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.