Not even at the depths of the 2008 financial crisis, did the man who unleashed the biggest asset bubble in history, Ben Bernanke, dare to cross the bridge into the final circle of moral hazard hell by refusing to openly monetize corporate bonds (or stocks). Jerome Powell has no such qualms, and two months ago the former lawyer shocked markets when supposedly in response to the coronavirus pandemic, the Fed decided it was high time to bail out all those investment grade companies that had spent trillions on stock buybacks as well as countless cash-burning shale PE portfolio companies, all of which were highly levered and needed a buyer of last resort to prevent their bonds from plunging, creating a self-fulfilling liquidation cascade and an avalanche of defaults. In short, the Fed said it would buy investment grade bonds and shortly after, fallen angel junk bonds, with the buying set to begin today through the Fed's Secondary Market Corporate Credit Facility (SMCCF) today. It's also why today is the first day the LQD is solidly higher in a month.
Here, courtesy of BMO's Daniel Krieter, is what traders should know:
- The program will initially buy Eligible IG and HY ETFs, "with the preponderance of purchases" being IG ETFs. The Fed will buy individual bonds through this facility once Eligible Issuers certify eligibility (with the Fed providing the investment manager a list of companies that have completed self-certification). However, these certification materials have not yet been released, and so it could be a matter of weeks before the program is expanded to individual bonds.
- Alongside the announcement of an operational SMCCF, the Fed released documentation around the various agreements made with vendors for this facility. Included in its Investment Management Agreement is a wealth of information of interest to spread market participants that was not previously made public. First, the investment strategy in broken down into three phases:
- Stabilization Phase: The facility will begin with purchases of ETFs, and be "focused on reducing the broad-based deterioration of liquidity seen in March 2020 to levels that correspond more closely to prevailing economic conditions." Purchases during this phase will occur at a higher pace than subsequent phases.
- Ongoing Monitoring Phase: As market functioning improves to near levels consistent with economic conditions, "purchases will continue at a reduced, steady pace to maintain these conditions."
- Reduction in Support Phase: The Facility will cease purchases by 9/30/2020 unless it is extended.
- Second, regarding the pace of purchases:
- The pace of purchases will be established (and amended periodically) by the Fed as a range of percentages of average daily volume in the relevant market, and will be tied to an array of measures of market functioning, the rate of change of such measures, as well as broader market health and macroeconomic indicators.
- The measures determining pace of purchases will include indicators of market functioning (such as transaction cost estimates, bid-ask spreads, credit curve shape, spread levels and volatility, volumes, and inventories), ETF-specific measures (such as premium/discount to net asset value (“NAV”) and creation/redemption volumes), and the results of Facility and PMCCF operations (such as operational execution metrics for the Facility, the demand in the PMCCF, and PMCCF share of new issuance). Qualitative market color will also be considered.
- If signs of improvement in market functioning are observed, purchases should take place towards the lower end of the range of percentages of average daily volume. If signs of deterioration in market functioning are observed, purchases should take place towards the higher end of the range of percentages of average daily volume.
- Third, the agreement states that purchases will be directed by the Fed and at times may be "concentrated in liquidity-challenged ratings or tenors" but over time will take place across the universe of Eligible Issuers in proportion to their amount of debt outstanding.
- Finally, the agreement makes T-bill and agency discount notes eligible for purchase by the Fed, which should help could help clean up excess supply at the short end of the curve. In addition, by explicitly delineating agency DNs as eligible for purchase, it is implied (though still not confirmed) that agency debentures will not be purchased by the SMCCF.
- Issuance in high grade corporates remains exceptionally strong, with $25.7 bn pricing yesterday. New issues were fairly well-received, with concessions averaging 10bp, but tightening from IPTs and order books continuing to reflect modestly waning demand, particularly outside of the highest quality names. Today looks to be similarly busy with ten deals likely to price today. Among the new deals is a 3-part (2Y Fix/FRN, 5Y) offering from Caterpillar, which issued 10s and 30s each at +200 in early-April.
Finally, while we still await for the Fed to start buying individual bonds, keep in mind the "Achilles Heel" of the ETF program, which we discussed last week, and which is i) that the Fed has made "outstanding requirements for issuers to make certain certifications to be eligible even under the SMCCF", ii) as BofA has estimated, the Fed has capacity to buy about $28b of IG and $8bn of HY ETFs given they will only buy up to 20% of each fund, a surprisingly small size which is why the ETF buying in itself will be underwhelming, and iii) The Fed's only pays a premium over NAV of at most 1%, meaning any major repricing between the ETFs and underlying bonds will ultimately be resolved in favor of whatever is cheaper.