For financial markets, March 23, 2020, is a day that will go down in history.
On that day, the S&P 500 fell to 2,191.86, easily wiping out all the gains since President Trump was sworn into office. It also marked what as of now appears to be the turning point in the coronavirus crisis. Not because of any epidemiological breakthrough, mind you, but rather because the Fed announced an array of programs in conjunction with the Treasury Department that went above and beyond the response to the 2008 financial crisis. Most notably, the central bank unveiled a facility to buy U.S. corporate bonds and ETFs tracking that market.
Since then, investment-grade bond issuance has rewritten the history books. Encouraged by the Fed’s backstop, the final week of March catapulted supply to a record $260 billion, only to be topped by April’s $285.6 billion onslaught. The first full week of May brought an additional $93 billion to market. Credit spreads are wider than they were before the pandemic, but on average remain 160 basis points tighter than their March 23 peak.
Remarkably, this all happened without the Fed buying a single corporate bond.
This seven-week period of all talk and no action will end Tuesday, with the New York Fed announcing that its Secondary Market Corporate Credit Facility will begin buying eligible ETFs invested in corporate debt. It will be the first Fed program using the $454 billion in total equity funding from the federal stimulus law to actually get off the ground.
Make no mistake, that’s a milestone in and of itself. These $750 billion corporate credit facilities are new terrain for the central bank, as opposed to purchases of U.S. Treasurys and agency mortgage-backed securities that are old hat from the last downturn. To get the program started in less than two months, while juggling several others, is impressive.
Still, it’s worth stepping back to say that the Fed is still mostly offering financial markets a placebo at this point. For better or worse, investors have mostly turned around the fortunes of risky assets entirely on their own.
STABLE CONDITION
Consider the Fed’s Primary Market Corporate Credit Facility, which would buy debt directly from issuers, rather than on the secondary market. The central bank said only that it would start up “in the near future.” Currently, there’s almost no need for it, given the record-breaking barrage of bond sales. According to the term sheet, any eligible bonds or syndicated loans will be subject to a 100-basis-point “facility fee.” The central bank will also only purchase debt due in four years or less, which might be an unappealing option to many companies that are looking to extend maturities over the coming decades. Just on Monday, PayPal and Walt Disney priced 30-year securities, joining a broader trend in the credit markets.
Relatedly, the terms for the Fed’s Municipal Liquidity Facility are also seen as overly constraining. As Bloomberg News’s Amanda Albright and Danielle Moran reported, even states and localities with top credit ratings would pay an extra 150 basis points above an overnight indexed swap rate to borrow. The Bond Dealers of America, in an April letter to the central bank, suggested a pricing penalty of benchmark index rates plus 10 basis points for double-A borrowers. Some state finance officials were taken aback:
Ben Watkins, Florida’s director of bond finance, said he was surprised by the pricing levels released by the Fed, thinking originally they were going to be lower. He said the rates may deter eligible issuers from tapping the facility and support the view of the Fed as a backstop if the market isn’t working properly.
“From an issuers perspective the first thing we ask ourselves is: ‘What is the cheapest source of funding?’ and that is what you go to every time,” Watkins said.
Even some of the industry’s cheapest products “may be overpriced” in that they’re “mirroring a passive index,” an expert says.
The question for bond traders is whether they’re comfortable being the cheapest source of funding for strapped cities and companies at this point in the coronavirus crisis. If the Fed’s facilities truly are meant as a last resort, rather than an additional source of large-scale buying power, is that consistent with the current yield levels in credit markets?
I contemplated this question of “buy the rumor, sell the news” in a column two weeks ago. Since then, the largest ETF tracking the investment-grade market, known by its ticker LQD, has only fallen further. It declined on Monday to the lowest level since April 8, the day before the Fed widened its corporate-bond buying facilities to include “fallen angels” and high-yield ETFs. It jumped in early trading on Tuesday. The largest muni ETF (MUB) is also lower than it was a month ago, with some $2.5 billion of deals considered “day to day” in a sign that issuers are skeptical of market conditions.
“We’re no longer in a market of panic, so participants can decide on a relative value basis whether they want to own investment-grade corporates or not,” David Schawel, chief investment officer at Family Management, told Bloomberg’s Molly Smith and Katherine Greifeld. The same appears to be the case for munis.
And yet, according to an agreement with BlackRock, the secondary-market credit facility will buy corporate bonds and ETFs in three stages: a “stabilization” phase, an “ongoing monitoring” phase and a “reduction in support” phase. It’s odd to think that a market with back-to-back months of record supply needs any sort of stabilization.
All this feels somewhat circular. The markets aren’t panicked because the Fed has said it will provide a backstop. But so far, it hasn’t had to do much in the way of support. Current pricing and the details of its facilities suggest borrowers may not need — or want — the central bank’s help. Therefore, the backstop could be much smaller than anticipated. The idea that the Fed will suddenly “turbocharge credit” seems misplaced.
In the long run, a light touch from the Fed is probably ideal. But those buying into the red-hot debt markets now should recognize that they’re on their own and understand the central bank’s efforts for what they are — a last resort. If companies and municipalities are flocking to the Fed’s facilities, something has probably gone wrong.
