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April 9, 2020, 3:10 p.m. EDT

Fed’s souped-up lending programs extends aid to ‘junk’ bonds

Fed will buy bonds from so-called fallen angels and high-yield exchange traded funds

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By Sunny Oh


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The Federal Reserve took the unprecedented action of offering aid to sub-investment grade companies, or “junk’-rated issuers, on Thursday when it super-sized its lending facilities to offer $2.3 trillion of credit to the companies, local governments and the broader economy.

The expansion of the Fed’s lending facilities will support a sizable chunk of the embattled and indebted junk bond market amid worries that containment measures to combat the COVID-19 outbreak could stay in place for longer than expected and place increased stress on U.S. businesses.

“This shock hits everybody, it turns good companies into questionable companies,” Roberto Perli, head of global policy at Cornerstone Macro, told MarketWatch.

In particular, investors say the Fed is now providing a safety net for former investment-grade companies to avoid a “cliff-edge” effect, in which bonds downgraded to junk were abandoned by investors because they were ineligible for the Fed’s lending facilities before.

See : Fed announces new lending plans it says will provide $2.3 trillion in support for economy.

The Fed will now buy debt from non investment-grade firms as long as they were rated as investment-grade on March 22, a day after the Fed’s corporate bond-buying programs were announced.

Economists and investors have noted former investment-grade companies that recently received a “junk” rating include large employers in the U.S., such as Ford Motor Co. /zigman2/quotes/208911460/composite F +3.36%  and Macy’s. /zigman2/quotes/201854387/composite M +18.43%  Shares of both companies were up sharply on Thursday.

But others worry supporting sub-investment-grade companies could inadvertently encourage excessive risk-taking in the future, leading corporate executives to put more debt on their balance sheets in the knowledge that the Fed would have their backs.

Beyond outright bond-buying from companies, the Fed could carry out indirect purchases of lower-rated debt through another lending program targeting exchange-traded funds.

The central bank could use up to $25 billion of funds from the Treasury Department to buy exchanged traded funds specializing in corporate debt including those targeting junk bonds. But purchases are capped at 20% of the ETF’s overall shares.

Read : Fed may nibble at junk bond market, says UBS

Shares of the iShares iBoxx $ High Yield Corporate Bond ETF /zigman2/quotes/204471305/composite HYG +0.75%   was up 6.5% on Thursday, while the iShares iBoxx $ Investment Grade Corporate Bond ETF /zigman2/quotes/206919681/composite LQD -0.14%   was up 3.8%.

Still, the Fed’s aid to junk-rated bonds will still pale to the support the central bank is extending to higher-rated corporations.

Check out : Fed’s aid to battered corporate bond market creates ‘winners and losers’

“The Fed loses leverage when it buys high yield,” said Stephen Stanley, chief economist at Amherst Pierpont Securities, in a note.

Stanley pointed out though the Fed could deploy as much as $750 billion of funds to buy investment-grade corporate debt, by levering up the Treasury-provided $75 billion funds by around 10 times. The Treasury Department’s funds also act as a capital buffer that will absorb any losses taken as a result of the Fed’s lending.

But the central bank can only lever up 7 times when snapping up downgraded high-yield debt directly from companies, a reflection of the higher potential for losses from owning such investments.

And for high-yield exchange-traded funds which could carry bonds that are rated below double B, the highest letter rating in the junk-rated universe, the Fed may only lever up to as much as three times the Treasurys’ funds, according to the central bank.

Patrick Leary, chief market strategist at Incapital, an underwriter of corporate bonds, estimated the central bank could lead to indirect purchases of $10 billion of high-yield debt through its buying of high-yield ETFs.

The reduced level of leverage the Fed could deploy to buy junk-rated bonds reflects its concerns that the central bank may take hefty losses from acquiring bonds of companies likely to default in the coming months.

“The Fed may end up losing a ton of money in this program,” said David Albrycht, chief investment officer of Newfleet Asset Management, in an interview.

/zigman2/quotes/208911460/composite
US : U.S.: NYSE
$ 5.84
+0.19 +3.36%
Volume: 86.02M
May 26, 2020 4:00p
P/E Ratio
N/A
Dividend Yield
0.00%
Market Cap
$22.47 billion
Rev. per Employee
$805,719
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/zigman2/quotes/201854387/composite
US : U.S.: NYSE
$ 6.17
+0.96 +18.43%
Volume: 64.91M
May 26, 2020 4:00p
P/E Ratio
3.41
Dividend Yield
0.00%
Market Cap
$1.61 billion
Rev. per Employee
$197,992
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/zigman2/quotes/204471305/composite
US : U.S.: NYSE Arca
$ 81.84
+0.61 +0.75%
Volume: 27.67M
May 26, 2020 4:00p
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/zigman2/quotes/206919681/composite
US : U.S.: NYSE Arca
$ 130.52
-0.18 -0.14%
Volume: 12.87M
May 26, 2020 4:00p
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Sunny Oh is a MarketWatch fixed-income reporter based in New York.

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