On March 23, the Federal Reserve (Fed) announced measures to support the corporate bond market beyond the more traditional support for only financial institutions.
The Primary Market Corporate Credit Facility (PMCCF) for new bond and loan issuance will provide what are in effect bridge loans to BBB-/Baa3 or higher-rated investment grade companies for up to four years with no debt and interest payments for the first six months. We think this will be loosely modeled on the existing Commercial Paper Funding Facility (CPFF) that buys newly issued commercial paper outright.
The new Secondary Market Corporate Credit Facility (SMCCF) will buy BBB-/Baa3 or higher-rated investment grade corporate debt in the secondary market and ETFs invested in investment grade debt with the aim of offsetting the impact of redemption pressures, which have led to widening discounts between the ETF NAVs and the underlying corporate debt.
Difference Between a Bad Recession and Full Depression
The Fed is trying to deal with distressed selling. With a large-scale shutdown of activity and the resulting loss of income, businesses and households still have bills to pay and debt to service. They need cash and will sell assets to get it. A system-wide run for cash puts strains on the financial system, which have become apparent. Only central banks can create cash. These new facilities are part of the Fed's program to unfreeze financial markets and narrow bond spreads. The buying will include both short-term debt (through the commercial paper facility) and long-term debt. By doing so, companies should be able to continue to borrow and therefore continue to function. And those selling bonds can access cash to pay bills.
To repeat my standard warning, there is nothing the Fed can do to slow infections or cure the sick or offset the impacts of containment and shutdown. What the Fed can do is try to prevent the epidemic from causing a financial crisis. This may make the difference between a bad recession and a full depression. The pain of the global financial crisis (GFC) is vivid in the memory of Fed staff, and we think that explains in large part why the Fed is moving fast and furious to help prevent a financial crisis from happening again.
Potential Corporate Bond Market Implications
- The market could experience widening spreads between debt rated BBB- and higher that can access Fed support versus those below-investment-grade issues that cannot.
- Beneficiaries of the virtual floor the Fed has established under corporate bonds rated BBB- and higher could include companies that took advantage of lower rates and leveraged their balance sheets during the past decade.
- With regard to the risk the Fed is taking by creating these facilities, it is highly unusual for a BBB rated credit to jump to default. (We have seen BBB debt evolve lower in the rating scale over time and eventually become CCC and then default.) The Fed expects to get paid back at par for its purchases.
- The government earned an attractive return from its facilities that were put in place to support liquidity during the GFC.
- The government has learned lessons from the GFC. In the coming days, the government could include provisions in fiscal legislation prohibiting future stock buybacks and golden parachutes for companies accessing government funds.
- In the short run, these facilities could appear to be corporate bailouts. But in the longer run, the economy should benefit.
- We expect the rate of new viruses reported globally will continue to move the markets.
- At the current level of yields, we see many good opportunities. A selloff like the one the markets are enduring does not happen often (thank goodness) and typically does not last long. In our view, this is a buying opportunity in companies that we believe are creditworthy and represent good values. We are working closely with our traders to monitor what is available at what prices and volumes. We are seeking to put cash and liquid securities to work, slowly building positions and taking advantage of market dislocations.
Highlights of How the PMCCF Works
- The PMCCF will serve as a funding backstop for corporate debt issued by eligible issuers.
- The Federal Reserve Bank of New York will create a Special Purpose Vehicle (SPV) on a recourse basis and lend the SPV the funds that it needs.
- The SPV will (i) purchase qualifying bonds directly from eligible issuers and (ii) provide loans to eligible issuers. Bonds and loans must meet certain qualifications: a maturity of four years or less, be issued by a US corporation, be dollar-denominated, and the issuer must be rated at least BBB-/Baa3 by a major nationally recognized statistical rating organization.
- The New York Fed will be secured by all the assets of the SPV.
- The Department of the Treasury, using the Exchange Stabilization Fund, will make an initial $10 billion equity investment in the SPV in connection with the Facility. The Fed is not allowed to take credit risks, which are a fiscal action. The Treasury will provide a backstop and absorb any losses.
- Eligible issuers do not include companies that are expected to receive direct financial assistance under pending federal legislation. The scope of eligible issuers may be expanded in the future.
- The SPV will purchase bonds and make loans that "have interest rates informed by market conditions." It is not now clear how the Fed is defining this.
- At the borrower’s election, all or a portion of the interest and principal payments may be extended for six months. Such amounts will be added to, and made part of, the outstanding principal amount of the bond or loan. This is part of the general forbearance policy the country is moving toward. The Fed will lend funds and defer requiring interest until the crisis has passed.
- A borrower that makes this election may not pay dividends or make stock buybacks during the period it is not paying interest. We question if this requirement might inhibit corporations from participating in this program.
- The commitment fee paid by the borrower will be set at 100 basis points.
- Bonds and loans under the Facility are callable by the eligible issuer at any time at par.
Highlights of How the SMCCF Works
- Under the SMCCF, the Federal Reserve Bank of New York will create and lend, on a recourse basis, to an SPV that will purchase in the secondary market corporate debt issued by eligible issuers.
- The SPV will purchase both eligible individual corporate bonds as well as eligible corporate bond portfolios in the form of ETFs in the secondary market.
- The Fed will be secured by the assets of the SPV.
- The Department of the Treasury, using the Exchange Stabilization Fund, will make an initial $10 billion equity investment in the SPV, backstopping the Fed from any credit losses.
- Eligible bonds must be issued by US corporations, be dollar-denominated, have a remaining maturity of five years or less, and be rated at least BBB-/Baa3 by a major nationally recognized statistical rating organization.
- The SPV also may purchase US-listed ETFs whose investment objective is to provide broad exposure to the market for US investment grade corporate bonds.
- Eligible issuers do not include companies that are expected to receive direct financial assistance under pending federal legislation.
- The maximum amount of bonds that the SPV may purchase from any eligible issuer will be capped at 10% of the issuer’s maximum bonds outstanding on any day between March 22, 2019, and March 22, 2020.
- The facility will not purchase more than 20% of the assets of any particular ETF as of March 22, 2020.
- The SPV will purchase eligible corporate bonds at fair market value in the secondary market but will avoid purchasing shares of eligible ETFs when they trade at prices that materially exceed the estimated net asset value of the underlying portfolio.
We expect the Fed to take further extraordinary measures, as it did in 2007-2009.
The Fed signaled it is planning a lending measure to help small businesses: "...the Federal Reserve expects to announce soon the establishment of a Main Street Business Lending Program to support lending to eligible small- and medium-sized businesses, complementing efforts by the SBA." The Fed may be waiting to see what is coming out of Congress.
But the Fed is going faster and further than it did in the GFC. The main reason is that this time, we are experiencing a direct shock to the real economy.
During the GFC experience, the shock started in 2007 as deteriorating mortgages damaged banks, resulting in tighter credit, which in turn, hurt the real economy. Monetary and fiscal actions were intended to fix the financial system and so fix the economy. This time, the shock of the pandemic hit the real economy, and the financial system is a victim. The goal of policymakers is different. The Fed is using special facilities to use the financial system to help preserve the real economy.
Most of any new measures would likely involve powers allowed by Section 13(3) of the Federal Reserve Act, which gives the Fed ability to lend to non-banks under emergency circumstances. Under the provisions of the Dodd-Frank Act of 2010, the Fed would need the approval of the Treasury Secretary to use such powers.
New legislation approved by Congress will raise the amount of the Treasury’s Exchange Stabilization Fund ESF to $425 billion. That would boost the ability of the Treasury to backstop the Fed, which would allow it do more lending to the private sector.
We continue to forecast the Fed will revive its Term Auction Facility (TAF), originally created in 2007. This program allows banks to bid for funds from the Fed. The key is that the identities of the banks are kept confidential, so banks can get liquidity without stigma. The Fed would not need permission from the Treasury to create the TAF; the Fed could create the TAF under its own authority. We are surprised the Fed hasn't revived this facility yet.
Legislation under review by Congress would allow the Treasury to guarantee money market mutual funds (MMMFs), and we think it will pass. That would reduce the danger of a run on those funds. But the concern remains that households and businesses may withdraw funds not because they fear their shares will fall in value, but because they need cash to pay bills. The Fed's job is to make sure redemptions go smoothly.
Technical details can be seen here:
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