

“And it certainly seems to me that this kind of activity at a time when the markets are already functioning smoothly and we’re not addressing individual borrower needs, but rather making these broad based purchases, we run the risk that we diminish price signals that we get from the corporate bond market, which can be extremely important in enabling us to detect problems”, Toomey continued.

This must be maddening for Jerome Powell. The circularity inherent in that line of questioning is so readily apparent that one struggles to imagine how it’s possible that the folks doing the questioning don’t realize the self-referential nature of their inquiries.

Some of what you’ll read (and see) below will come across as repetitive to regular readers, but it’s necessary to make the point and also to set up a personal anecdote which I hope will be some semblance of instructive, as well as entertaining.

You can illustrate the Fed effect on corporate credit in any number of ways. Those who want the longer version can peruse “The ‘Powell Effect’ On The World’s Most Popular Investment Grade Credit ETF“. But for our purposes here, let’s just forget about liquidity or discounts to NAV in the ETFs, or anything else that requires second order thinking, and stick straight to the simplest possible visual. The Fed’s promise to buy corporate bonds rapidly compressed spreads.

The red dot is where we were in March and the orange dot is where we are now.

The crucial thing to understand about this is that, until May 13, the Fed hadn’t actually bought any corporate bonds, either through ETFs or otherwise. Both the primary market and the secondary market were operating in anticipation of the Fed activating both of its corporate credit facilities.

As spreads tightened, the door opened for new supply, which has approximated a Noah-style flood in 2020. The pace of high grade issuance is unprecedented.

At the same time, inflows into corporate credit are off the charts. EPFR data for last week showed the second largest IG inflow ever at $18.6 billion, for example.

Meanwhile, Lipper data continues to betray record (or near record, depending on the week) inflows into both IG and high yield funds.

Obviously, none of this is a coincidence.

It is not as if investors took a step back, calmed down, determined that things actually weren’t as bad for the economy as it originally appeared, and then abruptly decided to pile into corporate credit. This was not dip-buying because anyone thought things were on the mend. This was front-running, plain and simple.

BofA put it best last month:

Note to Fed: A lot of investors (including non-credit ones) have bought IG corporate bonds the past two months on the expectation they can sell to you. So it would be helpful if you soon began buying in size.

The implicit message is that if the Fed didn’t follow through in fairly short order, the market might start to doubt Jerome Powell’s commitment to the purchases.

Let’s not kid ourselves: If the Fed were to do what some market participants (and commentators tossing tomatoes from the cheap seats) seem to want them to do, at least some of the progress evident in the visuals above would reverse. Spreads would widen back out. The primary market would be less forgiving and could slam shut for some borrowers. Inflows would turn into outflows. Liquidity in the ETFs could begin to deteriorate anew.

If the fundamentals were to subsequently sour (say, in the event of a true “second wave” of COVID-19 that forces additional lockdowns), it would exacerbate the situation. If the Fed had recently reneged on its promise to backstop the market, another such promise would be less credible.

In the simplest possible terms, once the Fed said it was going to start buying corporate bonds (not that it might buy corporate bonds), there was no turning back. Had Powell said, on March 23, that corporate bond-buying is on the table and would remain so for the duration of the crisis, then the Fed could have plausibly sat on their hands. But that’s not what happened. The unveil of corporate bond-buying by the Fed in March wasn’t some prototype showcase akin to a car company showing you some sketches of something they haven’t built yet — no, this unveil came complete with factsheets on the facilities.

The idea that the Fed could have simply waited around in perpetuity as investors continued to pile into IG and HY funds week after week, and supply continued unabated, is laughable. Eventually, the market would have called Powell’s bluff. It’s just that simple.

So, when Pat Toomey says “we run the risk that we diminish price signals that we get from the corporate bond market”, the rejoinder is that we’re not even three months removed from the panic. So yes, the overt goal is, in fact, to diminish those price signals. Until there are concrete signs that the economy is getting traction and borrowers could access capital markets in the absence of the Fed’s backstop, we’re not interested in finding out what those “price signals” might suggest.

Consider this: There’s not much in the way of clarity around corporate earnings. Given that, it’s impossible to say much about how levered a given company is, or how rich its equity is trading on a forward multiple, etc. When there is no clarity on that, market prices will reflect that uncertainty in the absence of a reason to ignore it. In this case, that reason is the Fed’s backstop.

Now, you can of course argue that the Fed has made that situation even more vexing. After all, some of the corporates which took on more debt over what is now a four-month borrowing binge, may find that debt difficult to service later.

You could also argue that this is a problem of the Fed’s own making. That is: If you didn’t want to create a situation where you were forced to follow through on a promise that’s replete with moral hazard, then you shouldn’t have made the promise in the first place.

But that begs the question. Either you think the Fed should have stepped in to ensure that COVID-19 didn’t cause a wave of systemic credit events, or you don’t. The argument that the Fed should have let a pandemic and a self-inflicted collapse in economic activity drive companies large and small into insolvency is clearly absurd. And that’s putting it nicely. It’s actually lunatic.

Going forward, the Fed has to make good on its promise to buy corporate bonds. If they don’t, spreads will widen again, the market will start to exhibit other signs of stress and could ultimately start to freeze up.

Once upon a time, when I went through the extremely arduous process of dropping a decades-old habit of consuming enough expensive scotch and bourbon every day to tranquilize an adult giraffe, I was prescribed Klonopin (obviously on the condition that I did not take it with alcohol). The purpose was to ensure that the physical shock associated with depriving my body of Balvenie and Woodford didn’t lead to panic attacks (or worse).

If you know anything about benzodiazepines, you know that their mere presence in the medicine cabinet is itself calming. For those unfamiliar, that class of anti-anxiety drugs (which includes Xanax and Ativan) is highly effective. They work infallibly.

My use of Klonopin during that period was actually very limited. But the drug was a life-saver (figuratively, I hope) on at least a half-dozen occasions. At all other times, simply having it around was enough of a palliative, without having to actually ingest it.

The point of that brief anecdote is this: More than a half-decade later, I still do not know whether that Klonopin was necessary or not. What I do know, though, is that if my neurologist had simply said “I will prescribe it if you think you need it”, as opposed to saying “I’m going to go ahead and prescribe it based on what I think is likely to happen when you go cold turkey off the scotch, and you can choose whether or not to take it”, there would have been some harrowing days with an empty medicine cabinet.

That was all I could think about Tuesday when Senator Toomey said “I’m wondering why we need to be continuing a broad based corporate bond buying program now”. Here is the expanded version, from the transcript:

Mr. Chairman, I want to talk about corporate bond buying because when we put together the Cares Act, the concept of funding SPVs so that they could go out and buy corporate bonds, whether through ETFs or whether through a new Fed created index or directly, there were always two reasons for having this capacity. One was to ensure the smooth functioning of the markets. For that, the mere existence of these programs has been remarkably successful. We’ve seen record volumes of corporate debt issuance. Clearly, the corporate bond market is functioning and functioning very, very well. The second possibility was to provide liquidity to a company that’s fundamentally solvent, but facing a serious liquidity problem because of the nature of the moment. It seems to me that continuing broad-based buying of corporate bonds now and including setting up yet a new index for doing so doesn’t serve either of those purposes.

In another part of the exchange, Powell attempted to explain this to Toomey. “The main reason… is we feel that we need to follow through and do what we said we were going to do”, he told the senator.

“But if it’s not needed, it’s not clear to me that you have to use it anyway to show that you’re willing to use it”, Toomey said. “I don’t think anybody doubts your willingness to use it”.

Maybe not. And I didn’t doubt my neurologist’s willingness to call in a prescription, either.

But ask anyone who’s ever had an honest-to-God panic attack if that’s relevant in the moment.

It’s the Klonopin, Pat.

Read more: The Fed Will Be Building A Corporate Bond Portfolio. Or Didn’t You Believe Them?

19 comments on “It’s The Klonopin, Pat. (Let’s Talk About The Fed’s Corporate Bond-Buying)

  1. you should send this anecdote to Powell and Toomey… or the Times in a letter.

  2. Great post.

    The Fed really has prevented deflationary winter. I’m a piss ant retail investor, but knew that there would be the buying opportunity of a lifetime in junk bonds. It was one of a handul, of when it happens, I’ll plunk some down trades. Didn’t really get the chance. This is as close as I’ll ever get to Gundlach et al.

    There is no stopping this. The Fed has to ensure that credit growth is, or gets back to, low, single digit positive. This is how our economy works any longer since maybe decades ago. They will keep going because they have to. They will bail out (almost) everyone anywhere at some point. We know if they stop, it all collapses. It just keeps getting bigger. What’s the difference between $250T and $500T worldwide obligations, and between a Fed with a $3T balance sheet and a Fed with a $30T balance sheet.

    Not that I wanted the system to run like this. Just saying. Now, we have to figure out where the next sieve of credit is going to be placed and position our tiny piss ant selves underneath to reap the dimes.

    • The difference is the point of no return, increasing the risk of sistemic change (revolution), normally leads to wars. If you dont let a system balance and adjust its risk it will fail catastrophically. Not a prospect I look forward to, with rising inequality.
      This approach to privatising profits and socialising costs… is only exarcerbating that.

  3. This is what I worry about and why I am unable to push the “buy” button-
    It seems like corporations, per your post, who are facing liquidity (but not solvency issues) have access to debt. Assuming they can service the debt (tomorrow’s problem), the Fed is buying that debt, so the issuer/holder is made whole and then some.

    However, what about commercial real estate (not owned by a REIT or other corporation), or a small business? These types of entities are on a slow motion train wreck to insolvency because they do not have the same access to debt.

    For example- commercial office and retail real estate is dealing with tenants (from CVS, Starbucks down to mom and pops), who are not paying rent, frantically renegotiating leases to reduce space/rental rates or vacating.
    Landlords are not able to borrow much because banks are
    1. reappraising properties using significantly lower rental rates and higher vacancies- which result in much lower values against which loans can be made
    2. requiring lower loan to value ratios than they were pre-covid
    3. requiring borrowers to personally guarantee loans.

    Meanwhile, the drop off in the amount of rents collected are leaving landlords without enough cash flow to service debt, pay real estate taxes and operating costs.

    The commercial real estate market is approximately $17T and I do not know the size of the businesses that are small and do not have access to the corporate debt market. However, even if only 20-30% of these two categories do not have access to the corporate debt market and need cash to survive, the amount needed, in total, would likely be in the trillions.

    This is one of several looming disasters that prevents me from getting back into the market.

    Thanks for the fantastic, nuanced writing.

    • Totally agree ( having been a small business) … Problem is that the system does a poor job in defining Small Business some of the reason due to market caps put on Tech based companies with no track record the last 20 years.. My experiences pertain to a totally different category of Entrepreneurial endeavor (main stream industries) usually sales under 50M or so manned by high earners with incomes in 7 digit numbers…. We don’t register on the Govt. scale except at Tax time.

    • I have no sympathy for commercial real estate landlords in NYC. None. Their unbounded greed has turned my once vibrant neighborhood into a wasteland of empty storefronts. A plague on them.

  4. We are in uncharted uncertain times and the system will not reverse it’s course because it can’t even more than it just won’t.. The efforts put into this website by it’s owner ( and the Pet Giraffe ) has given all of a view of events from an elevated trajectory that would be a difficult achievement under other circumstances.. A sense of reality is the gift that is offered on a day to day basis and that challenges what we think we know and translates it to what likely will be… Still the law of unintended consequences looms ahead ….but even in this we are better prepared intellectually. Appreciate the diversity offered in the comment section a lot..

  5. Great post. I had the same experience after having weird anxiety attacks (which I never had had before) many months after my Dad died. I did not think they were related at all, due to the lag and also the fact that while I missed my Dad, I didn’t feel unduly sad or depressed about it. The doctor declared my heart and vitals fine and insisted it was anxiety. But the attacks persisted despite that insight until he finally prescribed Ativan. I barely used it, but knowing it was there helped tamp the attacks before embers turned to flames. Before that, I would feel an attack coming on, and that would produce a self-feeding cycle of more anxiety. Knowing those pills were in the next room, ready to put out the fire, was all that was needed.

    Glad you got sober and stayed on the planet.

  6. Obviously, you and I disagree on the need for and the usefulness of, Fed intervention in a free market. I for one feel that without the Fed, several major corporations would have been non-existent by now who have made multiple bad decisions in each of the past two financial crises. What Fed intervention has signaled to EVERY business is that you don’t need to follow sound financial business practices. Regardless, if you borrow beyond your capacity to pay, we will step in and give you 0% loans when the economy bears down on you. And we will likely never expect a repayment of those loans. If you spend a Trillion dollar tax cut on share buybacks and thus do not have enough capital cushion to weather a down market, we’ll bail you out again.

    From a free market perspective, this enables bad business practices and blocks new innovative startups from filling the gaps. Those highly leveraged and entrenched companies will always have the advantage regardless of whether or not they should even rightfully exist anymore. Politically we could debate how we got to this point, but it’s fairly indisputable that we’ve lived in an oligarchic kleptocracy even before Trump was elected. He’s magnified this problem through his administration’s complete disregard for discretion.

    The real problem here though is not the lack of free markets or the ability of startups to gain ground against entrenched corporations. The real problem here is historic unemployment. The largest payers of taxes in this country are the least represented when the economy goes south. Businesses that are furloughing citizens and completely cutting off their ability to make ends meet are being rewarded with loans. Businesses that have been outsourcing jobs, eliminating jobs through automation, paying executives 1000X the average salary for employees, and buying back shares to incentive shareholders are who the Fed is most concerned with.

    This is the real problem.

    • That is one heck of a well written answer although I am not 100% in agreement….

      • I appreciate the sentiment. My view isn’t politically based even though it may appear that way.

        As an investor I have become increasingly frustrated by the complete disconnect of the stock market from it’s fundamentals. Our entire economy is a nihilistic representation that if you follow trends and government bailouts, it doesn’t matter if the fundamentals express an economy that is deeply troubled. I don’t think any of what is going on right now is real and I still feel that every asset class has a reckoning coming before this cycle is over.
        If you acknowledge, as I do, that the US economy is built almost entirely on consumerism. Then the group you should most hope for the government to support in a downturn are the people who can best restore the fundamentals of any business. Whether or not you want to describe government subsidizing of tax payer’s incomes as “handouts”, it’s impossible to argue that this type of stimulation provides positive GDP outcomes. The bounce in May, is directly attributable to the stimulus checks that were sent to in need taxpayers who turned around an immediately spent them.

        • You neglect to mention that “a free market” is the root cause of virtually every problem you cite.

          American-style capitalism (the unbridled “free market”) is why the US is so unequal.

          You correctly identify all of the problems in very eloquent terms, but you’re not properly assigning blame.

          The blame lies with the free market itself. Somehow, you’ve managed to both critique American-style capitalism and celebrate it all in one comment, which, despite outward appearances, is not always internally consistent.

          • Also (and I don’t want to put words in your mouth, but it’s essential that this is clarified for readers), there is no question (none) that the Fed’s emergency facilities backstopping the commercial paper market as well as prime funds are necessary. Same goes for the swap lines and the foreign repo facility. I don’t think you’re arguing against those, but too often, when people criticize “intervention”, they conflate all emergency facilities. Nobody with an understanding of markets would dispute the need for the facilities I just listed. I know you didn’t mention those, but again, it needs clarifying. You can’t let dollar funding markets freeze. You just can’t. It’s a non-starter. In no world will that ever be allowed to happen.

          • Agree to disagree I suppose. How can you view a market where the government has picked winners and losers to be “free”? Example, Bear Sterns failed while every other investment bank survived in the last recession. Was that due to free markets? They were not supported to be able to survive and thus failed.

            As another commentor noted, the current fed intervention primarily helps large corporations at the expense of small businesses. If our government is putting their thumbs on the scale for a particular segment of a market, then how can that market be considered to be freely operating? This is further portrayed through the Treasury’s complete unwillingness to even disclose who has even received tax payer funding.

            Now I’m not idealistic enough to ignore that in some cases government intervention will be required to prevent an economic catastrophe. However, where was the oversight prior to Covid-19 that said the corporate debt bubble was out of control and not sustainable for the longer term? It never happened. Covid-19 exposed the flawed fundamentals of all of these failing businesses who ignored future risk for current shareholder dividends.

            Put another way, if you or I decided to spend like there was no tomorrow and suddenly found ourselves out of work, what would happen? Would we get bailed out? No, we’d have to sacrifice all of our assets to our creditors and figure out a solution for how to survive on our own.

            And yes, thank you for distinguishing the difference between the commercial paper market et al emergency facilities, I agree that they are a necessary requirement.

            By the way, I appreciate you taking the time to respond to me and regardless of our agreement, I find your blog to be the most mentally challenging analysis that I read every day, and I am myself an analyst.

          • “Bear Sterns failed while every other investment bank survived in the last recession.”

            Really? I seem to remember an incident involving Lehman, but maybe that’s just my imagination. I’ve done a lot of drinking since then, so maybe my memory is fuzzy.

            Jokes aside, if you’re an analyst (I assume you mean at a bank), you know as well as I do that allowing the dominoes to just keep falling after Bear and Lehman (Merrill would have been next and then Morgan and then after that, it would have spread to BofA and Citi), is a silly proposition. I certainly hope you are not suggesting that in your hypothetical “free” market, local lenders and community banks would have swiftly stepped in with “innovative” solutions to fill the gap left by the largest global financial institutions after we allowed them to disintegrate on principle. Spoiler alert: That’s not how that would have turned out. It would have turned out with dark ATMs, and probably with some kind of martial law to avoid mass looting when payment networks ceased to function, and shelves went bare because without major financial institutions, corporations wouldn’t have been able to float short-term paper to finance their day-to-day operations. It would have been literal anarchy.

            But on top of that, I wonder if you’ve just started reading the site again. I recognize your handle, but I guess I’m confused as to the tacit suggestion that I don’t believe in bailouts for Main Street. As everyone here knows, I’ve spent the last three months arguing every, single day for the implementation of MMT now, and for the primary dealers to be cut out of the process, and for the Fed to directly monetize the deficit so the money goes directly to Main Street. I’ve been so adamant about that, in fact, that some readers got irritated about it. ha.

            My point with this post (and others like it), is simply that there is nothing inherently nefarious about the Fed’s decision to backstop the corporate credit market. The ECB and the BoJ have been doing this for years. Does it distort the market? Sure. Is it absolutely necessary? Probably not, depending on your definition of “absolutely necessary”. Is it indicative of the type of policies which have exacerbated inequality in the QE era? Absolutely. But is it some kind of moment that we should all collectively mourn and that will be enshrined in the history books alongside the comet that killed the dinosaurs? Not for me it’s not.

          • Correct, I used to subscribe and took some time off.

            I wasn’t implying that you don’t agree with main street bailouts, I was just arguing the point of view that the government and by extension, the fed, seem to be taking. I find your analysis to be conversely, a more eyes wide open approach. Which is refreshing.

            I agree, community banks couldn’t fill the void for large lending houses. However with no consequences for those large institutions, we find ourselves right back where we were 12 years ago with CLO’s replacing CDO’s. https://www.theatlantic.com/magazine/archive/2020/07/coronavirus-banks-collapse/612247/

            I agree that the fed is not behaving nefariously as well. But they are exacerbating the problem that is not theirs to solve. And as you so eloquently pointed out, as Congress refuses to act, the fed is forced to step in.

        • I don’t know how much of the May bounce is directly attributable to stimulus checks but I believe you are spot on as it relates to the transmission mechanism for allowing “free markets” to clear is completely broken. There is no way this ends well. Unfortunately, I suspect this will all come to a head around the time I’m ready to retire.

  7. Ah the ‘free market’; the problem is everyone has their own definition which makes discussion confusing and disconnected. Some folks think the market isn’t free until they say it is. What we have may not be a textbook free market but it is our free market. There is a general disconnect in the world of economics; the textbook version versus reality. The perfectly rational consumer is just one example.

  8. Companies needed that $1TR to survive. If it wasn’t provided, the job losses would have been 60MM not 30MM and those losses would be permanent. So that money had to be provided. By credit investors. The Fed’s support for the credit markets meant that investors provided it, but they got 3-6% in return instead of 6-9%. This was a bummer for some credit investors, I guess, but a lifesaver for the large majority of credit investors – those holding the outstanding debt – not to mention companies, employees, and equity investors.

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