Don't underestimate the Fed's playbook.

By: Uri Estrin - July 03, 2020 03:44pm EST
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Outstanding US corporate debt instrument issuance is around the $10T mark.
Outstanding US corporate debt instrument issuance is around the $10T mark.

The Fed announced it’s investment grade (IG) corporate bond buying program. They set the corporate bond market on fire. With $250B allocated to the special purpose vehicle and a promise to extend up to $750B, the Fed achieved a momentous task with very little risk or exposure.

With hardly any capital expended and mitigated risk, the Fed has allowed corporates – both IG and High Yield (HY), to go on a credit funding frenzy. This year saw more than $1T in new IG corporate bond issuance alone, barely into the second quarter, almost equal to the total 2019 issuance.

By giving the allusion of a backstop, the Fed has enabled corporates to gorge on new debt issuance in the hopes to raise enough fresh liquidity to see them through what the Fed may hope is a short term storm. It’s smart, really smart.

Outstanding US corporate debt instrument issuance is around the $10T mark, and with as little as a promise of $250B, the Fed has secured corporate America.When liquidity froze in 2008, TARP was an $800B injection into the ‘too big to fail’ companies, requiring the Treasury to take a messy stake and oversight into these troubled entities. The Fed has achieved at least that, if not more, by shifting the risk to the bond holders instead of the tax payers. The Fed has said it will buy IG bonds (as at March 22) with 5 years or less to maturation. In other words, they are buying short term debt of fairly good companies, who at IG are most likely to survive the length of the remaining bonds without default. The Fed isn’t chasing yield and they most probably won’t sell their holding, so they can afford to ride out a corporate bond sell off sit with a huge paper loss to maturity. Bond investors are not so lucky – their either take a capital hit or have a paltry yield for an oversized risk. There is an off chance that yields could sink further and provide the holder with a capital gain, by chances are slim given the amount of issuance to date and the deteriorating landscape.

Here’s what the Feds NOT doing. It is not guaranteeing or underwriting any of the paper. It has promised to buy corporate bonds of it’s own choosing. If some of those companies subsequently get downgraded or even default, the Fed is not mandated to step in and rescue the bond holders.

But the Feds outlook is short term – as per it’s play book – shunt from crisis to crisis and cauterize the bleeding without making any systemic changes. Market addiction to the ‘never going down’ is part of the power in a rather benign move in the corporate bond market.

In my opinion, the rush to corporate bonds is misplaced. The yield differentials between HY and IG don’t reflect enough compensation to the risky, over indebted, situation we are currently in.

Likewise, the yield spread between IG and Treasuries doesn’t compensate for the underlying risk. Should the market perception devolve (and I’m betting it will), corporates will be negatively impacted. Spreads will blow out and even though the market perception is there that the Fed will backstop (and even if they were), $750B vs $10T isn’t a fair fight. When corporate bond yields blow out to the 8%-10% yield for top quality, it would be a great buy. But at today’s spread, there is no compensation for so much uncertainty. Several IG corporate bonds will no long be Investment Grade when things get sticky. The downside risk of capital loses is large.

Ultimately it will be the bond holders are sitting holding the risk, the losses and the angst. With more and more companies heading for Chapter 11 – it’s the bond holders who get screwed – not a good place to be until the rewards match the risk. In the meantime, the Fed has played everyone with a wining hand. Fed-1 Bondholders-0

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